Rising borrowing rates could shave 10 per cent off Canadian home prices over the next year and lead to an even bigger drop in real estate investment, according to Capital Economics.
“When interest rates rise, home sales are usually the first domino to fall and this time is no different,” said Stephen Brown, senior Canada economist at Capital Economics, in a note to clients on Monday.
“With sales plunging, it is no longer a question of whether house prices will fall, but rather how much will they fall by?”
The latest housing data for April showed meaningful sales pullbacks are already underway in many major markets across Canada including Toronto, Vancouver and Montreal as higher interest rates sideline some potential homebuyers.
Fixed mortgage rates have surged over the past few months in anticipation of higher interest rates and variable rates – which now account for more than half of new mortgages, according to data from Bank of Montreal – have also started to rise alongside the Bank of Canada’s benchmark rate.
Brown said he’s operating on the assumption that home sales will ultimately be cut in half from first-quarter levels, which equates to 25 per cent below the pre-pandemic average from 2019.
“Because house prices have risen so far beyond a level that can be justified by underlying fundamentals, we suspect that, even in the absence of forced selling, prices will fall by 10 per cent during this tightening cycle,” he added.
He noted one safeguard against forced selling, or homeowners having to sell their home out of absolute necessity, is the fact that many variable rate mortgages in Canada still come with fixed payment amounts.
If the price decline is contained to 10 per cent, Brown said the largest impact will be felt from a pullback in housing investment. While that would cause a slowdown in the pace of economic growth, he’s not forecasting it would lead to a contraction in GDP.
“But if house prices fell by much more than we expect – which clearly should not be ruled out given their elevated level – a recession would be almost inevitable.”
Brown said the Bank of Canada is likely underestimating how sensitive real estate investors are to interest rates and that current market expectations for rate hikes are too aggressive.
“We expect the Bank to pause its tightening cycle once the policy rate reaches 2.5 per cent later this year,” he said.
“If house prices were to fall by much more than we expect, the Bank would loosen policy in 2023, but we doubt it would cut interest rates all the way back to 0.25 per cent for fear of reigniting the housing cycle all over again.”