Historical article note: This article was originally published on 2019-03-14. Rates, policies, home prices, statistics, product names and qualification standards reflect the environment at that time and may have changed. This archive is for historical record and general education only. It is not mortgage approval, investment, legal or tax advice.
A year ago, I was discussing the relationship between interest rate hikes and housing prices with netizens on a certain forum. At that time, the central bank had just raised rates twice. Some netizens said that for every x% interest rate hike, housing prices would drop by y%, while my view was that housing prices do not have a linear relationship with rising interest rates because there are too many factors affecting housing prices. Obsessively believing there is some kind of relationship between housing prices and interest rates has no theoretical or data support. Clearly, housing prices rose for 18 years, and interest rates didn’t fall for 18 years either, so why should housing prices fall when interest rates rise? This discussion later turned into a kind of verbal abuse. I was labeled as someone misleading people about housing price increases, while those who, due to limited brain capacity, only think emotionally became the embodiment of justice. People trying to manipulate housing prices downward were considered illogical; their strong desire for a price drop so they could afford a home had turned into an ideology and belief system, and dissenters were seen as counter-revolutionaries that needed to be defeated. Even after five consecutive rate hikes, the most embarrassing result was that Toronto condo prices didn’t drop but actually rose, completely defying gravity. Why do housing prices rise quickly but fall slowly? I once explained the basic principles of housing price changes in the article "Who Is Misleading Housing Prices," and now I am writing an enhanced version to reinforce everyone’s memory.
The most recent transaction price of a house is explicit and two-dimensional; whereas the overall housing price is three-dimensional, with the third dimension being the depth of the housing price. In Canadian real estate transactions, two-thirds involve second-hand homes, which are in the stock market where you sell to me, and I sell to someone else, belonging to the circulation sector; the remaining one-third involve new homes, which are in the incremental market where builders sell to buyers, belonging to the productive transactions. In circulation transactions, if the price is not right, the transaction stops, whereas in productive transactions, if the deal cannot be completed, the house becomes inventory and the producer will get into big trouble. Next, let's focus on analyzing the characteristics of second-hand home transactions. Suppose a community has 100 houses with similar layouts and roughly the same year of construction. It's now May 2018; 99 homeowners believe their houses are worth 1 million, while one neighbor who needs to sell urgently lists their house at 850,000 and it gets sold. When the bank sends an appraiser, it's also valued at 850,000, so everyone thinks the houses in this community are worth 850,000. The other 99 homeowners are saddened and no longer sell their houses. Rewind to January 2017, in the same community, a homeowner lists a house for 850,000, 10 buyers compete, the highest bidder wins, and the final transaction price is 900,000. Neighbors see this and think their houses are in even better condition than the one just sold, so they ask for 1 million, with 8 buyers competing, and the final price is 1 million. From then on, people in the community believe their houses are worth at least 1 million. Here is an important concept: housing prices are three-dimensional: time, price, and transaction volume. Transaction volume is the depth of the price. In 2018, if a house in the community sold for 850,000, neighbors would not sell anymore, and the community price gets fixed at 850,000. The recent housing price without supported transaction volume is the 'marginal price,' which is explicit; the psychological price of other unsold properties by other homeowners in the community is the 'overall price,' which is implicit and unseen by the market. When the market warms up and the 'marginal price' is higher than the 'overall price,' transactions occur, housing prices will continuously and rapidly break historical records as in January 2017, accompanied by transaction volume. Transaction volume = price depth = resistance to decline; this is the difference between housing prices and general commodity prices. Housing prices without transaction volume are marginal prices; prices with large transaction volume are overall prices. In most cases, the observable fact is: when housing prices fall, transaction volume decreases, and housing prices have no depth; when housing prices rise, transaction volume increases, and housing prices have depth, which is why housing prices rise quickly but fall slowly.
Another factor behind the slow decline in housing prices is that the price includes taxes and fees, and homeowners experience the endowment effect when selling their homes. Since the house was originally bought to live in, it carries the endowment effect. For second-hand houses in Canada, there are closing costs such as land transfer tax and lawyer fees when buying, which account for about 1.5-2% of the house price. When selling, there are real estate commission fees and lawyer fees that account for about 4-5% of the house price. Homeowners must consider at least 6% in transaction costs when selling. If you purchased for 1 million, you need to sell for at least 1.06 million to avoid a loss. If you want to buy the house from the homeowner for 1.04 million, it would rarely happen unless something major happens in the homeowner's family. The endowment effect, or loss aversion, describes the phenomenon where a person's valuation of an item or asset they own is higher than if they do not own it. A psychologist's experiment illustrates the endowment effect: students selling their own cups printed with the school emblem were willing to sell them for a price twice as high as what another student would be willing to pay. Daniel Kahneman, a psychologist who won the Nobel Prize in Economics, explained this economic phenomenon in the chapter on the endowment effect in his book "Thinking, Fast and Slow," using the example of homeowners overestimating the price of their homes when selling. In actual transactions, the endowment effect is most severe when the seller is selling a primary residence. If the property is an investment property, the effect is slightly milder. This further illustrates the endowment effect: the difference in pricing between goods for personal use and goods for exchange demonstrates the endowment effect. This phenomenon falls under the typical scope of behavioral economics research. Due to the endowment effect, when housing prices fall, transaction volumes sharply decrease; when housing prices rise, transaction volumes quickly increase.
The rise and fall of housing prices are not systematic, and different types of properties do not increase or decrease in sync. When the transaction volume of low-priced properties is high, it shows a decrease in average prices, whereas when the transaction volume of high-priced properties is high, it reflects an increase in housing prices. From 2010 to 2016, the proportion of condominium transactions was low, and the price increase was relatively small, with housing prices rising about 20% over four years. Because high-end property transactions were a large proportion, the average housing price increased quickly. From 2016 to 2018, the proportion of condominium transactions was large. Although housing prices increased by 20% over two years, since they were low-priced, the average housing price appeared to decrease. Many people think that condominium prices are rising too quickly and that there is a housing bubble. Personally, I believe that the residential value of condominiums is being realized, prices are within the affordability of first-time homebuyers, and they are also target properties for real estate investors. Competition among buyers will continue to push up condominium prices. The specific prediction for condominium prices is as follows: the current average price of second-hand condominiums in Toronto is about 560,000, and the pricing is relatively low, so in four years it will rise to over 700,000. The basis is: in December 2018, the average price of second-hand condominiums was 560,000, and the average price of pre-construction units at the same time was 790,000. When the pre-construction units are completed in four years and entered into the second-hand market, they will directly raise the average price of second-hand properties. Pre-construction units are futures prices, while second-hand properties are spot prices. Since the pre-construction units must be delivered in four years, it inversely shows that the current market pricing of second-hand condominiums is too low.
Throwing a tantrum at housing prices, being coquettish, acting clueless, rolling on the floor—none of it works; relying on the government to regulate housing prices only wastes your own time. When governments intervene in housing prices, there is only one direct outcome: a standoff. Buyers and sellers both wait and see. Whoever changes their mindset first loses. If buyers change their mindset first, housing prices rise; if sellers change their mindset first, housing prices fall. Time is on the side of whoever wins in the end. If interest rates continue to rise, sellers feel more pressure, and time is on the buyers' side; if rents keep rising, buyers feel more pressure, and time favors sellers. In 2019, Canadian interest rates followed the Federal Reserve in 'maintaining sufficient patience.' At the same time, because buying and selling activity was not active, yet population continued to flow in, rents would still rise significantly. In the game of housing prices, sellers hold the advantage.