The impossible has happened: Canadian house prices -- which, as everyone knows, only ever go up -- have started coming down.
With mortgage rates jumping to their highest levels since 2009, borrowers have found themselves with far less buying power than they had even at the start of this year -- and it shows.
Home sales in Toronto and Vancouver were down more than 40% in July, compared to the same month a year earlier, plumbing multi-year lows. Both cities have seen average selling prices fall by tens of thousands from their peak earlier this year, though prices -- for now -- are still higher than a year ago.
Economists across the board are slashing their forecasts for house prices, and many expect declines in the 10% range. Capital Economics, which has been bearish about Canadian real estate for years, is calling for a 20% drop.
READ: “Housing Market Correction Now Runs Far and Wide Across Canada”: RBC
It’s all a sign of just how important low interest rates have been to Canada’s epic, years-long housing boom -- and how little it takes to pierce an overinflated balloon.
Still, the prospect of a serious house price crash may be music to the ears of younger would-be homebuyers who have found themselves priced out of Canada’s major housing markets (and these days, many smaller ones too).
Sadly, it may be a false hope. This price drop is the result of higher mortgage rates, meaning monthly payments for new buyers are soaring. Even a serious drop in prices wouldn’t return monthly payments to affordable levels. The forecasts are that housing affordability will get worse this year, not better, amid falling house prices.
So it doesn’t look like much relief is on the way for homebuyers anytime soon. But what would it mean for the economy as a whole if this price crash happened?
Lessons From the 1980s Boom and Bust
To get a glimpse of what the future might hold, we can look to the past -- to the country’s previous major housing market bust: Toronto’s housing bubble of the late 1980s and early 1990s.
Starting in the mid-1980s, Toronto saw an unprecedented housing frenzy, with prices jumping 25% per year for four straight years. When the Bank of Canada reacted to this and began raising interest rates, house prices flattened, and then began to fall, triggering a decline that would go on until the mid-1990s.
“The boom contained greater excesses than we are seeing in (today’s) period, in terms of speculative buying, and also worry; the mantra at the time was ‘where will your kids live,’” economist Will Dunning wrote in a recent report.
Dunning, who has done research for Canada Mortgage and Housing Corp. and for Mortgage Professionals Canada, found that Toronto experienced a housing-led recession -- that is to say, it wasn’t a slowdown in jobs that caused house prices to fall, but the other way around.
“When The Boom ended, it took a while for people to start to feel that their wealth was being eroded, but once that realization kicked-in, there was a quite rapid drop in the employment rate,” Dunning wrote.
This is in part because of the “wealth effect”: when people see their wealth eroding, they spend less, even if there isn’t necessarily any change in their income. But that lower spending puts downward pressure on the economy, and pretty soon, some people are out of work.
During the period of falling house prices, Toronto’s employment rate -- the percentage of people with a job -- dropped from a record high around 70% to around 60%, Dunning’s research found. The city’s jobless rate rose from 4% in 1990 to a high of 11.4% in 1992, and stayed above 10% until 1995.
“At that time there was such a turn in sentiment, and expectations of future price drops combined to hit consumers very hard, very quickly,” Dunning said in an interview.
To be sure, many other things were going on in southern Ontario’s economy at that time, including a painful shift away from manufacturing jobs. Today things are somewhat different; Toronto’s labour market is considered to be very strong, and mortgage rates were much higher back then, peaking at nearly 14% in 1990.
But households also had much less debt back in those days -- less than half as much as today, relative to income. That makes today’s households more sensitive to changes in interest rates compared to the 1990s.
Dunning isn’t making any specific predictions about how things will turn out this time around -- much of it depends on the direction of interest rates from here on in, he says. But he does believe mortgage rates have already risen too far, and at these levels, there will be further downward pressure on house prices.
Moreover, he thinks the Bank of Canada’s fight against inflation may prove to be futile, because of the nature of today’s inflation, which Dunning says is driven by supply-chain disruptions resulting from the pandemic. That’s not something higher interest rates can fix.
“It’s entirely possible (the Bank of Canada) will shift back to where they were previously” on rates, Dunning said -- and in fact he’s urging the BoC to do just that.
Dunning recently calculated that Canada’s “neutral mortgage rate” -- the rate at which house prices neither rise nor fall -- is around 2.6%. But fixed-rate mortgages are currently in the 5% range, while variable-rate products are around 4%.
Those mortgage rates could do enough damage to the economy ”that there’s going to be a lot of regret at the Bank of Canada a year from now if they don’t soon change direction,” Dunning says.
Will Canada Get its Own ‘Great Recession’?
When many people think of housing market crashes, they picture the US housing bubble that burst in the mid-2000s, triggering the Great Recession of 2008 that saw multiple banks and other lenders go belly up.
That was an almost worst-case scenario, with prices falling 40% or more in some markets in California, Florida, Nevada and the US Midwest. But market analysts today largely agree that, whatever Canada is facing today, it isn’t a repeat of that crisis.
For one thing, back then, Americans had been loading up on adjustable-rate mortgages (ARMs), which had very low introductory interest rates for the first five years, but then shot up to levels many homeowners couldn’t afford. When the first wave of those rate hikes arrived in 2007, the housing market tanked. (This is all neatly explained in the 2015 movie “The Big Short.”)
The closest thing to one of these ticking-time-bomb mortgage products in Canada today is the variable-rate mortgage with floating payments. These mortgages see their payments rise immediately with every Bank of Canada rate hike, and the typical payment has already jumped by hundreds of dollars this year.
But a recent report from National Bank of Canada found that of the country’s roughly $2T in outstanding mortgage debt, only $181B -- or about 9% -- is in the form of these variable rate mortgages with floating payments. The majority of variable-rate mortgages (and all fixed-rate mortgages) have fixed monthly payments.
So for the vast majority of mortgage borrowers, the shock from higher interest will come slowly, one household at a time, as mortgages are renewed at higher rates. But what this means is there likely won’t be a huge spike in mortgage defaults, like the US saw during its crash, says National Bank economist Matthieu Arseneau.
Also, unlike many US states, Canada has “full recourse” mortgages, where the lender can come after you for losses even if you default and hand over your property, Arseneau noted in an email exchange.
In Canada, “individuals will opt to adjust their consumption before defaulting,” he wrote, adding lenders may want to consider refinancing mortgages to a longer amortization if borrowers find themselves in trouble.
Randall Bartlett, senior director of Canadian economics at Desjardins, sees other reasons why Canada would do better in a housing bust than the US.
“The US (housing market) has been hindered by the fact it hasn’t brought in as many new immigrants (as Canada),” Bartlett tells STOREYS.
On top of that, Canadians have “significant savings” and the labour market is strong, he added.
Nonetheless, Bartlett believes the Bank of Canada will see enough damage done to the housing market in the coming months to take a pause on interest rate hikes starting this fall. He sees a roughly 50% chance of a housing-led recession next year, though he notes that isn’t Desjardins’ “base case” scenario.
The Unlucky Few
Still, it does seem to be the case that the worst of the housing market downturn will be borne by a small group of people -- those who bought at the top of the market, during the period of ultra-low mortgage rates amid the COVID-19 pandemic.
Not only do these people have overall larger debt burdens compared to those who bought earlier, they are also more exposed to rising interest rates.
Historically, fixed-rate mortgages have been far more popular than variable-rate ones, but that changed over the past few years, when variable-rate mortgages were being offered at much lower rates than fixed-rate ones. As of May of this year, slightly more than half of all mortgages were variable-rate.
This means that many people who bought at the peak of the market may see not only a decline in the value of their homes, but higher mortgage payments right away.
“It’s going to be difficult for some households who bought at the peak of the pandemic housing boom,” Bartlett says. “But if you bought a home before the pandemic, you’re still going to see price gains relative to pre-COVID levels.”
That’s the prevailing expectation these days -- that this is a blip in an otherwise healthy housing market. Or as Bartlett put it: “You have a lot of tailwinds to the housing market, despite the fact that interest rates are rising.”
