The cost of ownership has risen to levels not seen in decades, and even though many people may want to buy, very few will be able to at current prices. Also, many existing owners facing rising costs might cash in their equity instead of subsidising their real estate investment from their savings. A recent report estimates 81 percent of new condo rentals in Toronto are losing money every month.
If economic fundamentals reassert themselves, according to the International Monetary Fund (IMF), that would lead Metro Toronto and Metro Vancouver home prices to drop significantly.
When buyers see a hot market softening significantly, they begin to fear a crash, and these feelings of uncertainty prompt them to take a ‘wait-and-see’ approach. They want to avoid buying at a peak when waiting a few months may save them five per cent or more on the price of a home.
In a weak market, potential homebuyers wait for news that inspires more confidence in an upward price movement.
Buyers can almost always wait, but sellers facing financial challenges may not have the luxury to defer their home sale until the market recovers.
Before the recession, some of the most respected economic analysts in the world believed there was concrete evidence that Canadian real estate was at a high risk of a significant correction.
The Bank of Canada
In early December 2023, the Bank of Canada released a report that delved into two housing-related vulnerabilities: the elevated level of household indebtedness and high house prices.
Bank of Canada Vulnerability #1: High household debt
Canadian Debt to Disposable Income Has Been Rising Steadily
“Turning to high indebtedness, a key concern here is that financially stretched households have little breathing room to absorb any disruption to their income. A job loss could force many to drastically cut their spending to keep servicing their debt. A drop in housing prices could also reduce household consumption because many people use their home as collateral to secure a home equity line of credit or refinance their mortgage. And an increase in unemployment or drop in house prices would have worse effects on the economy today because both debt levels and the share of wealth concentrated in housing have risen over time”
In a speech to the Ontario Securities Commission, the Bank of Canada Governor Tiff Macklem acknowledged rock-bottom interest rates are inflating house prices and that The Bank is monitoring Canada’s heavily indebted households.
“Let me sum up our current assessment of the housing market. House prices have increased significantly over the pandemic. The moderation that we saw until recently pointed in the right direction, but housing remains very expensive. And the risk of a correction in some markets is a concern that we need to watch,” Macklem said.
With record-high debt and rising interest rates, Canada could be headed for a high financial stress event.
In 2013, the Bank of Canada published a paper providing examples of financial stress events. Remember, these impacted financial markets and often resulted in recessions but did not necessarily result in a significant house price drop. The past high-financial-stress events listed by the Bank of Canada were:
2020 - The Coronavirus Pandemic resulted in government and Bank of Canada emergency intervention.
2007 - Lehman Brothers bankruptcy leads to the Great Recession
1994 - Mexican peso crisis
1992 - Black Wednesday, European exchange rate mechanism crisis
1989 - Toronto house price collapse
Bank of Canada Vulnerability #2: Imbalances in the housing market
Okay, the Bank of Canada’s biggest concern was Canadians taking out large mortgages to buy homes, so it’s no coincidence that their second most pressing concern is the housing market.
“When house prices grow at a faster pace than can be explained by economic fundamentals, a price correction that leads to financial stress becomes more likely. This can be serious when buyers are highly indebted.
Overall, imbalances in housing have diminished but remain an important vulnerability. Froth from rising expectations of house price growth has declined in housing markets in the Toronto and Vancouver areas over the past two years. While the Toronto market appears to be stabilizing, prices and resale activity continue to decline in Vancouver. Ongoing difficulties in the oil sector are weighing on housing markets in oil-producing provinces.”
They are saying that if homes become too unaffordable, then there is a risk that eventually, prices will drop to an affordable level so that all the properties for sale can find a buyer…eventually.
Commercial Banks
The CEO of Scotiabank and the Chief Economist for CIBC feel that these risks are much less likely to affect Canada. These banks have huge mortgage portfolios and are closely watching these risks. These same banks have been tightening their mortgage rules.
UBS Bank
According to UBS, a Swiss bank that serves the world's ultra-wealthy, eight financial centres are in bubble territory. Toronto and Vancouver are two of the ‘bubble cities.’
Concerned by real estate market risk, CMHC and the Canadian Federal Bank Regulator began enacting policies as far back as 2008 to reduce how much Canadians could borrow.
2008: Reduced the maximum lifespan of a mortgage from 40 years to 35 years.
2010: Applied a stress test against the 5-year contract rate for mortgages with a down payment of less than 20%.
2011: Reduced the maximum lifespan of a mortgage from 35 years to 30 years.
2012: Reduced the maximum lifespan of a mortgage from 30 years to 25 years on mortgages with a down payment of less than 20%.
2016: Banned default insurance on refinances, mortgages greater than 25 years, and single-unit rentals.
2018: Applied a stress test to mortgages with a down payment of greater than 20%.
2020: Raised the credit quality requirements for mortgage applications.
The continued government interventions show unabated concern about elevated household debt levels and potentially unsustainable home values.
Office of the Superintendent of Financial Institutions (OSFI)
The Office of the Superintendent of Financial Institutions (OSFI), the government agency that oversees bank risk, says “key vulnerabilities include Canadian household indebtedness.” On June 4th, 2019, raised the amount of capital that Canadian banks need to hold to weather a financial crash. Essentially, the regulator ordered Canadian banks to take out a bigger insurance policy against a financial crisis.
OSFI is the same arm of the government that, in January 2018, required Canadian banks to apply a stress test when Canadian borrowers apply for a mortgage.
What about other International Economic Institutions?
Based on BIS’s analysis, Canada has a greater than 50% chance of a financial correction (BIS would call it a “stress event”).
Finally, in June 2019, the IMF said that in the event of a downturn, the Canadian banks will be fine, but Canadian households are vulnerable. The impact on households would be significant as the share of households with debt at risk (defined as households with mortgage payments greater than 40% of income) would increase from 17% to 29%. If that happened, defaults would rise, and the Federal government would have to inject C$15 billion into the Canada Mortgage and Housing Corporation (CMHC).
Canada was risk-laden before the pandemic. Our regular debt payments are too high relative to our income, and the situation will worsen if the 5-year interest rate continues to rise.
