Historically, housing has been a popular investment among Canadians because of steady price appreciation. Rental property owners have enjoyed robust rental markets with low vacancy rates and annual increases in rent. The Canadian real estate market has helped many families build wealth and improve their financial situations. However, a significant shift is now underway due to recent unsustainable price increases and current rising interest rates.
1. An overview of the housing market: Prices, demand, and rent1
Prices are declining
Except for the 2008 global financial crisis and briefly in 2018, Canadian real estate prices have risen steadily over the past 20 years, with some of the fastest growth occurring during the COVID-19 pandemic. In the one-year period ending with the peak in February 2022, Canadian real estate prices increased by a record 29%.
This rapid price appreciation was unsustainable as prices increased far faster than family income growth. Consequently, housing affordability has become as big of a challenge for Canadian families as it was in 1989, just before the deep recession that began in 1990 and resulted in rapidly falling house prices.
Recently, real estate price growth has turned negative. From February 2022 to September 2022, the benchmark price of a Canadian home has fallen 9%. There is an expectation that the Canadian housing market could experience further price declines of potentially 20% or more from recent highs into 2023.
Demand is softening
Canadian home sales have dropped significantly in the past year. Fewer sellers are listing their properties for sale from the peak in February 2022, and properties are staying on the market longer.
As of September 2022, the number of housing sales is down 32% year over year. While this number sounds significant, it only brings the volume of Canadian real estate sales moderately below historical averages over the last 20 years.
Buyers expecting further price reductions in the near term may hold off on purchasing real estate with an expectation of future lower prices.
Rent is getting more expensive
Though house prices are now falling, the cost of renting in Canada has continued to increase due to low rental vacancy rates and annual government approved inflation-based rent increases. This divergence has the greatest effect on younger families and immigrants to Canada that tend to rent and are looking towards home ownership in the future.
Families who own rental properties as part of their overall investment portfolio, stand to benefit from the rise in rent. Low vacancy rates and annual increases in rent provide for steady and predictable cash flow that can be used to grow and enhance wealth.
2. Impacts of higher interest rates and inflation on home buyers
The Canadian economy is weakening and there is a risk of a recession in the coming year. Much of this risk is fueled by inflation and higher interest rates. These factors have increased living costs, house prices, and made affording a home more challenging for Canadians, primarily recent graduates, and young families.
By late October 2022, the overnight lending rate in Canada has increased six times, from 0.25% at the start of the year to 3.75%, increasing the cost of owning Canadian real estate. There is also an expectation that the Bank of Canada will again raise interest rates in the coming months, further increasing borrowing costs.
This past year, inflation has been driven by several factors, including global supply chain issues, a high demand for consumer goods, high gas and food prices, high household savings, and higher wages to attract and retain employees.
Together, higher interest costs and inflation have made it difficult for the average family to afford a home in Canada. The higher rates also make qualifying for a mortgage to purchase a home more difficult, especially as the rate changes typically lead to pre-approvals for lower mortgage amounts than what lenders were offering when rates were lower. With these increased costs, families have to dedicate a greater proportion of their household income to housing costs.
Variable rate mortgages
In a low interest rate environment, variable rate mortgages had provided significant savings on the interest costs of a mortgage. Lately, with interest rates rising, homeowners with variable rate mortgages are seeing their interest costs increase. Essentially, when rates increase, a larger portion of the mortgage payment is applied towards interest and less to the principal. This results in extending the amortization period of the mortgage.
If you’re concerned about the impact of changing rates on your variable mortgage, there are several options to consider. By increasing your mortgage payments you could help reduce your principal mortgage balance and effectively lower the impact of rising interest rates. Most mortgages offered by lenders allow an increase in the regular payments by a certain percentage or amount. Also, if you have the available funds, making an annual lump sum payment can help save on interest costs while shortening the length of your mortgage. Finally, switching to a fixed rate mortgage allows you to lock in a rate and protect against any future rate changes, while keeping the amortization period the same. If you’re concerned about the effect of rising rates on your variable rate mortgage, speak with your financial professional to consider these options in order to manage your mortgage with confidence.
To conclude, further interest rate hikes likely will be needed to help tame inflation. Once inflation is under control, it is expected that the Bank of Canada will pause for an extended period of time before reducing interest rates.
3. The rental market
In contrast to the current declining costs of purchasing Canadian real estate, the costs of renting continue to increase. Annual rent increases are beneficial for investors in residential rental real estate. Rental income increases help to offset the rising costs of ownership and may help with increased interest costs for the acquisition of the rental property.
However, this makes it much harder for young families and immigrants looking to rent or purchase their own home as their cash flows are pressured by higher monthly rent and inflation.
The ideal time for a renter to purchase their own home is when the cost of homeownership is at a lower threshold than renting. To the extent that the price of Canadian real estate falls, opportunities for renters to purchase their own homes will increase, though this will take time.
4. The housing market bubble and its impacts on homeowners
As Canadian home prices have risen in recent years, fears of an unsustainable growing bubble have become evident. A housing market bubble can be caused by buyers escalating prices due to a strong belief in ongoing future price growth, low interest rates and available investment capital. However, if any of these factors change, there can be a rapid price decrease or bursting of the bubble. Recent buyers are the most negatively impacted as they would have paid top prices to now own real estate that is worth less than the purchase price.
A housing bubble occurred in Toronto in 1989. After its peak, house prices decreased by more than 20%. Fast forward to today and we anticipate a 20% correction nationwide, though this should only take prices back to levels in the spring of 2021.
Home Equity Lines of Credit (“HELOC”)
For several years, established homeowners leveraged the equity in their homes for personal purposes such as home renovations or to fund personal expenses. Unlike most mortgages that have a set interest rate, HELOC interest costs are typically based on the prime lending rate.
With the prime rate having increased, borrowing costs on existing HELOCs impact overall available cash flows and stretch family budgets. Paying down some of this debt may be considered to help with regular cash flow concerns.
5. Impacts across Canada
Urban centres, such as Toronto, experienced a higher housing cost growth than the rest of Canada. In addition, cities that became telework hubs, such as Brantford and Barrie, saw even stronger price growth. With the recent drop in Canadian real estate prices, cities including Kitchener-Waterloo, Cambridge and London have seen the most dramatic price decreases.
Provinces less affected by the housing boom, such as Alberta, Manitoba, Saskatchewan, and Newfoundland and Labrador experienced slower price increases in recent years and, therefore, remain relatively affordable.
Conclusion
While the downturn in the Canadian real estate market is expected to continue into 2023, the market should once again become a significant source of wealth creation for Canadians and their families in the future, with support from strong immigration fueling housing demand.
For more information, please speak with your BMO financial professional.
You might also be interested in these related articles:
Article 2: Federal Budget 2022: 8 Measures that Could Make Real Estate More Affordable
Article 3: All in the Family: A Primer on Gifting Property
Frequently Asked Questions
How can I invest in real estate in Canada?
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Investing in Canadian real estate can be done through direct personal ownership, a partnership, a corporation or a trust, each with their own considerations and advantages/disadvantages.
How can I build a real estate portfolio in Canada?
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Building a real estate portfolio generally requires capital, expertise, research and collaboration with a team of professionals to help with the purchase, financing and management of the properties acquired.
Will the sale of Canadian real estate result in a capital gain?
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One-off sales of Canadian real estate can result in capital gains treatment for Canadian tax purposes. But when there are multiple properties or a series of several sales the Canada Revenue Agency may challenge the preferred capital gains treatment and assess the sale on account of earning income.
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If the property qualifies as a Principal Residence, any appreciation may be tax free for Canadian tax purposes.
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Note that the Federal government has recently introduced draft legislation that seeks to treat the gains on the sale of real estate property that is held for less than 12 months as fully taxable income, with some exceptions for certain life events, beginning in 2023.
Can I defer capital gains tax on real estate in Canada?
Will housing prices keep falling in Canada?
1The data and statistics referenced in this article have been sourced from BMO Economics.
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