In 2023, higher rates resulted in 30,000 fewer housing starts

How can Canada build its way out of housing supply challenges to improve affordability? With soaring demand and interest rates throwing a wrench in construction plans, the answer is far from simple.

This article explores the crucial role of the private sector in driving housing supply, analyzes the impact of interest rates on different types of housing, and outlines potential long-term solutions that could enhance private-sector confidence and inject capital in housing development.

Canada has an urgent need to build far more housing to address affordability challenges in many Canadian cities. Housing is a critical infrastructure for the economy, supporting labour mobility and ensuring a greater share of income can be invested in productive capital.

Significant barriers to increasing housing supply include the long-standing challenges of regulatory costs and delays. Increasing housing supply will also require training more workers and improving productivity in the development and construction industries.

In the short term, however, housing supply has been particularly affected by high interest rates.

Our modelling suggests that in 2023, higher interest rates decreased housing starts by about 30,000 units (roughly 10 to 15 per cent) in Canada.

The state of housing supply is summarized in our recent Housing Supply Report. It found that higher interest rates affected new construction of condo buildings across most of the country (apart from Alberta).

We remain concerned that starts in Toronto have yet to reflect the full impact of higher interest rates. While delayed effects of higher rates will likely continue, the move to lower interest rates should stimulate housing supply over the coming year. Given this opportunity, efforts conducive to supporting more housing supply must continue.

The private sector is central to increasing supply and improving affordability

Most of the increased housing supply that Canada needs must come from the private sector.

Small investors provide much of the funding to build condo apartments. Developers raise funds from prospective buyers who may occupy those units or rent them out. Buyers need to borrow money, perhaps not for their downpayment, but almost certainly to pay for units upon completion.

So, the willingness of individual buyers and investors to borrow will dictate the construction of condo buildings. Developers will move ahead with their construction if roughly 70% of apartments are presold. In turn, condo apartments have become a critical supply of rental availability in Toronto and Vancouver.

Large investors are also critical to supplying financing for building large multi-storey purpose-built rental buildings. While their multi-million-dollar construction costs will ultimately be covered by renters over time, those upfront expenditures need to be paid before revenues begin to flow in.

To manage this timing mismatch, financial institutions step in with debt to match current costs with future revenues. But this financing mechanism makes the decision of whether to proceed with construction more sensitive to interest rates and reliant on whether financial institutions are willing to provide credit.

The sensitivity of private investors in housing — whether large or small — to macroeconomic fluctuations suggests that ensuring long-term continuous flow of investment funds is essential to increasing housing supply.

What do the data say?

Clearly, housing supply is sensitive to interest rates. But in different ways.

Condominium starts are sensitive to interest rates that buyers face, while rental starts are sensitive to interest rates that corporate investors face. Longer-term mortgages faced by individual investors and short-term bond rates, more likely to be faced by corporate borrowers, increased by almost five percentage points.

Ultimately, condo starts fell recently as individual investors responded quickly to changing mortgage rates.

In the modelling we have developed to address how much housing Canada needs, we estimate that the recent increase in interest rates — leaving aside other changes in the economy — resulted in 30,000 fewer housing starts, out of a total annual average of around 250,000.

The effect of interest rates was offset by other economic factors and government policies to support construction of rental buildings across Canada. Construction remained stronger than anticipated in Alberta because of a strong economy. 

Long-term implications to securing Canada’s housing supply

Over the past two decades, Canada has built a structural deficit in housing supply that can only be remedied through extensive investment by the private sector. With the private sector providing roughly 95 per cent of housing in Canada, this is especially true to address the affordability challenges of the middle-class, whether for rental or for ownership.

Unfortunately, this also means relying on a sector that is affected by changes in the economy, notably changes in interest rates. So, all levels of government need to ensure that the private sector can build as much housing as possible when the going is good, and interest rates are low.

In practice, this means improving the responsiveness of the housing system, for example through faster approval times and reduced uncertainty. Frameworks may need to be designed to ensure construction continues even when interest rates are higher.

Recently the Government announced it would set up a working group to look at domestic investment opportunities for Canadian pension funds. Developing ways in which long-term patient capital can be devoted to meeting Canada’s long-term housing shortfall will clearly be important.

Ultimately, building a future where all Canadians have access to housing that is affordable requires a collective effort. While higher interest rates still present a short-term hurdle, they offer important learnings for us all. We must consider ways to empower the private sector throughout the economic cycle if we are to address the housing crisis.