What to do about the surging real estate markets in Toronto and Vancouver?

While the rest of Canada stares in awe, prices in these two cities and the communities round them keep climbing. In Vancouver, the benchmark home price index is up by 32.1 per cent compared to last year. In Toronto, the benchmark price is up by more than 16 per cent. The average price for detached homes in both cities is now well over $1 million and climbing.

"The warnings are piling higher on the Canadian housing market," says BMO chief economist Douglas Porter in a recent report. "After seemingly downgrading the alert level a few years ago, the Bank of Canada has now ramped up its rhetoric to four-alarm level along with similar concerns from both the IMF (International Monetary Fund) and OECD (Organisation for Economic Co-operation and Development). While we have heard the message on and off for years, the remarks have been sharpened and (are) much more focused on white-hot Vancouver and Toronto."

Now the federal government is taking the summer to consult with provincial and municipal housing authorities to see what should be done about the market. In the past the government tried to tame the market by tightening the rules for buyers to qualify for mortgages.

Particularly in Vancouver, there are calls to ban or tax foreign real estate investment; to put a "speculation tax" on properties that are resold within a short period of time; and to tax properties where the house is left vacant. But earlier this year, a report from the B.C. Finance Ministry said the province could lose $1 billion in residential real estate sales and about 4,000 construction jobs if foreign investment was curtailed.

"There is no doubt that heavy-duty buying from abroad is a major factor behind the price surge in Vancouver and Toronto, and is playing a growing role in Montreal," says Porter.

Many in the real estate industry have downplayed the role of foreign investors in the market, but Porter says, "Economics 101 will tell you that the marginal buyer sets the price; and, if you introduce a wave of new buyers on an already tight market, prices will soon reach for the sky as the demand curve shifts even slightly to the right."

Porter adds, "It's worth making the distinction between landed immigrants and those simply seeking to park capital -- the former are not of particular concern given the economic contributions they bring, but the latter (think vacant homes in tight markets, potential risk of capital flight) do deserve the attention of policymakers."

But he says moves to tighten borrowing standards in Canada "will simply crowd out the domestic buyer and leave the field wider open for foreign capital inflows."

In a report for Mortgage Professionals Canada, economist Will Dunning acknowledges that there have been calls for "further tightening of mortgage lending conditions in Canada to address what is considered excessive risk." But he adds, "From our perspective, the greatest risk to the housing market (and consequently to the broader economy) is not reckless consumers or lenders -- it is needless policy changes."

Dunning agrees that there is sufficient evidence that "foreign buying is very substantial in Vancouver and that the Vancouver housing market is being severely distorted in consequence. A similar situation may be developing in Toronto."

But he says, "changing mortgage lending criteria in response to those pressures would unnecessarily punish Canadians who have reasonable expectations of home ownership. As well, those policy changes would unnecessarily impair housing markets in Canada, which would have economic consequences."

Dunning says, "We do not have compelling evidence that significant numbers of Canadians are taking unreasonable risks in the housing market. Data from the Canadian Bankers Association shows that the mortgage arrears rate (0.28 per cent as of March) is close to the lowest all-time rate."

He also notes that research by Mortgage Professionals Canada has consistently shown that Canadians are highly motivated to pay off their mortgages as quickly as they can.

Dunning goes against popular opinion and says there is no housing bubble in Canada.

"Price growth in Canada, even in Vancouver and Toronto, is still consistent with the economic fundamental of interest rates and affordability (in combination with another economic fundamental of a moderate rate of job creation)," he says. "It is still too soon to speak of a bubble in Canada as a whole or in individual communities."

Porter agrees that economic fundamentals point to little change in the markets unless there's government intervention. In addition to the low borrowing costs, Porter notes that demographics are supporting housing as there are more 25-40 year-olds, the prime home-buying age group. He says Toronto and Vancouver now account for 25 per cent of all Canadian jobs, the highest share in the last 15 years. Other factors such as densification, land restrictions and a lack of single-family home building are also playing a role, Porter says.

"None of the major drivers of Vancouver and Toronto's housing market are pointing downward, suggesting that without official intervention these wildfires are likely to continue burning. Given the limitations on dealing with many of the lead accelerants, we would recommend that government policy action be aimed at those it can affect -- foreign investment, speculation and land restrictions, in that order."