The ‘Issue of the Year’ is Part 2 in an annual week-long STOREYS editorial series. Check back tomorrow to find out who our ‘2022 Newsmaker of the Year’ is.

What a difference a year makes.

This time last year, home sales were running some 50% above their long-run average, housing prices were hitting record highs, and mortgage rates were near all-time lows.

Today, sales are at multi-year lows, the Teranet house price index has clocked its biggest decline on record, and mortgage rates are at levels that are giving heart palpitations to variable-rate mortgage holders.

In short, the party ended, halting a two-decade bull run of nearly uninterrupted price gains in Canada’s real estate market. Homebuyers and sellers alike pulled back from the market, uncertain what comes next.

But why? What happened to this market that -- until now -- weathered every crisis that came its way, including a pandemic?

The answer can be summed up in one word: Inflation. 

After lying dormant for years, this old bogeyman of the economy reared its head up last year, and in 2022 it soared to its highest levels in decades. It took the world’s central banks by surprise, who found themselves playing catch-up when they realized these price hikes were more than a “transitory” shock from the pandemic. 

Central banks around the world began raising interest rates aggressively, and the Bank of Canada was no exception. This year’s jump in the Bank’s key lending rate, from 0.25% to 3.75% (so far) was the fastest series of rate hikes since at least the 1990s.

The market’s positive psychology, the strong underlying demand for housing -- none of it could hold in the face of a hard mathematical reality: That a house bought today will cost you a much larger monthly paymentthan the same house bought at the same price just a few months ago.

According to National Bank of Canada’s housing affordability monitor, the monthly payment on an average home in Canada took just over 40% of the average household’s income prior to the pandemic -- already a high level compared to historic norms. But by the second quarter of this year, it took an incredible 63.9% of household income. 

That’s the second highest level on record, behind only the early 1980s, when a previous fight with inflation led to double-digit mortgage rates that strangled the market.

So it’s little wonder that house prices have been falling since the BoC started raising rates. The average resale price of a house in Canada dropped by $172,000, or 21%, in the eight months between February and October.

That’s a considerably larger drop than most other countries are seeing, despite rising rates all over the world. For instance, though sales are slowing in the US, the average house price continued to rise this year, coming in at US$379,100 in October, up 6.9% from a year ago. Then again, the pandemic boom in US house prices was half as large as Canada’s.

So what caused this incredible Canadian house price run-up in the first place? 

According to Darren King, an economist at National Bank of Canada who tracks the housing market, a number of factors came together over the past few years to push the market up to dizzying heights. The first was a growing housing shortage.

“Supply was already limited in the market, and it just got worse during the pandemic with demand increasing,” King said.

Then the Bank of Canada injected very low mortgage rates into this housing shortage, in an effort to keep the economy stable during the pandemic shutdowns. 

“The Bank decreased rates to the lowest level they can without going negative, and they also signaled they would keep rates low for a long time,” King said. “That might have been a mistake in retrospect.”

Indeed, some central banks are owning up to that mistake. Reserve Bank of Australia governor Philip Lowe recently apologized to stressed-out homebuyers for telling them that interest rates were unlikely to rise until 2024. So far, Bank of Canada governor Tiff Macklem hasn’t followed suit for his own similar comments.

According to Capital Economics, the drop in mortgage rates in 2020 boosted the maximum amount homebuyers could afford by around 15% to 20%. Stephen Brown, Capital’s Chief Canada Economist, says the rest of the price jump can be explained by an overall increase in demand for real estate among Canadians.

“Because consumers were forced to stay home, many were able to build up more substantial down payments than they would have before the pandemic, which supported purchasing power,” he wrote in an email to STOREYS.

Brown noted that the increase in single-family home prices was much larger than the increase in condo prices. That “supports the idea that the increase in overall prices was driven to a large extent by a desire for more spacious homes, with people willing to either commit more of their income or move further away from their place of work and therefore bid up prices beyond what would normally be supported by local incomes,” he wrote.

Katherine Judge, a senior economist at CIBC, notes that during the pandemic, “job losses were concentrated in industries where people tended to rent, rather than in the homebuying segment.” That changed the balance in the market. The rental market took a hit, while the housing market took off. 

But with pandemic shutdowns coming to an end, some of that trend reversed. Rural areas and small towns that saw the largest run-up in house prices are now seeing some of the largest price declines. The apartment market, which saw rents falling in 2020, is now seeing steep rental increases, especially in major cities. 

Stuck Between Inflation and a Housing Shortage

With a price correction now well underway, the future of the housing market seems to hang in the balance between two opposing forces: Higher mortgage rates that are likely to endure for years, and accelerating population growth, which is likely to put even more upward pressure on house prices in the years to come.

On the one hand, mortgage rates are unlikely to return to the low levels seen prior to the recent run-up; almost no economist has that in their forecast. Many economists, including King, see higher inflation for the long run due to “structural” reasons like the shift to green energy and the “repatriation of supply chains,” meaning manufacturers moving production out of low-cost countries like China, often due to political tensions with the West. 

All this could mean higher mortgage rates for the long run. That means Canadians who renew their fixed-rate mortgages in the coming years will see their monthly payments jump, in some cases by large amounts. This could put downward pressure on the housing market, as well as on the consumer economy, in the years ahead.

On the other hand, “the demographics of the country are really, really strong,” as King puts it. The federal government recently announced it is raising its immigration targets, to 465,000 newcomers next year, rising to 500,000 per year by 2025. 

In King’s view, a million new residents every two years is good news in the long term for the housing market.

“With the lack of supply we already have, when you add to that a change in consumer preference (for homes) and borrowing capacity, it’s just another stimulus,” he said.

Still, this amounts to bad news for first-time buyers. King doesn’t see housing affordability returning to the levels seen before the pandemic -- levels that were already fairly high.

And while he expects Canada’s housing market to be healthy in the long run, next year’s market likely won’t be. 

Like many other forecasters, he expects the Bank of Canada to raise rates at least one more time, reducing homebuyers’ purchasing power yet again, before pulling back on rate hikes next year. Many forecasts see even slower sales next year than in 2022, with house prices bottoming out by the spring of 2023. 

But that doesn’t mean the market will immediately return to strong sales and price growth after that. And the wild card here is what the BoC’s rate hikes will mean for the broader economy. Central banks have a long track record of pushing economies into recession with their rate-hiking cycles, and this time may not be an exception. A September report from Bank of Montreal pegged the odds of a North American recession in the next year at above 50%.

If a recession does materialize, leading to mass job losses, expect the forecasts for the housing market to get considerably more pessimistic, at least in the short run. But among the most prominent economists looking at the housing market, the general view is that, whatever the short-term pain, the housing market has the wind at its back.

“Even if we [get] a slowdown in the market, it will still be resilient compared to other past economic slowdowns we’ve had,” King said.

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