Canada

How Much Will Canadian Real Estate Crash? Stability Requires A Big Correction: BMO

Canada’s real estate bubble is finally beginning to unwind and everyone wants to know how low it goes. BMO Capital Markets tackled the subject for clients on the weekend, providing models and historical context. Rising interest rates are certain to cause a correction, as it purges excess leverage. Prices need to drop significantly just to accommodate higher interest rates. As for how long it will take to recover, the only other Canadian housing bubble nearly this size took 15 years to recover. 

Canadian Real Estate Prices Historically Have Always Corrected To Fundamentals

BMO found that Canadian home prices have increased about 3% per year since the 1980s. This roughly reflects inflation, real wage growth, and falling interest rates. If that seems like a steep curve for wages, remember that low rates did most of the heavy lifting. 

Except for during a bubble, housing sells for a price consistent with liquidity. That’s a fancy way of saying people will only pay makes sense to them. This is directly related to mortgage leverage.

Traditional logic is lower rates make homes more affordable. It makes sense on the surface — less interest paid means more can go to pay down principal. In reality, a drop in rates increases the amount of leverage a buyer has. This allows buyers to more easily absorb price hikes, raising prices even faster. This is a point even the Bank of Canada (BoC) has made recently, but many seem to have glossed over.

That’s a deep dive for another day, but important to understanding price corrections. Yes, inflation is at a record high and mortgage rates were cut to a record low. Both of these issues drive home prices higher by increasing leverage faster. However, BMO points out that a third of today’s home prices were the result of just the past 2 years of price movements. That’s almost 10x the historic average for growth, and in excess of low rates.

“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.

Higher rates will unwind some of that excess, already deflating speculator enthusiasm. “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% Overvalued and Needs A Big Drop Just To Accommodate Rates

Just how much will Canadian real estate prices correct? BMO doesn’t have a crystal ball but calculations show home prices are about 38% overvalued. That doesn’t mean a 38% correction is coming, per se. But the overvaluation is so steep, prices need to fall to keep stretched affordability.

Higher interest rates are almost always how housing bubbles purge excess price gains. “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. 

Beyond the speculative mindset curb, higher rates change the buyer and investor outlook. For buyers, home prices go from being priced with mortgages at 1.5% to between 3.75% to 5.4%, warns BMO. If home prices stall and income growth continues, prices need to drop between 10% and 20% to maintain current affordability. That level may not have been sustainable long term, meaning prices would have to fall further.

Higher financing costs are also a challenge for investors, since it reduces attractiveness. BMO estimates cap rates, the rent received from being a landlord, would need to rise to between 4% and 5%. That would be a more typical scenario for investors.

Currently, many investor landlords aren’t even collecting enough to cover their costs. They end up topping rents up out of pocket in exchange for the home price appreciation. So far it’s worked out as prices climbed, but that wouldn’t be the case in a falling rate environment. Prices need to fall 20% to bring cap rates back to attractive levels without gains.

Of course, at the national level, a market breakdown varies significantly. For example, markets like Alberta have valuations that aren’t as stretched as Ontario.

Canadian Real Estate Corrections Have Taken Up To 15 Years To Recover

There are no set rules for how long a home price correction lasts, and it varied significantly. The bank pulled data on major price corrections over the past 40 years to try and figure this out. They found previous corrections take between 2 and 15 years to return back to peak after a crash. The 15-year recovery was the Ontario real estate market during the late 80s and early 90s. It was an extreme example, the norm being much tamer.

“…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.”

Don’t Expect A Financial Crisis Like The US Housing Crash

Despite the popping of a bubble bringing up images of the US in 2008, that’s not typical for a housing crash. Kavcic sees minimal spillover into other industries. The financial system has spent years preparing for this sort of event.

Full recourse mortgages are limited and stress tests ensure borrower ability. Virtually all mortgages issued in Canada are full recourse, keeping defaults low. Stress tests ensure buyers can pay between 4.75% and 5.25% mortgage rates without stretching.

“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 sees fundamentals preventing real estate from getting too out of hand, as well. Strong immigration and a peak Millennial demographic will prevent the floor from falling out — sort of. Affordability still has to make sense for these buyers.

“There will be buyers waiting; but prices need to make sense in a higher-rate world,” he said.

30 Comments

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  • Reply
    Sam 7 days ago

    We need a 75% correction for the housing to be barely affordable.

    • Reply
      Fraser 7 days ago

      agree

    • Reply
      Aziz 6 days ago

      This all inflation deflation interest is a hoax….the banks created a trap to take people’s savings and now they make them bankrupt by increasing interest rate….who will benefit the most from raising interest rate 🤔……. i feel sorry for 35 million Canadians who say they are really smart 🤓…but they aren’t

    • Reply
      Dave 6 days ago

      Yes, please crash. Maybe us normal folks just might be able to own a house in our lifetimes…

  • Reply
    Fazid 7 days ago

    Canadian home prices need to drop 50% for the average family to afford home prices.

  • Reply
    Trader Jim 7 days ago

    Ontario cottage country is something like 70% overvalued. It’s nutty and makes no sense how everything costs exactly as much as the CMHC limit. Oh wait, that makes perfect sense.

  • Reply
    Gerald Haw 7 days ago

    It’s fine. All of the world’s richest people plan to immigrate to Canada so they can see things like the rubber duck come to town. Canada’s a boring and quiet place, which is nice. But it’s hard to pay a premium for boring and an eroding standard of living.

    • Reply
      Craig 7 days ago

      You joke but real estate twitter is filled with that narrative. Some aren’t even smart enough to understand they need to be rich. They think someone who’s going to earn 80 cents on the dollar is going to beat locals who can’t afford to buy.

  • Reply
    Charlie Flynn 7 days ago

    While at University in Ottawa in 1975 I was offered a summer job in what can best be described as almost a village of buildings and offices dedicated to building econometric models for future economic activity and trends. It is entirely obvious the Minister of Finance and the Central banker has assess to this information. In spite of this mountain of information, they ignored it all and printed money ad infinitum with no adult in the room to monitor them. Then when the fruits of their printing machines dropping billions of dollars into Canada created inflation, they stated it was “transitory”. It is mind-numbing their reluctance to read and analyse the data presented to them. Like children gouging on Halloween treats we all must succumb to the stomach-churning results of their collective behaviour. There is simply no excuse for their childish over-indulgence and glee at printing money and reducing real interest rates by government intervention.

  • Reply
    Jared Webster 7 days ago

    Except he misses out in the fact that the stress test is useless if there is rampant fraud and money laundering as in the recent report by the Canadian intelligence agency. And according to the federation of Canadian municipalities the supply issue is a myth, supply has been meeting or exceeding demand for years. Also the most common mortgage over the last few years has been variable, and anything over $1 million isn’t covered by CMHC insurance. And when the crunch hits, Trudeau has added an extra tax to the banks. I think that your belief that we aren’t headed for a financial crisis is hopeful at best, possibly delusional.

  • Reply
    Daniel Ziffle 7 days ago

    Real estate pumpers and gurs controlled the narrative…now the same people seem to be saying we told you so..blatant self interest…unhuman nature

  • Reply
    Yoroshiku 7 days ago

    “…demographic and supply-side fundamentals have driven price gains”? Fundamentals? Really? 25% of Canadian homebuyers are speculators. No mention of the BOC’s endless avalanche of easy credit. The Canadian economy has become addicted to cheap credit.

  • Reply
    Chris 7 days ago

    Not sure how we can say that there will be no impact on the rest of the economy. If the average family with a slightly uncomfortable but not onerous mortgage today has to pay an extra couple grand in mortgage payments a month in a couple of years, I can’t see how that doesn’t create a ripple effect in consumer goods and services.

    • Reply
      Donald 6 days ago

      I think this refers to a sharp turn in market psychology where the opposite of enthusiasm sets in in such cases markets continue to speculate but the momentum is negative. We might likely be able to avoid that. Markets may correct but that’s different than crashing.

  • Reply
    JEFF13 7 days ago

    Full recourse mortgages are limited and stress tests ensure borrower ability. Virtually all mortgages issued in Canada are full recourse, keeping defaults low. Stress tests ensure buyers can pay between 4.75% and 5.25% mortgage rates without stretching.

    Problem with the bank economists is that their “credit growth” model doesn’t allow them to see what will happen in a few months…a major recession or a major CAD devaluation…for this you need common sense. When people loses their jobs, it doesn’t really matter if the mortgage rates is 2 or 5%.

  • Reply
    Rony Palmer 6 days ago

    My question is why you all analysts talking more about this issue. Blame the banking institution, Fed government, Provincial and moreover the Real Estate board. Specially the blind bidding game operated by the Real Estate Board and the banks who knowingly allowed both Mortgagees and Mortgagors to go beyond their buying and borrowing limits. The ultimate sufferers are the buyers. Ofcours there were lots of greedy folks both Real Estate agents and the buyers who kinda played the hiking game. A group of individuals brought Black money from Overseas which our Fed could easily tackle and save our Canadians who like to have a sounding life. This had to cool off. Finally the Fed started taking initiatives.

  • Reply
    Josh 6 days ago

    “Stress tests ensure buyers can pay between 4.75% and 5.25% mortgage rates without stretching.”
    In theory, yes but this is not true.
    For so many buyers who feared to be priced out and investors with heloc, they inflated their income to get mortgage as much as possible. So many people can get what they want if they pay a fee to mortgage brokers. And banks and other lenders just don’t care. With sharp increase of interest rates, buyers cannot afford $1000 more a month. They will be forced to sell the properties.

  • Reply
    Ron 6 days ago

    Every economist before every collapse always says the exact same thing as this article. Minimal impact for whatever reasons and the economy and households can handle the downturn. In reality the whole economy is dependent on residential real estate. If we stop building and selling homes you have a self reenforcing feedback loop. 20% of the population lose their jobs and have to sell their houses and stop spending. More lay offs in stores, restaurants, etc. more houses go up for sale. Our successive governments have all pursued a 1 industry policy for Canada which is money printing going directly to new mortgages. People don’t realize the largest industry in Canada, the US and Europe is our governments counterfeiting money. It is larger than every industry combined. We have neglected real industry and jobs for the quick and easy addiction of free money going into real estate speculation. We do not have a real economy. I think we will be extremely lucky if real estate goes down by less than 70%. Real estate is the Canadian addiction and when the party ends and addicts have to go into detox the pain is always severe.

  • Reply
    Heather 6 days ago

    I agree with Ron 100%. And when you add food prices on top of this, you have a bigger mess.
    However, I will add that I have lived through a housing drop of 15-20%. Just hold on, pay your bills, get on with your life.
    You never want to take on too much debt.

  • Reply
    Jappan Singh 6 days ago

    If prices fall 10% the Liberals , NDP coalition will step in and BOC will do their part too. They will inflate this bubble further. Any would be immigrants if you have a half decent living in your home country, don’t jump to Canada as an immigrant. It is not worth it. Canada is spending a lot of money in their PR to attract immigrants. Do proper research.

  • Reply
    raj 6 days ago

    stress test was bypassed by fake financial papers. People won’t be able to afford increased mortgages.

  • Reply
    M. Hope 6 days ago

    As a retired real estate broker in the GTA, I have seen and been through every type of market…the good; the bad and the ugly. It truly ceases to amaze me how any family can afford all the luxuries of a fantasy world and sleep at night. Record personal debt; high end vehicles; bars/restaurants; expensive vacations; all the kids sports leagues; music lessons; the latest iphones and on and on!
    In November past a leading RBC senior housing analyst stated that only 24.6% of pop in the GTA can afford the average home. In addition, one would need an income of $147,500 plus a d.p. of $312.000 to afford the average priced home. That leaves 75.4% out of the market! Add in the REAL inflation rate, which is 2 points higher then stated plus 10% increase in food; $2.00 a litre for gas, this is a recogining on the horizon.
    I’ve seen this in 1983; 1989; 1993/4 and 1999. People absolutely refuse to live within their means. They want,want, want at any cost! I’ve seen many people cry in their luxurious estate driveway filled with high end vehicles. I have ZERO empathy or sympathy for anyone who has zero value for money living a life as if they won the lottery.
    Boy, I could write a book on this outrageous shit. Four big crashes since 1983 and the fifth is on the horizon.
    38% over valued is bang on! The clock is ticking!!

  • Reply
    Donald 6 days ago

    He doesn’t think about monetary policy he thinks about families

  • Reply
    Joe Roberts 6 days ago

    Has anyone heard from Jagmeet Singh on any of the stuff, does he still live here !

  • Reply
    Greg 5 days ago

    We’ve been sold on society and people buy into it at different levels. Suckers! You think it’s great if it’s perceived as ” a deal” and buy into and crave to have more. Big house, luxury car, 3 wives(2 don’t know) and everyone crooked as a snake. Prove me wrong!!!!
    We anesthetize ourselves with vacations, toys, booze and now cannibis will save the day and we’ll soon have gay turtles that have a tax advantage if they file early. Best is see if they post this as in whatever happened to free speech? It is all smoke and mirrors. Someone always has a nicer home, a faster car and 3 wives. But trust me on the sunscreen.

  • Reply
    Chris 5 days ago

    @Ron you could effectively say that the government used the housing market as its own massive HELOC. Servicing that debt is going to crush us for the next 50 or so years. I’m working a multi-pronged strategy to be able to retire comfortably outside of the country and encouraging others to join me.

    • Reply
      JCH 1 day ago

      Agreed, Chris! I also see the writing on the wall – don’t want us and our kids to be taxed heavily for generations to pay for the insane debt here. So, I too am planning to leave Canada in 6 years, when the kids finish school.

      Looking into countries to retire to, where the kids can work, and a different country to store our money. Have half our assets in Canada and half in US now. Not confident that either will have much value in future so getting ready to move $ elsewhere soon, while they are still reasonably strong.

      Love to have sound currency suggestions! Wondering if Norwegian crowns may be sound; considered CHF but they also have so much debt and no gold.

      Best of luck to others making similar plans – think you’ll be financially safer because of it!

  • Reply
    Jing-Xing Zhu 5 days ago

    Do you think government would want to see it happen, you are nave and green. Can you imagine how much more tax revenue government can bring in with the high price. Same as the gasoline price, government has no intention to bring it down.

  • Reply
    Desai 5 days ago

    This is a consequence due to the unfortunate policies of the government in the last 20+ years. CMHC, Bank of Canada, politicians, wild immigration & refugees, developers, and relator slurped the exquisiteness out of this vast immaculate country.

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