1: Readers are well-aware that the Canadian property bubble is epic, with especially savage levels of unaffordability in Toronto and Vancouver. The situation is quite worrisome for a few reasons:
- Unaffordability is eroding Canada’s middle class and homeownership is quickly becoming limited to the wealthy. Young first-time buyers in Toronto are either earning $200k household income or received a six-figure gift from the bank of mom and dad. Not part of the privileged class? You either live with your parents, rent a shoebox or commute from 2 hours away.
- “Normalization” of the property bubble – as with any housing slowdown – will be long and painful, resulting in a negative wealth effect that trickles through the economy.
- The Canadian economy doesn’t have much else to lean on besides the housing industry and raw materials. Construction, services, finance, asset management – they’re all connected to real estate in one way or another. Yeah, people talk about Silicon Valley North and so on but there’s relatively little innovation coming out of Canada. Most tech jobs in Canada are within branch offices of US companies. Even Canada’s most iconic retailers, Hudson’s Bay and Tim Hortons, are owned by US and Brazilian firms respectively. Canada is a great country, but without the housing market propping it up its competitiveness is limited.
2: Relative to the US, Canadian real estate is more sensitive to changes in lending rates because a large proportion of mortgage debt is issued with a variable rate. Even fixed rate mortgages in Canada tend to have at most a 5 year term, which is essentially variable in comparison to 30 year terms used in the US.
Due to this difference in lending structure, central bank interest rate hikes should transmit to the real economy faster in Canada than in the US. Changes in mortgage rates mainly affect new buyers in the US. In comparison, changes to rates in Canada quickly flow through to existing homeowners as their rates reset.
Also, many borrowers that don’t qualify for more favourable loans from traditional providers opt for short-term (i.e. variable) mortgages from subprime or private lenders at higher rates.
During the past decade, buyers would get their foot in the real estate door using a high interest subprime or private mortgage, and later refinance at a more favourable rate as house prices appreciated and they gained equity in their home.
With house prices now falling, the option to refinance is shrinking, leaving people stuck with high interest mortgages they never intended to keep for the long term. Of all variable rate mortgages in Canada, it’s fair to say these are the most sensitive to rate changes. In my opinion, these are likely some of the first mortgages to default.
3: The inventory overhang of homes in Toronto is likely to continue to weigh on prices for a while. Even though Toronto home prices have declined by about 20% from their peak, affordability has actually worsened due to higher mortgage rates. Value-buyers aren’t likely to swoop in until it’s clear that rates will start coming down again. This won’t happen unless inflation falls significantly, potentially because of economic recession.