Canada’s largest bank still sees home prices making a steep drop in a worst-case scenario. RBC regulatory filings for Q2 2021 show the bank’s forecast for risk planning. Currently, they see price growth slowing from current levels, but still advancing. If housing surprises to the upside, they see home prices advancing a little more quickly. If housing surprises to the downside, they forecast home prices could drop up to 30% in the worst-case.
Macroeconomic Scenario Assumptions
Financial organizations are required to disclose risk using unbiased and realistic outcomes. As mentioned earlier this week with BMO, they do it by creating forecasts for key indicators. They usually split the forecast into three — a best case, base case, and worst-case scenarios. One of those indicators is housing, and that’s what we’re looking at today.
The base, best, and worst-case scenarios are self-explanatory. The base case is the outcome if everything goes as planned. The best case (“alternative upside” at RBC) is the ideal outcome if everything was perfect. The worst-case (“alternative downside” at RBC) is if things are worse than expected. As I said, it’s self-explanatory.
The fact that all of these scenarios are realistic is the sticking point for a lot of people. If the best-case forecast is too optimistic, the firm may take on too much risk. In that case, a tiny hiccup can derail the whole firm. If the worst-case forecast is too pessimistic, the firm is overpreparing for risk. That would come at the cost of taking reasonable exposure, leading to lower profits. Managing the right balance of “to the moon” and “it’s going to crash” is the goal of their risk manager.
The Base Case At RBC Sees Next Year and Beyond Revised Lower
The base case got an upward revision near-term, but the long-term outlook was pulled back. As of April 30, 2021, home prices are expected to rise 3% over the following 12 months, up from 0.6% in October. It would be followed by compound annual growth of 3.7% over the next two to five years. This was a downward revision from 4.5% in October. The combo of higher near-term and lower long-term implies pulled forward demand. That’s exactly what lowering interest rates was intended to do.
RBC Canadian Real Estate Risk ScenariosRBC macroeconomic assumptions for Canadian real estate prices under various risk scenarios. Source: RBC; CREA; Better Dwelling.
Canadian Real Estate Prices Fall Up To 30% In The Worst-Case
The worst-case scenario is still one of the biggest downside forecasts for housing. As of April 30, 2021, home prices are expected to fall up to 29.6% over the following 12 months in this scenario. This was unchanged from previous forecasts. The next two to five years are forecast to see compounded annual growth of 4.2%. The latter numbers are an upward revision from previous forecasts. It implies a faster recovery in the event of a home price crash. In other words, they likely see the Canadian economy as much more resilient if home prices tanked.
Canadian Real Estate Prices Rise Up To 11% In The Best-Case Scenario
The best-case received a small upward revision, but is about a third of the size of the downside scenario. As of April 30, 2021, home prices are forecast to rise 10.9% over the next 12 months in this scenario. This is an upward revision of 6.1% in the October 30, 2021 forecast. The following two to five years are forecast to see 11.1% compound annual growth. The best-case scenario’s growth would be less than half of the current rate of annual price growth.
There are a few key points that stand out in this risk forecast. RBC is acknowledging the pull-forward effect, which likely borrowed some future growth. The risk-reward ratio is still surprisingly high between the best and worst scenarios. If housing were a stock, investors would say their model shows a risk-reward ratio is 0.34:1. For context, most professional traders would look for a ratio of 2:1 or greater.
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