Much has been written about the performance of the Canadian housing market. Since 2000, home prices have more than tripled. While US home prices fell 25% in the five years after the financial crisis, Canadian home prices escaped largely unscathed. They fell 8% in early 2009, before nearly doubling to today's level. Meanwhile, US home prices only just recently recovered, passing their pre-crisis peak in December 2016. Many wonder if Canada faces a similar fate.

Only two regional pockets have driven Canada's accelerating home prices. Together, the Greater Toronto area ("GTA") and Greater Vancouver area ("GVA") comprise over half the value of Canada’s housing stock. In recent years, the two markets have completely decoupled from the rest of Canada.

With relatively inelastic housing supplies, there are structural reasons why home prices in Toronto and Vancouver should be higher relative to incomes – but this level seems a stretch. In just three years, home prices in the two markets have advanced 50-60%. Factoring in two other nearby markets in the GTA and GVA – Hamilton and Victoria – then almost 95% of the gain in the Canadian home price index is attributable to just these four markets.

Toronto's Regulatory-driven Decline

In Toronto, that all changed in June. Home prices there have now fallen for several straight months. Now down 7%, this has been the sharpest drop for prices since the 11% decline in 2009. While dramatic, it appears that Toronto home prices have now stabilized.

Regulation has been the primary change in the Toronto market. Last April, the government implemented a new Non-Resident Speculation Tax, which applied a 15% tax to certain home-buyers in the Greater Toronto region. British Columbia’s provincial government implemented a similar 15% tax in mid-2016. After falling a few percent for the duration of 2016, home prices in Vancouver similarly stabilized and then continued their ascent, rising a further 16% in 2017. With prices now stable and buyers returning, will Toronto follow Vancouver's pattern, or is this time different?

Canada's Tightening Credit Conditions

It appears that this time is different. Since July, the Bank of Canada has raised its policy interest rate three times, by a three-quarters of a percent in total. At each step, the big five Canadian banks have passed on the entire cost to households, raising their key prime lending rate – to which consumer credit card, student loan, and some mortgage rates are linked – from 2.70% in July to 3.45% most recently. This has fed through to increased borrowing costs for homeowners with average variable mortgage rates up about 30 basis points and fixed mortgage rates up about 60 basis points since July.

Effect on New Buyers: Increased borrowing costs will hurt affordability and limit sources of new demand. According to National Bank, Toronto and Vancouver are now the least affordable since the early 1990s. On average, it takes 114 months (9.5 years) to save for a down payment in Toronto and a mere 354 months (29.5 years) to save for one in Vancouver. This together with new stress-test rules for new mortgages does not inspire confidence for the outlook on new home-buying demand.

Effect on Current Home-owners: For the one-in-five homeowners with a variable rate mortgage, higher cash mortgage payments are already a reality. For the remaining four-in-five homeowners with a typical five-year fixed-rate mortgage, no change has yet occurred. They will remain shielded from higher borrowing costs until they renew their mortgage within the next five years. The chart below plots the difference between the average five-year fixed mortgage today and the prevailing rate from five years prior. For the past 8 years, these holders of fixed-rate mortgages have been able to lock in a rate 100-300 basis points lower than their previous mortgage. It appears that 2018 will be the first year in many these homeowners will have to renew at a higher rate.

Conclusion: Yet to See the Full Effects

The simultaneous tightening of financial conditions and stringent new regulations have already pressured Canadian home prices. The pressure will continue, though the extent of the correction remains unclear. To see a further 15-25% fall in Toronto home prices, mortgage default rates would first need to rise as existing homeowners feel the building pressures of high borrowing costs. With household debt at all-time record levels, not much financial stress would be needed. As defaults rose, an increase in housing supply would outstrip new demand, forcing prices lower.





For more on the Canadian housing market, see this research paper I wrote in July 2017.

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