Canadian real estate’s high flying prices are increasing the risk of a large correction. BMO Q2 2021 disclosures show the bank made big revisions to its risk forecast. In the best-case scenario, they see exuberance pushing prices more than twice as high as previously thought. In the worst case, they’ve more than doubled the size of potential price declines.
Macroeconomic Scenario Assumptions
Financial organizations are required to assess risk using unbiased, and possible outcomes. When they do so, they create various forecasts for different macro environment risks. Typically they create three forecasts — a best case, base case, and worst-case scenario.
The base, best, and worst-case scenarios are exactly what you would expect. The base case is the most probable outcome they believe will happen. If the future goes exactly as planned, this is how they would expect things to unfold. The best case is if the situation surprises. The worst-case scenario is if the situation surprises to the downside.
It’s important that all three of the scenarios are realistic though. Too optimistic, and a few bumps in the road mean bail-out time. Too pessimistic means taking too few risks, and failing to maximize profits… which leads to a different kind of bailout. The point is these aren’t fear-mongering or asset-pumping numbers. They’re reasonable outcomes the bank believes are possible.
The Worst-Case Scenario For Canadian Real Estate Is A 29% Drop
The worst case, or “adverse” in BMO lingo, is a lot worse than they had expected just a few months ago. As of April 31, 2021, this scenario includes a drop of 12.3% for 2021, and another 18.7% decline in 2022. Compounded, that works out to a 28.7% decline in home prices from a year before.
BMO Canadian Real Estate Risk ScenariosBMO macroeconomic assumptions for Canadian real estate prices under various risk scenarios. Source: BMO; CREA; Better Dwelling.
This is a much larger house price decline than they anticipated was possible just a few months ago. In October, they had forecast a 9.1% decline for prices in 2021 for this scenario. It would then be forecast to fall another 4.6% in 2022, bringing the worst-case loss forecast to 13.28% by the end of next year. The revision sees the decline becoming more than twice as large in the event of a downturn. In other words, the bear case is even more bearish than before.
The Base-Case Scenario Sees Home Prices Rise 24%
The base case, or the most likely outcome they currently see, also got some big revisions — one positive, one negative. The bank’s risk department sees 17.8% price growth in 2021, followed by another 5.1% in 2022. That puts the total increase at 23.81% higher by the end of 2022. At the current rate, one more month of growth would put prices above their year end target. Most institutions do expect the market to cool a little by year end.
This is also a massive increase compared to what they were expecting just a few months ago. As of October 31, 2020, the bank had forecast prices to increase 4.5% in 2021, followed by 2.5% in 2022. This would compound to a 7.11% increase by the end of next year. The revision for the base case is more than 3x what was expected less than a year ago.
The Best-Case Scenario Is Home Prices Rise 33%
The best case, or “benign” at BMO, would mean the country would be pretty much unlivable for anyone under 40. They see prices rising up to 20.8% in 2021, and then adding another 10% in 2022. This would bring the gains to 32.88% by the end of next year. If you consider that few local incomes can already support these prices, it would require a huge injection of foreign capital.
Just a few months ago, they didn’t see this kind of growth at all. The October 31, 2020 best case scenario forecast 9.6% growth in 2021, followed by 5.4% in 2022. That would have brought prices 15.52% higher than last year. The revision filed today is more than twice as large, so the bull case is even more bullish.
The bearish case is much worse than previously expected, but the bullish case also got better. It’s kind of confusing if you’ve never seen a risk scenario, but the takeaway is uncertainty. The spread between the best and worst-case scenarios is now 33.1 points for 2021. It was only 18.7 points in October. Markets see the spread shrink in more predictable environments. Spreads increase in less predictable ones.
Back in October, when dinosaurs roamed the earth, home prices had only seen modest growth. Economists argue price growth was even in-line with the interest rate cut in Q2. Since October, Canada’s benchmark home increased $100,000 in price — a year of the median household’s income. Now prices dropping 30% is just as likely as another year of exuberance. At least from a bank’s risk perspective.
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