The Canadian Real Estate Bubble’s Supply Shortage Myth Is Unraveling: BMO

Canadian real estate suddenly had a shortage of supply after record low rates. Not in major boomtowns, but in small cities and rural municipalities. Canada had the biggest boom, but this was seen in almost every advanced economy. Right after rates were slashed to stimulate demand, everywhere had a sudden shortage. BMO Capital Market economists have maintained this was a credit driven bubble. Climbing interest rates are now showing the supply shortage narrative is collapsing.

Canadian Real Estate Was Driven By A Speculative Bubble, Not Supply Shortage

BMO has prominently challenged Canada’s supply shortage narrative. With the exception of SFU professor Andy Yan, few professionals questioned the supply narrative. It just made sense — interest rates were cut and there were no more houses. Obviously low rates designed to stimulate demand to help inflation had no role. Clear as mud to most economists. 

It’s true there was a shortage of real estate inventory for sale across Canada… the US, Australia, the Netherlands, and pretty much every advanced economy. That’s an intended consequence and natural reaction to slashing rates.

Slashing interest rates help expand budgets but more importantly stimulate demand. This demand stimulus is meant to overrun the supply and increase home prices. When prices rise, it attracts more people to buy as well. No one wants to pay more for something, and it’s the same principle that drives deflation fears. Falling prices mean people wait to see how much they’ll fall, while rising prices lead to FOMO. It’s a well understood feature of inflation.

At the same time, no one wants to sell their assets as prices climb since it’s their golden ticket. No one wants to sell a tool that’s paying them thousands of dollars a month. In fact, existing owners of that asset even try to leverage to buy more. This is prominently seen with the influx of cash flow negative investors. Canada has seen over a quarter of recent purchases from investors.

Everyone saw a once in a lifetime opportunity to make a fortune, it didn’t matter where. Canada, the world’s second largest country and one of the most sparsely populated — had run out of land. Not in Vancouver or Montreal, but small towns and rural land, often in the middle of nowhere.

BMO wasn’t buying it. “For much of last year, we relentlessly harped on the wildness in Ontario housing markets in medium and small cities,” said Douglas Porter, the bank’s chief economist. 

Small, Low Income Rural Real Estate Markets Were Trading Like High GDP Cities

To illustrate his point he uses Chatham real estate. A nice but unremarkable town about 3 hours from Toronto. Typing it into Google gives you the second most common question, “Is Chatham a deprived area?” It somehow became a boomtown, where investors and exuberant home buyers sent prices up at a rate even faster than Toronto. 

“One choice example was Chatham, where after decades of almost no growth, prices suddenly vaulted by roughly 90% in the first two years of the pandemic,” said Porter. 

Adding, “The sprint lifted home prices in cities like this above Edmonton (which as recently as four years ago sported prices double that of Chatham), and almost to Calgary levels.” 

Chatham trading at prices close to Calgary. A small, largely rural, real estate market at the same price as a global energy hub. With half the median household income as Calgary, to boot.

No, Every Market Didn’t Suddenly Run Out of Housing After Rates Were Cut

The surge in price was attributed to a shortage of supply, and no one would hear otherwise, explained BMO. “A certain segment of analysts—i.e., almost everyone except us—assured us that this was all due to a shortage of supply, while rampaging investment demand amid rock-bottom rates had almost nothing to do with the sudden price spike,” said Porter. 

“Strange how cities as widespread as Windsor, Welland, Woodstock, and Waterloo all simultaneously had a p
ressing supply shortage, after decades of no such talk in this region.” 

The supply shortage occurred in almost every advanced economy with excessively low rates. BMO argued last year that it was unlikely major cities all around the globe ran out of land at the same time. It was also unlikely that city management failed all at the same time as well. More likely this was due to excess demand created from easy credit.

The BIS, the global central bank organ, produced research arguing central banks inflated real estate prices. They released a study attributing the global home price boom to monetary policy. Cheap credit was the primary driver they argue, not a lack of supply. Monetary policy mistakes were made around the world as they basked in easy growth.

The BIS advised central banks to raise rates and reduce credit to reverse the mess. Failing to do so can result in a financial crisis, they warn. It should be noted that Canada’s central bank head was recently appointed the BIS Chair of Governors.

Phew! Higher Interest Rates Solved The Real Estate Supply Crisis

Lo and behold, higher rates have suddenly solved the supply crisis. Many people aren’t aware that demand needs to be qualified or it doesn’t exist. Everyone wants a diamond the size of their head, but are they willing to shell out millions for it? Probably not, so making more to buck inflation probably isn’t the limiting factor. Bluntly put, it doesn’t matter if there’s a bazillion investors waiting to buy homes. They aren’t buying them at these prices, so the demand doesn’t actually exist. 

When rates climbed and prices began falling, qualified demand to buy at these prices fell off a cliff. Good-bye investors looking to buy cashflow negative properties and depend on appreciation. Hello new inventory. 

“Well, presto-changeo, the first moderate rate hikes have caused prices in these hot-house cities to suddenly plunge with precisely no change in the fundamental supply backdrop,” he said. 

“Chatham, for instance saw a 20% price drop in the four months to June—one of the largest pullbacks in the country; and recall, this is before last week’s 100 bp mega hike weighs in. Do you suppose that in fact all along that it was out-of-control speculative demand that was the real issue?” 
Central banks. Is there any crisis they can’t create solve?

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