Systemic Failures of the Canadian Real Estate Market
It wasn’t too long ago when the hottest topic for conversation among Canadians revolved around the weather. However, the focus over the past couple of years has shifted towards an ever bubbling real estate market.
Real estate prices across the country have been increasing so significantly, that double digit percentage moves have become the norm. In fact, prices have appreciated by magnitudes that Canada was the only country that had two of its cities listed as unaffordable in the top five real estate markets globally, according to a report by Urban Reform Institute.
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Yep, you guessed it! Vancouver came in second only to Hong Kong, and Toronto came in fifth, after Sydney and Auckland. Montreal and Ottawa were also rated as unaffordable.
Why is Canadian real estate booming?
Several factors come into play when determining the price of (Canadian) real estate.
Habitable land
While a quick glance at a globe (or Google Maps) may motivate one to conclude that Canada is roughly the same size as the United States, the reality is that most of Canadian territory is unhabitable. In fact, around 80% of Canada is uninhabited due to harsh weather and inhospitable terrain. Moreover, around 90% of Canadian residents live within 100 miles of the Canada-US border due to the abundance of arable land. So Canadian residents do have to cram into a much smaller-than-meets-the-eye area.
Immigration
In 2019, Canada welcomed around 341,000 immigrants, which is around three times as many immigrants per capita as the U.S.
Canada’s immigration system gives preference to economic-based applications, which made up around 57% of all immigration categories. This means that Canada aims to attract more individuals into the working force.
And why do you ask?
Death and Taxes!
Workers generate income, income is taxed, and governments use tax dollars to fund their spending! That’s not too shabby of a plan, especially for Canada, which has one of the highest income taxes in the world easily ranging between 30% to 50%.
But if taxes are for certain and consume about half of one’s hard earned money, then living costs better be affordable to make it worth the long winters. Spoiler alert, they are not.
Free money
Well not entirely free, but interest rates in Canada (and globally) are close to all time lows. This means that investors are able to borrow money at an annual cost between 1% and 2%. With money being so cheap and easily available to people, it seems attractive to borrow at the low rates and invest the funds in assets that have generated significant returns in the recent past, such as real estate. Thus, the availability of cheap capital fuels the real estate bubble.
While this may seem like a lucrative idea for now, investors may find it hard to pay off their mortgages and loans when interest rates begin to rise again (which they most definitely will). Those who have currently maxed-out their borrowing capacity will find themselves paying significantly more in interest to the banks when rates begin to rise again. If interest rates rise enough to the extent where many individuals begin defaulting on their mortgages, people who have leveraged positions will not be able to exit their real estate investments quick enough before prices start to fall, leaving them with an asset that is worth far less than what they had purchased it for.
Blind auction model
In Canada, people bid on real estate in a blind auction. This means that after a seller puts their real estate up for sale with an expectation of what they would like to get for it, investors submit their offers such that they are only visible to the seller. Investors do not have any indication of how much their counterparts are bidding for the property. After all offers are in, the seller (via their broker) typically reaches out to the potential buyers to sharpen their offers, which most often results in a bidding war that can push the price well above asking. It is not uncommon to see properties going for 20% to 30% above asking with premiums upwards of CAD $300,000. Yes, the premium in itself is what a house is sold for just south of the border.
Many real estate agents defend the blind auction model, stating that the final price the property is sold for is the true value of the property since it is what someone was willing to pay for it.
I argue that the prices at which the properties are being sold include a very large FOMO — Fear Of Missing Out — premium. People are placing outrageous offers, well above the second best offer, because they fear that if they didn’t, they might lose out by a few hundred dollars. So they go all in and max out their borrowing capacity. Even then, this is not enough and people are missing the mark by a mile.
Moreover, investors do not really know how many other offers (if any at all) they are competing against. The blind auction model is highly succeptible to manipulation where the real estate broker on the seller’s side can fabricate a fake offer just to create the illusion of competition. Another form of deception that can occur is when the broker of the seller and of the buyer collude in order to extract the highest valuation for the property. And why would they do that you ask? Read on!
Variable broker commissions
Real estate brokers in Canada earn a commission that typically ranges between 3% and 7% of the value of the property sold. The seller typically pays this commission, which is split between the buyer’s and seller’s brokers.
For example, if a house is sold for $1,000,000 (which you would be lucky to find), the seller would pay a 5% commission fee (2.5% for each broker), which would amount to $50,000 (or $25,000 per broker). If we included HST (yes you pay a 13% tax on that) that would total $56,500. So you are able to earn more than the average and median wages of the working force in Canada if you simply execute two deals as a real estate broker. Not a bad return on time invested!
If the incentive of both brokers is positively associated with the value of the property sold, then the odds are stacked against the buyer. It is not only the seller, but also both brokers, who wants the property to be sold for the highest price.
While a variable percentage commission can be very lucrative when the market is going up and investors are pouring in to scoop up properties, the higher real estate prices eventually make it harder for the brokers to find buyers who can afford to pay an arm and a leg. This can lead to many brokers struggling to make a sale and eventually going out of business, leaving behind a less competitive brokerage industry.
What will it take for more affordable housing?
If we want to have more affordable housing in Canada to be able to attract and keep talented individuals while offering and maintaining a superior quality of life, we need to implement policy changes on multiple fronts.
- About 89% of Canada’s land is Crown land (i.e. owned by the government), where 41% is federal crown land and 48% is provincial crown land. The government should be more proactive in releasing affordable land to the public and supporting affordable housing programs to encourage new builds.
- Canada is built by hard working immigrants, and many people around the world yearn to move to Canada to be part of this amazing country and enjoy an exceptional quality of life. However, welcoming an extremely large number of new migrants without having the proper infrastructure in place can only cause a downgrade of that quality for everyone.
- Interest rates have been kept artificially low for years, which has resulted in household debt levels to reach all time highs. While there is a case to keep rates low to boost the economy after the pandemic, investors should understand the risks associated with borrowing against an asset class that has been dubbed by many experts a financial bubble.
- Making the auction market more transparent (yet still anonymous) can help eliminate the fear factor from the pricing equation of Canadian real estate. Similar to eBay, or any auction house, investors should be able to bid on a property while knowing how many authentic bidders are competing and what the current best offer is for the property at stake.
- Broker incentives, especially the broker’s commission on the buyer’s side, should not be proportional to the value of the property sold. A simple flat fee structure can help eliminate the bias that brokers may exhibit to push the selling price as high as possible.
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