The market is cooling and that could put pressure on indebted consumers
Falling house prices have been generating a lot of headlines lately. That’s understandable, given the fact that over two-thirds of Canadian households own their own home, and 36% of their wealth is wrapped up in that single asset.
Higher real estate prices have created a lot of wealth for Canadians, and the economy in general, in recent years. The rising value of homes, even if only on paper, makes homeowners feel richer, encouraging them to borrow and spend.
Now that house prices are increasing more slowly or falling in some areas, typically this consumption pattern would reverse with homeowners turning cautious on spending. That, in turn, would slow the economy at least in the short-term. However, over the longer term, the fundamentals behind continuing demand for housing in Canada, especially in urban centres, remains positive.
Three key reasons why housing price increases are slowing
1. New regulations in B.C. and Ontario
To curb rising prices, the governments of British Columbia and Ontario imposed taxes on non-resident buyers, among other measures, in an attempt to limit possible speculation driving up prices.
In August 2016, the B.C. government imposed a 15% tax on foreign buyers in the Greater Vancouver area. In April 2017, the Ontario government copied the measure, covering Toronto and the Greater Golden Horseshoe area. Then, in February, the B.C. government increased the foreign buyer’s tax to 20%, and expanded it to cover areas outside Greater Vancouver.
2. New bank lending rules
The Office of the Superintendent of Financial Institutions (OFSI) announced last autumn new restrictive lending rules for banks, beginning on January 1. Banks must now ensure that uninsured mortgage borrowers can afford to pay interest that is either 2% above the contracted rate or the five-year benchmark rate published by the Bank of Canada, whichever is greater.
This measure affects new homebuyers seeking a mortgage and homeowners renewing their mortgage with a different bank. This year, there is a higher than usual number of renewals coming due—47% instead of the typical 25-35%, according to CIBC.
3. Higher interest rates
The Bank of Canada began raising the overnight lending rate in July, moving it from 0.5% to 1.25% where it currently stands. Commercial banks have raised their borrowing rates as well, with the effective interest rate for households up about half a percentage point.
What’s the impact?
Recently, average prices have fallen in the previously hot markets of Vancouver and Toronto. The average price in the Greater Toronto Area peaked last April at about $920,000. As of March this year, it was about $785,000. While less dramatic in the Greater Vancouver Area, the peak price was $1.1 million in May last year, and average prices have been hovering just above $1 million for the last few months.
This is a result of a lower number of transactions. Between March 2017 and March 2018, the number of sales of existing homes has fallen by about 30% in Greater Vancouver and 40% in Greater Toronto, whereas sales in some other major markets declined by about 14% based on data from the Canadian Real Estate Association.
Canada’s economic growth is likely to slow down
One important outcome of these developments is that homeowners will have less equity to borrow against if the value of their home falls.
Some homeowners use the equity they have built up as collateral to access credit, using it to pay for everything from home renovations to cars to restaurant meals.
As well, the pick-up in interest rates means it’s more expensive to service a mortgage, leaving less disposable income. Last spring, Manulife found that 72% of mortgaged homeowners would have difficulty paying their monthly mortgage payment if it were to increase by 10%, equal to mortgage interest rates rising by one percentage point. Mortgage rates are up half a percentage point since July 2017.
Already, Canadians are feeling the pinch of rising interest rates. Interest and debt payments rose 9.2% and 6.7% respectively in the fourth quarter of 2017 compared to the prior year (see chart).
Because of the high debt load of Canadian households—$2.1 trillion in mortgage and non-mortgage debt at the end of 2017—the Governor of the Bank of Canada estimates the economy is 50% more sensitive to rate hikes than in the past.
As a result, the Bank of Canada needs to raise interest rates sufficiently to manage inflationary pressures, but not so much that it risks putting households into a cash crunch, sending loans into default. This would hit bank balance sheets, restraining their lending capacity with negative effects through the whole economy.
Foundation for a balanced housing market
The good news is that rising disposable income and population growth are providing support to the housing market.
The pace of wage growth is strengthening in Canada, leading to more disposable income in the pockets of consumers. (For more details on wage growth, see the feature article in our February Economic Letter.)
Meanwhile, Canada’s population will continue growing at a pace of about 1.2% over the next few years, with immigration responsible for two-thirds, according to Statistics Canada. While this is modest, there are two aspects to our population growth, which are positive for housing demand.
- First, the aging of the population won’t necessarily reduce demand for housing. Researchers at the Bank for International Settlements argue that in wealthier countries, such as Canada, the elderly will stay in their homes, given they generally own them outright and it is stressful to move. This will help underpin demand for new housing stock.
- Second, non-permanent residents coming to Canada are today more likely to be workers and students rather than refugees as they were 20 years ago, which means they are more likely to form households. According to research by Canada Mortgage and Housing Corporation, non-permanent residents were more likely to buy either more expensive homes than, or homes of the same value as, permanent residents. This will also be supportive of continuing housing demand.
What does this mean for entrepreneurs?
- Businesses may see consumer spending slow as interest rates continue to rise, limiting households’ disposable income.
- If your business is exposed to the housing sector, a slowdown is occurring which is likely moving the market to a more sustainable pace of expansion.
- The housing market is cooling, but a crash is not anticipated.
Culled from BDC Monthly Economic Letter. May 2018