Everyone is interested in determining how low real estate prices can go in Canada now that the real estate bubble there has finally started to deflate. Over the course of the weekend, BMO Capital Markets provided clients with an analysis of the topic, including models and historical context. Increasing interest rates will undoubtedly bring about a correction because they will eliminate excessive leverage. Simply to account for the higher borrowing rates, prices will need to fall by a large amount. Concerning how long it will take for the market to recover, the only prior housing bubble in Canada that was nearly this magnitude took 15 years for the market to recover from.

Historically, Canadian real estate prices have always adjusted to fundamentals

Since the 1980s, BMO Research discovered that the cost of housing in Canada has climbed by approximately 3% annually. This is roughly a reflection of inflation, growth in real wages, and lowering interest rates. Remember that low-interest rates handled the majority of the heavy work, so don't be surprised if it seems like a sharp slope for salaries. Housing often trades at a price that is in line with its liquidity, with the exception of when it's in the midst of a bubble. People will only pay for something that makes sense to them, to put it in more eloquent terms. This has a direct bearing on the use of leverage in mortgage transactions.

The conventional wisdom holds that a reduction in interest rates will make housing more affordable. On the surface, it makes perfect sense: paying less interest means more money can go toward paying down the debt. In point of fact, a decrease in interest rates results in an increase in the amount of leverage available to a buyer. The ability of purchasers to more readily tolerate price increases results in prices rising even more quickly. This is a point that has been emphasised in recent times by the Bank of Canada (BoC), but it appears that many people have ignored it.

This will require a more in-depth discussion at another time, but it is essential to comprehend pricing adjustments. The rate of inflation is currently at an all-time high, while mortgage rates have recently fallen to an all-time low. Both of these factors contribute to a faster increase in leverage, which ultimately drives up housing prices. However, according to BMO, a third of today's housing prices are the result of price fluctuations that have occurred during the past two years alone. That is far higher than low rates, and it is approximately ten times the historic average rate of growth.

“We’ve long maintained that demographic and supply-side fundamentals have driven price gains, even in the early stages of COVID-19 alongside some economic adjustments. But, as we warned early last year, more recent price behavior has been driven by excess demand, market psychology and froth,” explained Robert Kavcic, a senior economist at BMO.

Increasing interest rates will reduce some of that excess, which is already dampening the enthusiasm of speculators.  “So, when we speak of a housing correction, it’s not a question of if, but where, how much, and for how long?” he said.

Canadian Real Estate Is 38 Percent Overpriced And Requires A Substantial Decline Just To Accommodate Interest Rates

How much will the market for Canadian real estate eventually correct? Home prices are approximately 38 percent overvalued, according to BMO's estimations; the bank does not have a crystal ball. That does not necessarily mean that a correction of 38 percent is on the horizon. However, the level of overvaluation is so high that prices need to reduce in order to maintain the same level of affordability. Raised interest rates are nearly invariably the method that is used to eliminate excess price gains in housing bubbles. “After leaving policy too loose for too long, psychology and affordability have already been tested by just 75 bps of Bank of Canada tightening, and we expect another 125 bps by year-end,” warns BMO.

In addition to putting a stop to speculative thinking, a rise in interest rates alters the perspective of buyers and investors. According to BMO, housing prices for purchasers go from being priced with mortgages at 1.5 percent to being priced with mortgages between 3.75 percent and 5.4 percent. In the event that housing prices remain flat and incomes continue to rise, prices will need to fall by between 10 and 20 percent for affordability to remain at its current level. That level may not have been able to be maintained over the long term, which would have meant that prices would have to go further lower.

Investors face an additional challenge in the form of a reduction in attractiveness when there are higher financing expenses. According to projections provided by BMO, cap rates, often known as the rent collected from being a landlord, would need to increase to between 4 and 5 percent. That is a situation that investors encounter more frequently than not.

At the moment, a significant number of investor landlords are not even receiving sufficient income to meet their expenses. They wind up increasing their rents out of their own pocket in exchange for the rise in the value of their home. Up until this point, it has been successful since prices have gone up, but if interest rates were to go down, this wouldn't be the case. A twenty percent drop in price is necessary in order to bring cap rates back to reasonable levels if there are no gains. At the national level, a market breakdown, of course, varies greatly from place to place. Comparatively speaking, markets such as Alberta have values that aren't as stretched as those in Ontario.

Real Estate Corrections In Canada Took Up To 15 Years To Recover

The length of time that a decline in housing prices lasted was extremely variable due to the absence of any predetermined guidelines regarding the matter. In order to try to figure this out, the bank gathered information on significant price drops that had occurred over the preceding 40 years. They discovered that it takes between two and fifteen years for the market to return to its original peak after a correction. The real estate market in Ontario saw a recovery that lasted for 15 years throughout the late 1980s and early 1990s. This was an extreme example; in general, things are considerably more subdued.

“…history suggests that localized price corrections in Canada usually take 2-3 years to bottom, and 4-to-5 years to fully recover,” said Kavic. “Interestingly, with the exception of oil-driven markets in Alberta, interest rates were the trigger for all major corrections since the 1980s.”

Do Not Anticipate A Financial Crisis Comparable To The US Housing Crash

Even if the bursting of a bubble conjures up thoughts of the United States in 2008, that kind of scenario is not typical of a real estate crisis. According to Kavcic, there will be little impact on other businesses. The global financial system has spent years getting ready for anything like this to happen.

The availability of full recourse mortgages is restricted, and stress tests are used to evaluate borrower capability. Full recourse is required for almost all mortgages in Canada, which helps to keep the number of defaults to a minimum. The stress test ensures that purchasers have the financial flexibility to pay mortgage rates ranging from 4.75 percent to 5.25 percent without experiencing financial hardship.

“This won’t save house prices from falling, but it provides good insurance that payments will keep being made, especially with the labor market so tight,” explains Kavcic. 

The bank believes that fundamentals will keep real estate from spiralling out of control for the foreseeable future. Strong immigration and a Millennial cohort that has reached its peak will, to some extent, keep the floor from collapsing. Affordability must still make sense for these prospective purchasers.