To what extent will Canadian real estate collapse?  Stability requires major correction: BMO - better analgesic

To what extent will Canadian real estate collapse? Stability requires major correction: BMO – better analgesic

The real estate bubble in Canada is finally starting to subside and everyone wants to know how low it is. BMO Capital Markets addressed this topic to clients over the weekend, providing examples and historical context. A rise in interest rates is sure to trigger a correction, purging the excess leverage. Prices have to drop dramatically just to absorb the higher interest rates. As for how long it will take to recover, the only other Canadian housing bubble of close to this size has taken 15 years to recover.

Historically, Canadian real estate prices have always corrected according to fundamentals

BMO found that Canadian home prices have increased about 3% annually since the 1980s. This roughly reflects inflation, real wage growth, and lower interest rates. If this sounds like a steep wage curve, remember that lower rates did most of the heavy lifting.

Except for the bubble period, housing is sold at a price compatible with liquidity. This is a great way of saying that people will only pay that makes sense to them. This is directly related to the mortgage leverage.

The conventional logic is that lower rates make homes more affordable. On the surface, it makes sense – lower interest paid means more can be paid to pay off the principal. In fact, lower prices increase the amount of leverage the buyer has. This allows buyers to absorb price increases more easily, and raise prices faster. This is a point that even the Bank of Canada (BoC) made recently, but which seems to be abandoned by many.

This is another day’s deep dive, but important for understanding price corrections. Yes, inflation is at a record high and mortgage rates have been lowered to a record low. These two problems cause housing prices to rise by increasing the leverage faster. However, BMO notes that a third of home prices today are the result of price movements in just the past two years. That’s nearly 10 times the historical average for growth, and more than low rates.

We have long emphasized that demographic and supply-side fundamentals drove price gains, even in the early stages of COVID-19 along with some economic adjustments. But, as we warned early last year, more recent price behavior has been driven by excess demand, market psychology and foam,” explained Robert Cavic, chief economist at BMO.

Higher rates will dampen some of that increase, already dampening speculators’ enthusiasm. “So, when we talk about housing correction, the question is not about whether, but where, how much and how much, and for how long?” He said.

Canadian real estate is 38% overpriced and needs a big drop just to accommodate the prices

To what extent will Canadian real estate prices correct? BMO has no crystal ball but calculations show that house prices are overestimated by 38%. This does not mean that a correction of 38% is coming by itself. But the overvaluation is very sharp, and prices must come down to maintain affordability.

Higher interest rates are often the way housing bubbles unwind excess price gains. “After leaving policy too loose for too long, psychology and affordability have already been tested by just 75 basis points of Bank of Canada tightening, and we expect another 125 basis points by the end of the year,” warns BMO.

Besides curbing the speculative mindset, high rates change buyer and investor expectations. For buyers, home prices range from 1.5% to anywhere from 3.75% to 5.4%, BMO warns. If home prices stall and income growth continues, prices must fall between 10% and 20% to maintain current affordability. This level may not be sustainable in the long term, which means that prices will fall even more.

High financing costs also pose a challenge to investors, as they reduce attractiveness. BMO estimates cap rates, the rent received from being the landlord, should go up to between 4% and 5%. This would be a more typical scenario for investors.

Currently, many landlord investors don’t even collect enough to cover their costs. They end up raising rents out of their pocket in exchange for higher house prices. It has worked so far with higher prices, but that will not be the case in a lower price environment. Prices must drop by 20% to bring the cap rates back to attractive levels without gains.

Of course, at the national level, market crashes vary greatly. For example, markets like Alberta have ratings that are not as stretched as Ontario.

Canadian property corrections took up to 15 years to recover

There are no set rules for the length of a home price correction, and it has varied widely. The bank has pulled data on major price corrections over the past 40 years to try to figure it out. They found that previous corrections take between two and 15 years to return to peak after an accident. The 15-year recovery was the Ontario real estate market during the late 1980s and early 1990s. It was an extreme example, and the convention is that it’s more tame.

“…History shows that it usually takes 2 to 3 years for domestic prices in Canada to correct downward, and 4 to 5 years to fully recover,” Kavic said. “Interestingly, with the exception of oil-driven markets in Alberta, interest rates have been the driver of all major corrections since the 1980s.”

Do not expect a financial crisis like the housing crisis in the United States

Although a bubble evoked US images in 2008, this is not typical of a housing crash. Kavcic sees minimal diffusion in other industries. The financial system has spent years preparing for this type of event.

Full return loans on mortgages are limited and stress tests ensure the ability of the borrower. Almost all mortgages issued in Canada are full haven, which keeps defaults low. Stress tests ensure buyers pay between 4.75% and 5.25% mortgage rates without extension.

“This won’t save home prices from falling, but it does provide good insurance that payments will continue to be made, especially with the labor market tight,” Kavcic explains.

The bank also sees fundamentals as preventing real estate from spiraling out of control. Strong immigration and the millennium demographic peak will prevent the floor from falling – sort of. Affordability still makes sense for these buyers.

“There will be buyers waiting; but prices need to make sense in the high-priced world.”

2022-05-24 18:51:50

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