Housing Market Could Face a Historic Correction

Amid Sharply Rising Interest Rates

According to a new RBC report, Canadas real estate market could be facing its largest downturn in several decades. After home prices soared during the pandemic - with some of the priciest markets seeing gains of 50 percent or more - the countrys largest bank is forecasting that national home prices will fall by more than 12 percent by early next year.

According to RBC economist Robert Hogue, this downturn will be larger than any of the four corrections the Canadian real estate market has gone through over the past 40 years. Economic conditions are deteriorating sharply for Canada's housing market, Hogue says.

The correction is being driven largely by the Bank of Canada's recent monetary policy shifts, which have pushed interest rates up to their highest level since the country emerged from the 2008 financial crisis. With inflation already at its highest level in 40 years and expected to keep climbing in the months ahead, the Bank of Canada raised its key policy rate to 2.5% in July, driving up borrowing costs for both existing mortgage holders and prospective buyers.

The market is already showing significant signs of cooling. According to a report from the Canadian Real Estate Association (CREA), June marked the third consecutive month of slowdown, with home prices posting their largest monthly decline on record. RBC projects that home sales volumes will fall 23% this year and a further 15% next year. The overall decline - 42% from the start of 2021 - would exceed the 38% drop recorded during the 2008-2009 downturn.

According to RBC, British Columbia and Ontario will be the epicenters of this correction. Sales volumes in these two provinces - where activity and prices climbed the most during the pandemic - are expected to fall by 45% and 38%, respectively, across 2022 and 2023. The scale of this correction could rival the downturn Ontario experienced in the early 1990s, when home sales fell 41% and prices dropped 15%. Still, Hogue notes, it won't be as severe as the 1980s correction in British Columbia, when sales fell 62% and prices dropped 27%.

While many economists are forecasting a cooling housing market in the months ahead, RBC's forecast is among the most bearish of any major Canadian bank. Earlier this month, RBC was also the first major bank to forecast a moderate recession for the Canadian economy in early 2023. Still, while RBC anticipates a correction, it doesn't believe a full-blown collapse of the housing market is in store, Hogue explains. We'd characterize the unfolding downturn as a desirable cooling-off after two years of frenzy that placed an enormous financial burden on many new homeowners and made the dream of homeownership harder to achieve, Hogue says. While we can't rule out the possibility of a harsher, more prolonged downturn, we believe the correction will largely run its course by around the first half of 2023, with some markets stabilizing faster than others.

Robert Kavcic, senior economist at BMO Capital Markets, also noted that the Bank of Canada's latest decision to sharply raise its key interest rate is pushing the housing market toward an even deeper correction (i.e., price decline) next year. Kavcic says the surprise full-percentage-point rate hike delivered by Tiff Macklem in July hit the housing market like a sledgehammer. He argues that the increase - which pushed commercial banks' prime rates up to an average of 4.70% today - has made it considerably harder to qualify for a mortgage under Canada's stress test rules. The test sets the qualifying rate for uninsured mortgages at the contract rate plus 2%, or 5.25%, whichever is higher. Kavcic notes that before the rate hike, borrowers with a variable-rate mortgage were still able to qualify at 5.25% - but that figure has now climbed to nearly 6%. In his view, that's simply too high a bar for the market to clear. Borrowers choosing a fixed-rate mortgage today are already qualifying at roughly 7%, which Kavcic says will likewise weigh on their purchasing power.

At the same time, government bond yields have begun falling significantly in recent weeks, as economic concerns have gradually started to overtake worries about inflation. The yield on five-year government bonds, which determines fixed mortgage rates, fell to 2.84% by the end of July. Just recently it stood at 3.15%, and in mid-June it was as high as 3.59%. That decline has been driven by growing expectations of an economic slowdown and a possible recession.

What does this mean for fixed mortgage rates? Central banks are expected to soon be grappling with an economic downturn. That means slower growth, lower inflation, and lower mortgage rates. By the end of July, the lowest five-year fixed mortgage rate offered by national lenders had fallen by nearly 0.10%, as five-year bond yields declined following their earlier increases. Barring any other changes, a five-year bond yield below 3% would put uninsured five-year fixed rates at major banks on track to return to the 4.5%-4.7% range, or possibly even a bit lower, down from over 5% currently. We're continuing to watch this trend unfold, though it's still too early to say whether fixed rates have peaked.

And what about variable rates? Borrowers with variable-rate mortgages shouldn't expect much relief in the near term, having already watched the prime rate - which drives variable mortgage rates and lines of credit - climb to 4.70%. As a reminder, it stood at 2.45% during the pandemic.

Further rate hikes are all but certain. The Bank of Canada is expected to raise its overnight rate again at its next meeting on September 7. Most economists believe the rate will reach 3.25% by year-end - 0.75% higher than it is today. The average five-year variable rate with the deepest discount is now approaching the 4% mark. The combined increases in fixed and variable rates are having a significant impact on affordability, says analyst Ben Rabidoux. By his calculations, the average monthly mortgage payment on a typical home has risen by $1,150 over the past 10 months.

In closing, we want to emphasize this: don't give in to panic or make hasty, ill-considered decisions about changing your mortgage. We've been watching and analyzing the real estate financing market for more than 20 years, and we've seen various booms, busts, and crises, along with the Bank of Canada's and the financial markets' responses to them. If rising mortgage payments are a concern for you, reach out to your bank or an experienced mortgage broker for guidance and advice!