Have you ever wondered why home prices in your city are what they are? It likely has something to do with the demand and supply of real estate.
From your economics 101 course in college, you probably know that when demand for a product is high and supply is low, prices tend to be higher. Conversely, when the demand for a product is low and supply is high, prices tend to be lower. The real estate market is no different. However, the factors that influence the demand-supply of real estate are not as simple as they may seem. Let’s take a look at those factors:
Factors that Influence Demand
In real estate, demand is how many people want to buy homes. A variety of factors influence this.
Interest rates play a key role in housing demand. If all things are equal, then the lower the interest rates, the higher the demand for real estate. Low interest rates mean that the cost of borrowing is lower and homebuyers can afford to borrow more by way of a mortgage and, consequently, can spend more on a home. The reverse also holds true; high interest rates mean that the cost of borrowing is higher and homebuyers can afford to borrow less in a mortgage and, therefore, can spend less on a home.
Think about it this way: Back in the 1970s and 1980s, when Canadians were seeing double-digit mortgage rates, many people didn’t want to own a home. Housing demand was down. It simply didn’t make sense to own a home when mortgage rates were almost as high as credit card interest rates. Conversely, with mortgage rates at less than 3% these days, this low cost of borrowing has helped fuel the demand for real estate in markets across Canada.
The overall economy and job market also play key roles in the demand for real estate. When the economy is good, the demand for real estate tends to be higher. However, when the economy is struggling, demand for real estate tends to be lower. It’s the same for the job market. When the job market is good, demand for real estate tends goes up; but, when the job market is poor, the demand for real estate goes down.
This makes a lot of sense; if the job market is struggling and you’re out of work or you’re unsure whether your job is secure, you probably aren’t going to rush out to buy a home. Similarly, when the job market is doing well and your employer and the overall economy are on the upswing, you’ll probably feel a lot more confident about buying a home.
The same can be said about the overall economy. While you might still have your job during a recession, you also might be worried that you could be laid off at any moment, and you’re probably not looking to buy a new home. The last thing you want to do is to is buy a home, lose your job shortly afterwards and have no way to afford the mortgage payments.
Affordability is the third factor to consider. This simply means how affordable real estate is in your desired city or town in comparison to your paycheck. When home prices are high relative to income, demand tends to be less, whereas when home prices are low relative to income, demand tends to be higher.
For example, Toronto has a low overall average income, but home prices are the second-highest in the country. Meanwhile, Ottawa has a higher average income than Toronto and lower overall real estate prices. This plays into the demand for real estate in both markets and the price of homes.
The affordability of renting also plays into the demand for real estate. If renting is a lot cheaper than owning a home, people may choose to rent instead of own.
Immigration also plays into the demand for real estate. The more immigrants there are in a particular city, the higher the demand for real estate. In order to become a Canadian citizen and a permanent resident, an immigrant needs to earn a certain number of “points.” That means that they have a bright future and are likely to earn a decent income, which helps them buy into the real estate market and boosts the demand for real estate.
As an example, the Greater Toronto Area sees about 100,000 new immigrants each year, which boosts demand for real estate and leads to higher home prices.
Likewise, foreign buyers also affect the demand for real estate. These foreigners are looking for a safe place to park their money outside of their home countries. Although they may not plan to reside in Canada, buying a property here means there’s a higher demand for real estate and decreases the supply, as well. While a foreign buyers’ tax has been introduced in some areas, foreigners with deep pockets may not mind paying it – so it may not affect demand that much after all.
In recent years, the government has been tightening mortgage qualification rules. While you used to be able to get a mortgage with a 40-year amortization, you can’t do so anymore. Now, the maximum amortization available for someone putting down less than 20% is 25 years, while the maximum amortization is 30 years for someone putting down more than 20%. If you earn a decent income and you’re buying in an affordable real estate market, that may not be a problem. But, if you’re buying in a city like Toronto or Vancouver – where home prices are higher – it may disqualify you from a mortgage on the property you had hoped to buy.
The mortgage stress test has also had an effect on housing demand. If you’re buying a home, you must qualify at the greater of your mortgage rate plus 2% and the Bank of Canada’s five-year benchmark rate (currently at 5.19%). This has essentially reduced the purchasing power of homebuyers by about 20% compared to before the stress test went into effect. Homebuyers who were on the cusp of being able to afford a home before the stress test may now choose to sit on the sidelines because they simply can’t afford to buy a home under the new rules, thus reducing demand.
Factors that Influence Supply
Let’s turn to the less-discussed side of the equation: the supply of real estate.
Active listings play a key role in the supply of real estate. More active listings mean there’s a greater supply of homes for homebuyers to choose from. However, when active listings are tight, there are fewer homes to choose from; one neighbourhood might have only one or two homes for sale. Fewer active listings and stronger demand for real estate mean that homes are more likely to sell for more. However, if there are many homes available but few buyers, then homes are likely to sell for less or not at all.
There are two main types of homes: existing homes and new homes. Existing homes are those that aren’t new, while new homes are newly constructed homes. When there’s a mismatch between housing demand and supply, new homes can help fill the gap. However, there have to be enough new homes built to keep up with demand. When a lack of serviceable land and government red tape gets in the way, the new homes being built simply may not be enough to keep up with demand, thus leading to higher home prices.
In new home construction, permits influence the supply of housing. If there’s a lot of government red tape and it takes a long time to bring new homes to market, there tends to be a lower supply of homes, which means that home prices tend to be higher. However, if the government streamlines the process for obtaining a permit, then there tends to be a greater supply of homes and, consequently, prices tend to be lower.
It’s important to note that more permits doesn’t necessarily mean a greater number of homes will be built. A new home project still has to be financially viable for the developer to proceed with it. If home prices drop too much or interest rates go up, it could lead to a developer deciding not to move forward with a project – even if they have the permit to do so.
Land also plays a big role. At a high level, land use is as the name states – how you can use the land – and it’s generally controlled by municipalities. Land use determines whether you can build residential or commercial properties there. It also stipulates density, the height of the buildings and the types of properties – such as houses, townhouses or condos.
If there’s a mismatch between the land use and the demand for new homes, it can lead to a shortage of homes and an increase in home prices. For example, if everyone wants to live in a detached house with a yard in a certain area, but the land use only allows for condos, it could lead to higher home prices for the few detached houses that are there.
A lack of land can also lead to higher home prices. For instance, in Vancouver, the close proximity of the mountains means that there’s only so much land available for housing developments.
As you can see, there are several factors that influence the demand and supply of housing, and each plays an important role. The next time you ask yourself why home prices are higher in a certain area, be sure to consider each of these factors. Although it’s tough to say how much each factor contributes to higher home prices, it’s almost certain that each of them is playing a role in one way or another.
This is a guest post by Sean Cooper, the bestselling author of the book, Burn Your Mortgage: The Simple, Powerful Path to Financial Freedom for Canadians. He bought his first house when he was only 27 in Toronto and paid off his mortgage in just 3 years by age 30. An in-demand Personal Finance Journalist, Money Coach and Speaker, his articles and blogs have been featured in publications such as the Toronto Star, Globe and Mail, Financial Post and MoneySense. Connect with Sean on LinkedIn, Twitter, Facebook and Instagram.