A Full-Scale Assault on Canadian Real Estate Market Has Begun

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From rising mortgage rates to provincial-level intervention, to the uncertainty of what Canada's Minister of Finance has in store for us next week, a senior economist at BMO Capital Markets has put it in blunt terms about the domestic real estate market. We're seeing a full-scale assault on Canadian home prices from policymakers at every level, says Robert Kavcic.

Chronic supply shortages in major cities and their surrounding suburbs have put renewed focus on affordability. The Canadian Real Estate Association (CREA) says national supply hit its lowest level on record in both January and December. As a result, the composite home price index (seasonally adjusted) posted a record year-over-year increase of 28% in January. Kavcic identified four factors that could interrupt the run-up in home prices that has been eroding affordability for so many first-time buyers.

Two of these are new provincial rules announced on March 29: a higher, expanded non-resident buyer tax in Ontario (raised from 15% to 20%), and a two-percent foreign buyer tax introduced in Nova Scotia's budget. He also pointed to the recent jump in mortgage rates amid growing expectations of further hikes from the Bank of Canada. A number of economists, including some at BMO, have recently flagged the possibility of a 0.50% rate hike in April. There have also been signals from Citibank and Bank of America about potential 0.50% increases at each of the next three meetings.

Shifts in the bond market have already driven up fixed mortgage rates, since the five-year Government of Canada bond yield that influences them hit 2.5% by the end of March. As a reminder, it stood at just 1.25% at the end of 2021. Five-year fixed mortgage rates are already approaching 4%, and Kavcic believes variable rates could climb into the 3% range by early summer. This market held steady on rates near 1% throughout the pandemic. That's not coming back. On top of that, he says, it's still unclear what measures Finance Minister Chrystia Freeland will include in the federal budget on April 7.

Canada's Liberal Party placed heavy emphasis, during the last election, on an expanded set of measures aimed at improving housing affordability. One of the promised items was a two-year ban on foreign buyers purchasing property. Details on that measure, however, never materialized. What's more, a senior source told Bloomberg in December that the lack of progress on this front pushed the province to take matters into its own hands and raise the foreign buyer tax itself. Housing Minister Ahmed Hussen was directed by the Prime Minister to follow through on the campaign promise regarding foreign buyer activity, along with other measures, including an anti-flipping tax on residential property.

All of this is unfolding as rising interest rates are already starting to have a cooling effect on the Canadian real estate market, though some economists warn that the Bank of Canada will need to walk a careful line with its monetary policy, so as not to risk triggering a full-blown collapse of the housing market.

Central banks around the world have signaled plans to raise interest rates in 2022, in an effort to rein in global inflation. Earlier in March, the Bank of Canada already began its rate-hiking cycle, raising its key overnight rate by 0.25%.

In its updated forecast, CIBC projects that interest rates could reach 1.5% by the end of the year, and as high as 2.25% by September 2023.

We've been talking to a number of realtors who say they're already seeing demand soften in the red-hot Greater Toronto market over the past couple of weeks. In their view, this may be related to what's happening in the suburbs and nearby cities, which have seen extraordinary price growth over the past two years.

Some listings that would have drawn well over a hundred showings back in January are suddenly only getting 5 to 6 views a week. Homes listed with a set offer date are suddenly getting zero offers on that date. This is a transitional period, and it isn't affecting every market or every price range. But it's noticeable.

Michael Bourque, CEO of the Canadian Real Estate Association (CREA), recently told a federal finance committee that upward pressure on prices in Canada will keep intensifying, since the country's population, growing faster than any other G7 nation, mainly due to immigration, continues to outpace market supply. New home supply isn't coming anywhere close to matching demographic shifts and population growth, Bourque noted. Housing is becoming a scarce asset, and prices will keep climbing as a result. Until the obstacles to faster home construction are addressed, and Bourque listed NIMBYism, bureaucracy, high fees, and delays in municipal permitting approvals, real estate prices in Canada aren't going to come down anytime soon.

At the same time, many analysts believe rising interest rates genuinely have the power to cool Canada's booming real estate prices.

Investment banker Hilliard MacBeth warned the committee that such a correction, a sharp shift in asset values, typically 10% or more, isn't just coming, it's actually necessary to effectively rein in inflation. MacBeth first wrote a book back in 2015 warning of an impending burst of Canada's real estate bubble. While no collapse materialized, MacBeth told the committee his forecast remains correct, it was simply made too early. He says he's grown increasingly convinced there's a bubble in the real estate market every time he hears people talk about what seems like endless price growth across the country. In his view, the belief that real estate as an asset class is immune to market correction has become a genuine mania, one that's shown up worldwide since the start of the COVID-19 pandemic. Interest rates need to keep rising to correct this sharp run-up in prices, he argues, even if that risks a serious blow to the economy. MacBeth says central banks around the world need to show real resolve and keep raising rates, even in the face of short-term pain for consumers. Inflation needs to come down, he said, even if that means the market bubble collapses and triggers a recession.

Last week, Capital Economics senior economist Stephen Brown wrote that rising interest rates could crash the real estate market. That said, he also noted in a recent interview that the Bank of Canada may be willing to risk a modest downturn in real estate just to bring inflation under control. In his view, a modest 5-10% decline in home prices would likely be tolerable, since it would help cool the economy somewhat. He believes the real estate market can handle that, given that prices shot up so sharply during the pandemic, roughly 50% over the past two years. Brown believes the Bank of Canada won't be as aggressive as the US Federal Reserve, which signaled earlier this month that it expects to raise rates at every meeting through the end of this year. He expects the central bank to raise its overnight rate to 1.25%, then pause to see how that plays out on inflation.

Right now, rising mortgage rates are only affecting new homebuyers, since those renewing their mortgages can still lock in rates secured before the recent hikes. That's about to change soon, though. Mortgage holders renewing at rates from six weeks ago are happy with what they're getting. We'll see how things look six weeks from now.

That said, we're seeing borrower preference currently leaning toward variable rates. Five years ago, the five-year fixed rate sat around 2.75%. That means borrowers coming up for renewal soon will be facing a rate increase of at least 1%. Every 0.25% rate hike adds roughly $12 to the monthly payment on a five-year mortgage for every $100,000 of mortgage debt.

As we always remind our readers: every forecast from leading economists deserves a healthy dose of skepticism! Take Capital Economics itself, for example, which spent years forecasting a sharp drop in prices, only for Canadian real estate prices to nearly triple over that same stretch...