In a report released this week, the Bank of Canada (BoC) outlined critical risks that could challenge Canadian financial systems in coming years, among them the high levels of Canadian household debt and record-high home prices. With interest rates on the rise, buyers who got in during the recent explosion in prices may be facing increasing financial strain – with the potential for up to a 45% increase in mortgage payments over the next three years.
Also this week, the BoC and others have forecasted a widespread cooling of real estate markets and large price drops. With the real estate market now seemingly over its peak, the question is how far and how fast things may turn around.
In their recent Financial Systems Review, the Bank of Canada remarks that despite seemingly strong balance sheets of both businesses and households, “tightening financial conditions, high global inflation and increased geopolitical tensions” have led to elevated risk against the vulnerability of our financial systems.
The role the housing market and real estate play in these vulnerabilities is significant and makes up two of the six key vulnerabilities that the bank identifies.
First, the report indicates that the number of highly-indebted households in Canada has been on the rise in recent years. This means there is an increasing number of people at risk of financial vulnerability from things like loss of income, increasing inflation, and increased mortgage rates. This widespread risk to individual households could, if pushed too far, snowball into broader effects on the Canadian economy.
In one scenario, the BoC describes how mortgages originated in 2020-2021 could see payments increase by up to 45% when they renew in 2025-2026. Though not a true forecast, it is also far from an impossible scenario. Keep in mind that 2020 and 2021 were some of the highest sales years on record in which many thousands of Canadians began new mortgages.
The second key risk comes from elevated house prices. Along with the effects this has on indebted Canadians as mentioned above, they also point toward the likelihood of a housing correction. This could especially cause problems for those with high mortgage debts that purchased at the peak of the housing boom. These borrowers, the Bank indicates, may find themselves unable to draw on significant equity for credit purposes, further tightening their financial circumstances and increasing their vulnerability.
Other key risks identified by the Bank include a reliance of business on high-yield debt markets, cybersecurity threats, and the mispricing of assets affected by climate change effects. Overall, there are numerous unique but interconnected concerns that the bank is monitoring as it attempts to navigate Canada’s economic recovery.
Other reports this week seem to add precedence to the Bank of Canada’s financial risk report by forecasting the very scenarios the bank points towards.
For one, the BoC report itself presents data showing that the Home Price Exuberance Index places many major Canadian cities within the exorbitant price range. This essentially indicates the extent to which prices are expanding beyond the underlying fundamentals, making a correction in these markets more likely and more pronounced. The BoC notes, however, that “although house prices declined in April 2022, it is too early to tell whether this is the beginning of a substantial correction in prices.”
Other analysts have not taken such a soft stance on a price correction. Take, for example, the recent Residential Real Estate Outlook from Desjardins. “While two months of data don’t make a trend,” the report says in response to falling prices in March and April, “we believe they do suggest that the Canadian housing market has reached an inflection point.”
Going on, they predict the national home price to fall by 15% from February 2021 to December 2023. Though this may sound significant, it would still fail to erase much of the gains seen in the last two years and would remain 30% above 2019 home price levels.
They note that price corrections will not manifest in the same way across the country. The general expectation is that areas that saw the most rapid price increases, particularly the Maritimes, may see the greatest correction while slower-growing areas should fall less. The large markets in Ontario, BC, and Quebec may correct somewhere in the middle.
Going even further, RBC bank indicated in a recent shareholder report that they project house prices to increase modestly in a best-case scenario and drop up to 30% in a worst-case.
Finally, a survey from the Bank of Canada reports that risk management experts now believe that the risk of a serious shock to the Canadian economy has increased, though overall confidence in the resilience of Canadian financial systems is at its highest since 2018.
With multiple interest rate increases behind us, we are now starting to see the effects of a higher cost of borrowing on the Canadian market. As the bank proceeds with future increases in order to curb inflation, they must be careful to go too far and allow a serious shock to occur. Regardless of whether the effects are gradual or sudden, Canadians will continue to feel increasing financial pressure in the coming years.
With warning calls beginning to be heard from many different sources, it’s clear the next few years could present a fair amount of turbulence. Unfortunately, despite the best guesses of economists, no one can say for sure what the future will hold.
As an investor, it is important to understand how the market may change so you can avoid panic and make the most of a down situation. Now may be the time to reevaluate your risk capacity and long-term goals to ensure you can weather what may come. While turmoil can echo into all aspects of the Canadian economy, when it comes to real estate, it seems it will be those who bought in at the highest point that will see the greatest injury as a result of shifting markets.
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