Are First-Time Home Buyer Incentives Justified?
By Mustafa Bukhari, CCUF Columnist at Queen’s University
Many pundits say that property values in Canada are overvalued. The fundamental factor which should determine housing prices is income. So any growth in GDP per capital should be matched by housing prices, and if property values rise faster for a sustained period of time then a bubble will essentially be created. Canadian house prices have risen by 23% in real prices where as income has risen by 16.4% over the same period. Over a substantial 10 year time period this is quite an over valuation so why is it that prices have risen faster than incomes and are we in a bubble?
Inflation can affect housing in a number of ways. The nominal prices will of course rise to match inflation. This is good for a home buyer as the price will be higher than when he purchased it and especially if you have a mortgage the payments will be easier to cover as their worth is less. As well as a nominal increase a real price rise is also likely as the demand for housing will go up but sellers will hold so as to benefit from further rises (remember most people don’t take inflation into account). Untamed inflation may cause a rise in interest rates but this has not happened and is unlikely to happen in Canada for the foreseeable future. In this case, the rise in house prices have risen higher than incomes in real terms so inflation was certainly not a major reason.
Canada’s price to rent ratio is almost one and a half times higher than its long run average and has been like that for over a decade. The price to rent ratio takes into account micro factors such as overcrowding, quality, and others where the quality of houses is reflected in the rent charged. This means that as an investment a house will not generate enough income to give you a good return on your investment (think of it as a bond with rents coupon payments). Income inequality may explain this as if a part of the population can afford to pay higher prices for housing it may skew the market and push prices on average higher. But income inequality hasn’t risen by much over the last 10 years and even rich people count buying a home as an investment so they would watch this metric carefully.
The real reason is that the percentage of people owning homes is rising and this is making people take less notice of rents as they are not renting out. This is putting upward pressure on prices without the same pressure on rent.
There are a number of reasons why this is so. One is the freely available credit. With developing nations such as China having huge savings which they invest mainly in US money markets but Canada’s as well, pushing down interest rates. This may seem all well and good but the cheap credit is allowing otherwise untenable projects (especially real estate) to go ahead. When interest rates will rise these mostly long-term projects will be very much ‘out of the money’ and will represent noting more than wasted resources.
Evidence of this was seen when during the recovery housing prices in Canada rose very quickly due to ultra low-interest rates forced on by the financial crises. There is no easy fix for this fundamental problem as it really concerns a global effort to realign the world’s economy into a more sustainable model, balancing investment and savings.
Control on capital, widely regarded as an anathema among economists before are widely been seen as an effective if not perfect way of controlling exchange rates and other fundamental factors at their ‘true’ values. Canada should definitely look into these measures for example a tax on foreign bond ownership which brings the effective interest rate being received by the holder in line with true market determined levels across the term structure. What these levels are is hard to say but a tax would be better than no tax.
Exacerbating this problem is the fact that the Canadian government gives subsidies to encourage first-time home buyers to get their own home. The goal of having every Canadian owning their own home is certainly a noble one. But the way to do this is by having market oriented policies which encourage growth. These will not only be cheaper but will be safer for the housing market as it will not distort its fundamentals thereby creating a bubble. I think especially with the subprime mortgage crises in the US this would have become abundantly clear.
While I don’t think that real estate is a bad investment right now, and I’ll lay out the reasons in a forthcoming psot, I do think that if left unchecked a housing bubble cold hurt us in the future.