What is a housing bubble?

05 March 2021 by National Bank
Housing bubble

Are you thinking about buying or selling property? You may have heard talk of a housing bubble. What does that mean for you? We met with our experts to learn more about what housing bubbles are and the impact they can have.

What is a housing bubble?

A housing bubble happens when the increase in real estate prices is fuelled by demand and not the economy. House prices go up, but the increase can’t be explained by logical reasons, like demographic changes, interest rates or job creation.

Something similar happened in the United States just before the 2008–2009 recession. The real estate sector was booming, with prices, sales and construction all increasing rapidly.

But the bubble eventually burst. The market was booming for the wrong reasons.

It was too easy to get a mortgage loan. Many borrowers didn’t have the firm financial footing required to continue making repayments when the economy took a downturn and they lost their jobs. Obviously, that’s simplifying the situation a little. But, basically, when the economy ran out of steam, everything else came crashing down like a house of cards.

In Canada, the rules for buying a home have been tightened up over the last decade. They’re more stringent than the rules were in the States in the run-up to the 2008–2009 recession.

To buy a home in Canada, your financial situation must be sound. Financial institutions are required to check that you would still be able to repay your mortgage loan if interest rates went up. This is what’s called a “stress test”.

What causes a housing bubble?

A housing bubble forms when there’s a high level of speculation. To understand what speculation is, let’s imagine that everyone started buying shares in a certain tech company for $10,000 each, hoping to sell them on for more. For a while, some people are willing to buy their shares for more than $10,000, so that they can resell them at a profit too.

But if the tech company’s stock isn’t actually worth $10,000, because there’s nothing—like a revolutionary product—to justify it, then the share price could plummet. The stock was overvalued. At the end of the day, there must always be a reason for a price. As we’ve seen, the reasons behind a growth in real estate sales and prices include interest rates, demographics and the job market.

What is an overvalued housing market?

We use the word “overvalued” when the price of something is much higher than its real market value. It’s based on supply and demand. To give a real-estate example, if you put your home up for sale for $1 million, but it’s actually only worth $300,000, the house is overvalued.

That might not be a big problem, even if you don’t sell it. Where things start to get risky is when the majority of homes are selling for inflated prices over an extended period. If the houses aren’t really worth those prices, but everyone wants to buy at the same time, this could lead to trouble—a bubble that could eventually burst.

What’s the housing market like in Canada?

The housing market has been surprisingly buoyant during the COVID-19 pandemic. There’s been an increase in demand for single-family homes in areas around large urban centres like Toronto, Montreal, Vancouver and Calgary. Clearly, buyers are looking for more space.

Although there has been less demand for condos, the market has remained resilient. It’s possible that some renters, looking for housing with better soundproofing, may have opted to buy a condo.

We’ve also seen strong demand for second homes, like cottages. This demand may be temporary, driven by the pandemic.

What’s driving this growth?

There are a number of factors that influence how the real estate market performs. Here are a few of them:

1 – Interest rates

Interest rates affect the cost of borrowing. The higher they are, the more you pay the lender. When interest rates are low, however, buying power goes up, encouraging people to purchase property.

2 – The job market

When people are well-paid and feel secure in their jobs, they may be more inclined to buy property. However, if people lose their jobs, they may decide to reduce their outgoings and put off their plans to buy.

While the COVID-19 pandemic has led to job losses in such industries as accommodation and food services and the arts, entertainment and tourism, other sectors remain stable. Workers who have kept their jobs may even have been able to save more to buy a home, as their expenses have often decreased.

3 – Demographics

Immigration to Canada is part of the reason for housing market growth in recent years. Many young skilled workers are coming here and finding good jobs, which adds to demand.

Canada’s population is increasing year after year, mainly driven by the arrival of qualified young people from abroad.

During the pandemic, immigration has slowed. But this slowdown seems to have been compensated for by other factors, including the desire of non-homeowners to buy property.

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What are the potential impacts of a housing bubble?

The danger of rampant speculation comes when the bubble bursts. When this happens, property prices could come crashing down, leaving borrowers with mortgage loans that could exceed the market value of their property. This could lead to several negative consequences, such as increased debt, bankruptcies, reduced access to housing and a decline in economic activity.

However, it’s difficult to predict the precise consequences of a bubble bursting. In fact, it can be difficult to tell whether you’re actually in a bubble until it bursts.

What should buyers and sellers do?

The first question you should always ask yourself before buying or selling is: “is this the right time for me?” Think about your down payment and your financial situation, and make sure that you can afford it. Weigh the pros and cons. There will always be opportunities and risks. Bear in mind that the particular market you’re interested in often plays a role.

There isn’t just one real estate market in Canada—there are many. The situation varies from city to city and from one neighbourhood to the next. It also depends on the type of property you’re buying.

One thing is certain: it’s hard to predict the future. The growth in property prices may continue, or it may peter out. After the pandemic, there will be a period of economic recovery. Demand and prices could continue to rise or remain at the same level. A sudden increase in interest rates might also cause house prices to fall. 

In conclusion, remember that there are big differences between different real estate markets, and some property types are more in demand than others. Finally, remember that everyone’s financial situation is unique. Have you discussed your plans with your advisor? We're here to answer your questions.

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