Canadian Real Estate Could Be In For A “Correction Or Worse”: BMO

Canada’s excessive low rate policy has created a wave of speculative housing demand. That demand can end very quickly, as interest rates climb and real estate price growth slows. In a weekend note to clients, BMO explains it’s a less than ideal time to expect home prices to grow. Rising rates won’t have much of an impact on many homeowners, since they are prepared and stress tested. Investors looking to make a quick buck might be in for a surprise, though. The bank warns the current environment can lead to a “correction or worse.”

Canadian Real Estate Prices Are Linked To Interest Rates

Interest rates play an important role when it comes to real estate prices. Housing is primarily a financed good, meaning falling interest costs play a big role. As the cost of interest falls, borrowers are able to carry higher debt loads. Being able to carry higher debt loads allows buyers to more easily absorb higher home prices. This is especially important for price growth during an inventory squeeze. 

Interest rates tend to influence prices the other way too. As they rise, the ability for buyers to carry higher debt loads shrinks. This reduces the ability for homebuyers to absorb higher home prices, slowing growth. Currently the world is seeing interest rates climb, and this is the focus of the bank’s research note. 

“Looking at recent history, it’s pretty clear that policy rates and home prices have a strong inverse relationship,” wrote Benjamin Reitzes, BMO’s macro and rate strategist.

Inverse being the relationship outlined above. Lower rates mean higher price growth, and higher rates mean lower price growth. We don’t have to go back to the 90s to see this, but just a few years ago it was on full display.

Canadian Interest Rates and Real Estate Prices

Canada’s overnight rate compared to annual price growth for the CREA benchmark (typical) home.

Source: BMO; Haver Analytics.

He adds, “higher policy rates will dampen the enthusiasm around housing. The 2017-18 rate hike cycle clearly dampened price gains (with tax measures providing a helping hand), pushing the annual increase in home prices from the high-teens to close to zero.”

Low Interest Rates Have Fueled Speculative Demand In Canada

The bank is receptive to the needs of more supply, but it’s overemphasized. This is a more common theme being seen over the past few months. Researchers and government are now arguing supply has kept up with population growth. In a few pricey cities, the rate of supply growth exceeds population. Future supply needs to keep flowing, but the role of a supply shortage in relation to price is overstated.

“While there’s room for discussion around the ‘lack of supply’ narrative, the recent surge in prices is demand-driven,” he says.

The bank points to the share of investors as a sign of this excess demand. Bank of Canada (BoC) data shows annual growth of the segment reached 100% last year. Many investors aren’t being driven by an investment thesis of rental income. They’re acting on the assumption of future price growth exceeding rental income. 

Reitzes explains, “… [the] surge in investor activity is in no small part driven by expectations of higher prices in the future, as rental properties are cash-flow negative in many parts of the country. It is this psychology that needs to be broken to ensure prices don’t resume the upward march when rates inevitably fall again.”

Forecast Is For Cool Housing, With A Chance of A “Correction or Worst”

Canadian households are better prepared for higher interest rates than many assume. The bank argues stress tests and a pile of savings will help to offset rising costs. Longer fixed-terms and a host of other resources exist to prevent a larger economic issue. “… it doesn’t look like that type of interest rate increase is enough to derail the broader economy,” he argues.

Since mortgages are stress tested, the vast majority should be able to pay non-emergency interest rates. In the event households can’t, the bank still doesn’t see much of a problem. They expect those who feel the pinch will just extend the amortization, and pay it off over a longer period. Those impacted by lower (or negative) appreciation over the short-term are the ones at risk. This group is largely composed of speculators. 

Canadians have been exposed to warnings of a housing crash for so long, they’ve become numb. The US Federal Reserve model shows the real estate bubble only first formed in 2016. However, some observers have called a crash since 2013, and before. The elite group of “alarmists” include the current head of the BoC, while he served as deputy Governor. He no longer sees a bubble now, just for context.

“The calls for a housing crash and disorderly outcome for households have been consistently wrong for over a decade, but the latest surge in home prices could make things different this time,” says Reitzes.

BMO forecasts home prices will cool along with interest rates. The trend can become more serious if interest rates need to rise more aggressively. This is a strong possibility, since a late policy response requires a bigger shock to make its point.

“Look for housing to cool in line with the pace of rate hikes. However, if policy rates climb above prior cycle highs, we’d be in uncharted territory and could be in for a correction or worse,” he warns.