The government is trying to prop up housing market. (Part 1)

I think the Canadian government is trying to prop up the housing market, and I can understand why. I’ve felt this way for myriad reasons and for a long time, but it has become abundantly clear as of late. Two key policies have cemented my perspective. Each one of these is going to become its own article, so that you don’t have to spend an hour reading this.

1. Part 1: The government is offering 30-year mortgages to first-time buyers if the buy a brand new house
2. Part 2: The government is exercising de facto Yield Curve Control on insured mortgage rates by becoming the largest buyer of Canada Mortgage Bonds and increasing the CMHC capital pool by $20 billion (50%).

I will preface by saying that while I understand why the government would want to prop up the housing market, I don’t support it. I do think that economic darwinism should be allowed. Natural selection is necessary to eliminate rents (economic waste) from the market and free up real estate (housing). The owners of that housing are currently paying economic rent in the form of negative cash-flow and excess capital cost, forfeiting capital to control an asset that would more suitably be absorbed by an owner-occupier.

In neoclassical economics, economic rent is any payment to the owner of a factor of production in excess of the cost needed to bring that factor into production. In this scenario, the product is a rental unit, the factor of production is a mortgage, and the excess is heightened interest rate expenses, which are still higher, despite GOC 5-year bond yields being materially lower than Q3 of last year, which held the same mortgage rate environment:

This means that the banks are pocketing the spread above the 5-year as a likely risk premium, which is reasonable, given risk is markedly higher today than it was during the last year. So in this example, Canada’s oligopolistic banking system stands to benefit most from the perpetuation of Canada’s housing crisis. The longer investors and speculators bleed cash to service expensive debt, the more money is taken out of consumption in the economy and given to the aforementioned financial institutions.

It could also be argued that buyers who continue to hold overvalued, cash-flow-negative assets are choosing to continue paying their inflated price every day they don’t sell the property at a loss, so economic rents are also being paid to our past selves. This is how debt cycles kill us slowly, as our sunk-cost bias outweighs our will to stop the bleeding, and we continue to pay a heightened cost for past mistakes.

This is most clearly visible in a chart posted by M3 Development Management in their newsletter, which shows how disposable income in Canada’s major markets has fallen off a cliff:

I don’t like this.

I’m bearish, and have been for a long time, so it’s easy for people to imagine that I see this as some sort of “win.” I don’t. I would like to make it abundantly clear that the idea of millions of Canadians suffering financially is not something I am fond of, nor something I wish for. It is something that occupies a lot of my psyche to the point that it depresses me and keeps me up many a night. But, I think it’s a necessary evil that was created by myopic policy, and I it will happen either way:

1. Scenario 1: the housing crisis persists > Canadians suffer
2. Scenario 2: a recession gives us deflation > Canadians suffer

So, as the saying goes:

Let’s start with the debt.

As of August 1st, first-time homebuyers in Canada will have access to 30-year mortgage amortizations. As a clear policy support to the suffering pre-construction home market in Canada, this product will be available to first-time buyers only if they buy a brand new house.?

The government seems to have a bit of a dual mandate with this one:

1. Make younger voters less angry with them;
2. Increase pre-construction purchases, which are somewhat necessary to get homes built in our current economic model.

Their primary objective seems to be to throw a bone to the younger generation, who are clearly communicating their frustration in their voting intention:

Young people feel marginalized by Canada’s current housing market structure, especially given that they’ve had to accumulate more and more debt to buy in a more volatile market, with annual price changes moving up and down in double-digit percentage increments for much of their adult lives:

1. 2015: +10%
2. 2016: +10%
3. 2017: -20%
4. 2020: +10%
5. 2021: +10%
6. 2022: -20%

Many young Canadians are eager to get off of the rollercoaster and into a normal housing market. Perhaps if we can end up with a long bottom like the 1990’s housing market correction, we’d have a solid 5-year period of sideways pricing, allowing many participants to trade safely in and out of the market, provided they’re not already overlevered. This is how markets deleverage and recalibrate.

Young people are especially at risk because they’ve accumulated the most debt relative to older generations, who have mostly benefitted from the inflation of their assets. RBC visualized this nicely in a 2023 report

Presumably, the government will try anything that will make this reality less painful for younger generations. Ironically, this solution is just giving them more debt.

The policy effectively allows buyers to extend the amount of time it takes to pay off their mortgage from 25 year to 30 years. This allows buyers to reduce their monthly payment and, as a result, increase their borrowing power, since that borrowing power is limited by their debt service ratios.

Below is an example of how the extended amortization would reduce the mortgage payment, but increase the total amount of interest paid. This example uses a mortgage principal amount of $500,000 and an interest rate of 5.00%.??

Before (25 Years)

After (30 Years)

Source: https://itools-ioutils.fcac-acfc.gc.ca/MC-CH/MCCalc-CHCalc-eng.aspx?

The benefit of a longer amortization

You can observe in the example above that the payment drops about 8% from $2,908.02 to $2,668.45, which is why most buyers are compelled by the longer amortization. In Canada, many people buy things based on the payment they can afford, ignoring the total cost. So then, let’s look at that total cost.

The cost of a longer amortization

It’s really important to note that switching from a 25-year amortization to a 30-year amortization will cost you more as well:

1. You will pay about 1.5% more interest payment over the course of the term ($117,019 to $118,915)?
2. It would cost you about 23% more interest over the life of your mortgage. ($372,407 to $460,643)

Saving the housing market

Their secondary objective would be to keep the housing market from falling further (remember we had a record price drop in 2022), because no politician wants a housing crash on their record, especially before an election.

It’s not a horrible idea. The biggest issue we’re seeing economic strain on the housing market is in demand for new homes. At the same time, the Bank of Canada observed that first-time buyers are the largest portion of homebuyers in Canada:

So, if you’re going to try to create a policy that will have the biggest impact on the housing market, it would only make sense for that policy to target the biggest group of housing consumers, which is first-time homebuyers.

There is economic benefit to first-time buyers having access to new homes. Buying a brand new home allows a first-time buyer to avoid the natural work that comes with owning a resale property. This is especially true given the highly-depreciated nature of many entry-level homes in Canada’s major cities. Buying brand new would allow first-time buyers to avoid the “busy work” of chasing around deferred maintenance of a resale home. The first-time buyers could then focus on things more important to them, like starting a family or succeeding in their career. With that being said, the policy has been criticized for solving a debt problem with debt, by giving an extended credit product (longer-term debt) to buyers who most need affordable access to housing.?There are likely better policy concepts to give first-time buyers the necessary advantage on new homes.

Did they forget something?

The spirit of the extended amortization is to give first time buyers the ability to access CMHC-insured mortgages with lower downpayment requirements. The challenge is that builders require buyers to make a deposit on their preconstruction home, and this deposit has been historically in the 15-20% range.

Can builders reduce deposits?

The most idealogical conclusion of this is that builders will be compelled to reduce their deposits to make brand new homes more accessible for end users who want to capitalize on this new lending program. The challenge is that builders depend on those deposits to fund their projects, and so this change may not be as impactful as the government might hope:

The above analysis from Oakbank & Well Grounded Real Estate shows how deposits typically account for 10-20% of the total project - more than the land value and the developer’s cash in the deal. These deposits become part of the capital stack when coupled with a Westmount Guarantee, which allows builders to access deposit capital for project financing. To understand the magnitude of this, consider that Westmount’s website presents the following figures:

• $1.51B in active Tarion Bond issued
• $5.53B of active deposit insurance facilities
• $2.85B of purchaser deposits working for developers right now

In this regard, preconstruction buyers, especially for condos, play a crucial role in the financing of development projects. By providing deposits and getting a project to reach its presale target for construction financing, typically 70%, preconstruction demand is fundamental to getting housing starts created in the built-for-sale environment.

With new construction sales trending about 75% below their long-term average, it is clear that something needs to be done to add demand to this end of the market if we’re going to get housing built.

And while I’m not certain that this policy lever will do much given the way that preconstruction projects are typically structured, it could be meaningful in markets with ground-based housing, reduced deposit structures, and a less demanding capital stack.

What do you think?