The decline in Canadian home prices this year will not turn into a prolonged downfall like the one that happened in the early 1990s.
Back then, home prices kept declining for several years. In the case of Toronto, prices fell for seven long years following the 1989 peak and eventually lost roughly 30% of their value. What is different this year is that price declines are happening in a unique economic and demographic environment. Four main elements of that changed environment are discussed below.
Mortgage rates vs. inflation
In the late 1980s, mortgage rates were at double-digit levels, peaking at nearly 14% in 1990 for both variable rates and the benchmark 5-year mortgage rate.
As inflation was running at 6% annualized growth at that time, the real rate (the nominal rate minus the inflation rate) was at a hefty 8% level. This seems like an extremely tight monetary policy.
In retrospect, it seems clear that at that time the Bank of Canada’s determination to prevent inflation with extremely high real interest rates had contributed to the outbreak of a recession of the early 1990s, and a consequential prolonged decline in home prices.
Fast-forward to this year, and the annual growth rate for inflation appears to have peaked mid-year at 8% and is now at 6.9% (annualized rate as of October) and mortgage rates, both variables and 5-year fixeds, are in the 5% to 6% range. This means the real mortgage rates are marginally negative, in sharp contrast to the situation in the early 1990s. Clearly, the Bank of Canada is now threading much more cautiously in its fight with inflation than two decades ago.
Furthermore, inflation seems to have halted in the U.S. It’s now at 7.7% as of October following a gradual but steady decline from its peak of 9.1% in June 2022. American inflation rates are a traditionally good leading indicator for Canadian rates.
All this suggests that mortgage rates alone will likely not be a strong factor undermining house prices in the long run.
The immigration factor
The federal government has recently announced that its target immigration level will rise steadily over the next few years to reach 500,000 new residents in 2025. This would be an all-time high for Canada and well above the last few decades’ annual average of roughly 300,000.
Newcomers to Canada are traditionally a good source of housing demand. A National Bank of Canada study shows that 30% of all 25- to 44-year-old immigrants (a prime age for homebuying) who arrived in Canada in the previous five years are already homeowners.
Among those who arrived five to 10 years earlier, 53% were homeowners, only six percentage points less than those Canadian-born. In Toronto, Vancouver and Calgary, their ownership rates were even higher than those born in Canada.
If past trends are any indicator, of 500,000 new immigrants expected in Canada in 2025, more than half will end up in the Greater Toronto Area.
Providing housing to meet the needs of this huge inflow of new residents will be a challenge. In other words, if there are any risks to the stability of the Toronto housing market in the long run, they are more likely to come from the lack of supply rather than the lack of demand. Thus, rising immigration levels will be an important underpinning of home price strength in the long run.
In the first half of 2022, roughly one-third of all homebuying in the U.S. was done by institutional investors such as hedge funds, private equity funds and pension funds.
There is no reliable data on institutional homebuying in Canada as neither Statistics Canada nor the Canada Mortgage and Housing Corporation (CMHC) collect such data. However, if recent trends in the U.S. are any guide, institutional homebuying will be on the rise in Canada.
This is well-illustrated by the announcement late last year of the Core Development Group, a Toronto-based real estate firm, of their intention to invest $1 billion in buying single-family homes in Canadian cities and convert them to rental housing.
The main reason why institutional investors affect housing markets in a different way than individual homebuyers is rather simple: institutional investors increasingly buy homes with the intention of taking them off the market and converting them into rental, income-generating properties.
Given their formidable financial capacities, institutional investors can be reasonably seen as less pressured to react to the temporary vagaries in the housing market.
They have more means to look for buying opportunities in a declining market and they are certainly less pressured to sell in such markets, and maybe not sell at all. Institutional investors are better equipped to “weather the storm” than individual players in the market.
Notwithstanding legitimate concerns about the negative effect of institutional homebuying on homeownership (which is not under consideration in this essay), from a strictly business-cycle perspective, large corporate investors are a factor of stability in a declining housing market.
Mortgage industry strength
After the housing-related financial crisis hit the U.S. in 2008, there was a widely shared expectation that similar turmoil would happen in Canada.
Yet, this never happened. No large mortgage lender in Canada went bankrupt and the federal government’s quantitative easing policy implemented at that time was meant more to calm down the markets than to help mortgage lenders survive.
Furthermore, in the post-2008 period, the government has introduced additional risk-mitigating measures such as:
- raising the minimum down payment for insured mortgages;
- reducing the maximum amortization period to 25 years for insured mortgages;
- and mandatory stress-testing where borrowers must qualify for rates higher than those contracted.
All this is often praised as a clear sign of strength of the conservative and risk-averse Canadian mortgage financing system. One example of this praise came from Ben Bernanke, former Chair of the U.S. Federal Reserve who managed the 2008 crisis in the U.S. As a consequence, investors’ confidence in the mortgage lending business continues to be strong.
This is well-illustrated by a recent offer by Smith Financial Corporation to acquire Home Capital Group, a lender specializing in alternative mortgages. These mortgages are offered at higher rates to borrowers who, for various reasons, do not qualify for “prime” loans at the major banks. The borrowers are often newcomers to Canada, self-employed, small business owners and seasonal workers.
Smith Financial is an experienced player in the housing finance field (controlled by Stephen Smith, co-founder of First National, another major lender of alternative mortgages, as well as chair of Canada Guaranty, a private mortgage insurer).
The fact that sophisticated players are betting their money on the long-term profitability of the housing finance industry, even the high-risk portion of the industry, is an indirect but clear sign of support for the housing markets in general.
As this support happens at a time of price softness across the country, it presents yet another sign of the long-term viability of the country’s housing markets.
In short, despite the present softness in the Canadian housing market, several factors, including relatively low real mortgage rates, record-high immigration, institutional homebuying and investor confidence in the mortgage industry, suggest that, in the long run, the outlook for this market remains positive.
To no surprise, the Bank of Canada raised rates again this past week. Another 50bps. Interest rates are now up a whopping 400bps since this tightening cycle began in March. According to Macquarie Research, this is the sharpest calendar year of rate hikes on record going back to 1936. The most common rebuttal you see circulating online is that rates are still low from a historical basis. While that may be true it is an irrelevant point if you’re not also considering the levels of debt.
I often hear people comparing todays rate hiking cycle to that of the 1980s. The Bank of Canada had rates as high as 18% in 1981 so we have a lot more room to go! Except household debt to GDP levels were also around 50% in the early 80’s, today household debt to GDP sits at nearly 110%.
ou could also buy a single family house on one income at roughly two to three times your annual salary in the 1980’s. Today that is obviously not the case. The recent 400bps move in interest rates is blowing up highly indebted household balance sheets. Let’s look at a few examples.
$500,000 mortgage, 25 year amortization, 1.5% mortgage rate = $2000/month
$500,0000 mortgage, 25 year amortization, 5.5% mortgage rate = $3052/ month
$1,000,000 mortgage, 25 year amortization, 1.5% mortgage rate = $3997/ month
$1,000,0000 mortgage, 25 year amortization, 5.5% mortgage rate = $6104/ month
In other words, many mortgage holders are going to have to aggressively start trimming discretionary spending. This is the demand destruction the Bank of Canada is hoping for. Inflation is going to come down, give it time. It is already happening if you look close enough. The three month annualized rate of inflation in Canada is now running at 3.7%.
It should not come as a surprise that The Bank of Canada is now signalling a pause. The bank now says it “will be considering” whether or not the rate has to go higher. This is a big change from each previous meeting where they emphasized “that rates would have to go higher”.
It is worth emphasizing here that a pause does not mean a PIVOT. An overnight rate paused at 4.25% and a prime rate of 6.45% is not good news for housing. Your typical mortgage hovers between 5.5-6%, equating to at least a 30% reduction in purchasing power.
The longer rates hold at these levels the more pressure on sellers to reduce prices. For those hoping that OSFI would reduce the mortgage stress test at their annual review this month, don’t hold your breath. Just last week the bank watchdog pushed back on growing calls to lower or kill the stress test, “We see great risk in speculating on the mortgage rate cycle, and we do not consider the minimum qualifying rate to be a tool to manage the demand for housing,” OSFI Superintendent Peter Routledge said in a statement. “We see the minimum qualifying rate as an underwriting practice that adds an important safety buffer to residential mortgage portfolios, the largest exposure Canadian lenders have on their books.”
We may have reached the end of this rate hiking cycle but this chapter of the story is far from over.