$1.7 Trillion of Canadian Real Estate Equity will disappear: Radius Financial CEO

Canadian home prices have fallen 2.4% in just one month. According to the Teranet––National Bank National Composite House Price Index, sales fell sharply in August from July and the year over year price gains have slowed even further.
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As interest rates continue to rise, keep in mind the following: Although property prices are higher than they were last year, and this statistic is being used to persuade home buyers to buy now, the reality is that some areas have seen gains of up to 50 percent in the last two years. Therefore, even as prices come down, they will still appear higher than last year, and this by no means signals we’ve hit the bottom. This reality is something potential investors and home buyers should keep in mind when contemplating their next property purchase. 

In the Composite House Price Index, Toronto is down 8.3%, Hamilton is down 10.5%, Halifax is down 8.7%, but Calgary and Alberta are up. The Toronto housing market acclimatized to sharply higher interest rates by dropping home prices for a fifth consecutive month, the longest slide since 2017. The Toronto Regional Real Estate Board reported on September 2 that the benchmark price of a home in Canada's largest city dropped 2.8% from July to August. 

It is likely that interest rates will keep rising in response to inflation and the effort to reduce inflation and bring the CPI down to at least 2%. In the US, the main message has not changed. Despite Jackson Hole, Powell's main message hasn't changed: the Fed is committed to bringing inflation down to 2%.

The Federal Reserve began hiking rates in March and is expected to do so until the funds rate reaches a "terminal rate" of 4.6% in 2023. Rate cuts are unlikely until 2024, according to the dot plot of individual members' expectations. Since Canada usually follows the USA’s lead, we can expect the same policies here. 

In July, the preferred personal consumption expenditures price index showed inflation at 6.3%, while the summary of economic projections shows inflation falling back to 2% by 2025. The FOMC's statement tweaked language to describe spending and production as having "softened" while still observing that inflation remains elevated and that "ongoing increases in the target rate will be appropriate."

The markets and economists are now signaling that 75 basis points are the new 25. Here in Canada, the central bank used to raise rates by 15 to 25 points or less (if at all), at each meeting, but now it is expected to follow the US Fed and raise rates by at least 75 basis points at each meeting for the foreseeable future.

After this front-loaded strategy to tame inflation, there could be three rate cuts in 2024 and four more in 2025, according to the Fed's dot plot, which means there will only be higher interest rates, even in Canada, for the next year or two.

As mentioned, the market is still heavily overpriced compared to pre-pandemic and pre-stimulus levels, and this could change quickly as consumer sentiment changes and mortgage interest rates continue rising. More consumers are beginning to use their credit cards and lines of credit to manage rising interest rates and the cost of living since core inflation is still at a 40-year high and has actually risen despite overall inflation dropping to 7.6% last month. This means that when hit with higher interest rates there may be a breaking point where homeowners need to sell and liquidate or face delinquency and power of sale. More inventory means less competition and add in the mix of hesitant buyers, a huge market correction is inevitable. 

CIBC's deputy Chief economist Benjamin Tal warns that rising interest rates could cause a situation where mortgage borrowers could see the pain of rising mortgage and debt levels for years to come.  In a report released Aug. 22, Tal and CIBC's Karyne Charbonneau analyzed the impact of rising interest rates on Canadian household debt. 30 percent of Canadians are debt-free, so a higher borrowing rate won't affect their payments in any way, according to the authors.  Most people with debt don't have a mortgage, meaning their household debt comes from credit cards or loans to finance a new car. Tal argues that credit cards already have very high interest rates, so rate hikes by the Bank of Canada are unlikely to have much of an impact, and installment loans typically have steady interest rates over the term of the loan.

Mortgage holders - and homeowners who take out home equity lines of credit (HELOCs) - will bear the brunt of rate hikes.

Mortgage holders with adjustable rates are certainly feeling the impact of higher rates, as their monthly mortgage payments increase as soon as the Bank of Canada raises its policy rate. The same applies to HELOC interest rates.

Nevertheless, 70 percent of Canadians with variable-rate mortgages are on fixed payment schedules, which means they do not pay more each month as their rates rise. As a result, the amortization, or the overall length of their mortgage term, lengthens. This is what I discussed in my last video. As a result of higher interest rates, mortgage amortizations are increasing. For example, borrowers can refinance or transfer their mortgage to a new financial institution and extend their amortization period during renewal. In order to afford double mortgage payments, someone with a 5-year amortization may need to extend the amortization again. Additionally, those in fixed payment variable mortgages will also see their amortization lengthen since more of their payments will get allocated to interest instead of principal.

Some lenders are urging the Federal Government to create policies that help mortgage affordability in this time of rising interest rates. A CEO at radius financial warns that $1.7 trillion of equity in real estate may disappear if the government does not extend mortgage amortizations to at least 40 years. 

Radius Financial founder Alex Haditaghi recently wrote an opinion piece based on his two decades of experience in the mortgage industry.

Unless the Canadian Government responds immediately with urgent policy changes, he warns that the Canadian real estate market will experience a significant correction of up to 30%, putting at risk $1.7 trillion in equity.

Approximately 43 percent of Canadian mortgage holders surveyed by Pollara Study after the Bank of Canada's last rate hike in July said they weren't sure how to make ends meet.

Despite Rob McLister's (ratehub founder) assertion that the federal mortgage stress test introduced in 2018 means Canadians should be prepared to handle higher borrowing costs, mortgage rates could still rise higher if the central bank hikes rates beyond September to control inflation because of a global supply shock or other economic disruption.

Anyone who wants to save money right now should manage their budget and revisit their budget because according to Oxford Economics, Canadians are not in for a "soft" landing as Chrystia Freeland and others have proposed. Based on Oxford Economics' predictions, Canadian real estate will fall by another 30 percent and return to the benchmark price, wiping out the 50 percent gains made over the last two years. 

It is a recession that follows a rate adjustment, when inflation is being tamed. A soft landing occurs when rates rise but the economy only slows - no recession occurs. A moderate recession is expected to start in Q4 2022, according to Oxford Econ's Tony Stillo. Rate hikes, high inflation, and weak global demand are attributed to the forecast.

In the next six months, they project a moderate recession. From Q4 2022 to Q2 2023, the firm's models predict a contraction of 1.8% peak-to-trough. This size of recession would be considered moderate, so essentially, we're past the point of a soft landing.

A flexible response is impossible for Canadian households because of their high levels of debt. With supersized debt loads, small increases in interest will have a big impact on income. In Q2 2023, 8.2% of disposable income will be used to carry mortgage payments, up from 6.5% this year. Since 2009, it has consumed the largest share of income compared to the 2018-2019 debt cycle.

According to Stillo, because of Canada's historically high household debt and housing prices, interest rates are more sensitive to the economy. As interest rates rise, debt service costs will rise and the housing correction will deepen. Reduced real incomes due to persistently high inflation will further squeeze households and lead to cuts to discretionary spending and deleveraging."

You may have noticed that despite the somewhat steep corrections we have already seen since March, prices still remain elevated. To provide an example, an online listing for a house priced at $1,399,000 in Toronto advertises a mortgage payment of approximately $7,000 a month, not including property taxes. I think we can agree this is definitely NOT sustainable or even realistic  when the average salary in Toronto is $93,000 gross, which is $1500 a week or about $6,500 a month, which is why people are just not buying. 

It’s safe to say we are in the stage now where sellers still want March’s prices and buyers don’t want to pay them. In addition, the purchasers have likely received pre-approvals with rate guarantees back in June that will be expiring at the end of September and mid October. Recently, BMO told investors mortgage preapprovals prop up markets. Canada's real estate market just experienced a shock, and one is on its way. Many home sales today don't reflect current mortgage rates, since many secured their rates months ago. The erosion of buying power will deliver another shock in the coming months, according to the bank.

When a borrower applies for a mortgage, they obtain something called a pre-approval. These allow the borrower to secure a rate while they shop for a home. Typically this gives buyers 90 to 120 days of interest rate protection. It’s a lot more practical for buyers to not have their purchasing power fluctuate day to day.

Mortgage comparison site Ratehub data shows the average 5-year fixed was 3.59% back in June. That means these borrowers with a pre-approval have until October to buy at their secured rate. A borrower in this situation has a nearly 1 point discount and limited time to use it. BMO contends that this creates a kind of buying threshold, where sales are still motivated at lower rates. The price of homes is falling, but without pre-approvals, they could be falling even faster. Buyers with pre-approvals question whether their interest costs will rise more than prices. You may value speed over value when you have a mortgage that expires.

According to Robert Kavcic, senior economist at the bank, there is a unique situation in which many potential buyers have pre approvals in hand from before the BoC tightened, as well as expecting 10%-to-20% discounts on home prices. There is still a huge interest rate shock to be dealt with in the bigger picture. According to Kavcic, the one-year increase in carrying costs of a typical home purchase in Ontario was only equaled in the late 1980s (when prices were already lower).

For industry professionals, it’s obvious, but for the average person, it’s the sharpest tightening in decades, which means a recession is imminent since discretionary spending will significantly decrease as borrowers allocate more of their income to their mortgage and rent payments.

Sarah A. Colucci, Senior Mortgage Agent
Sherwood Mortgage Group, Broker 12176
Direct: (647) 773-4849
Email: scolucci@sherwoodmortgagegroup.com