Focus
December 09, 2022 | 13:38
Housing Outlook: Testing the Foundation
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Housing Outlook: Testing the FoundationThe Canadian housing market is firmly in correction mode, and the adjustment will likely continue through 2023. Despite much debate in academic and media circles about the causes of the recent housing boom, our strong view through the pandemic was that underlying demographic and supply-side fundamentals gave way to excessive froth, fuelled by too-low for too-long mortgage rates and investor expectations of never-ending price increases. The sharpest monetary policy tightening in a generation has broken market psychology, and the froth is getting cleaned up. Our baseline forecasts for housing in 2023 are shown in Chart 1. Sales volumes are expected to bottom in the spring as the market more actively clears; downward price discovery will continue through the year; and, the supply pipeline might actually get pulled back despite an ongoing push from policymakers. |
|
Mortgage Rates: The New, Old NormalThe Bank of Canada is most likely near the end of its tightening cycle, and mortgage rates will thus peak early in the year, barring an even more stubborn-than-expected inflation backdrop (Chart 2). The current interest rate outlook suggests that variable mortgage rates should top out at around 6% early next year. Five-year fixed rates might have already peaked with the yield curve now deeply inverted, and those mortgage rates could grind back down below 5% through the first half of 2023. As we near the peak for rates, the key question is when they will come back down—for the BoC, that’s likely a 2024 story. Even then, it doesn’t mean we’ll go back to levels that fuelled the market. Neutral rates might now be higher than those of the past decade, and market expectations should move accordingly. Sales: Market Will Eventualy ClearSales volumes are expected to bottom in the spring, as more listings actually close. New listings flow has been relatively normal, but many sellers have opted to decline offers at current prices. That should gradually change as the reality of market conditions sets in, allowing more sales volume at lower prices. Canadian resale volumes are expected to fall 13% for all of 2023, reflecting late-2022 weakness, but ending the year at a run rate closer to pre-COVID norms. The rebound should be tempered by the incredible amount of demand that was already pulled forward in recent years. In fact, there were roughly three years of sales activity compressed into the period between the start of 2020 and the spring of 2022 (Chart 3). |
|
Supply: Dare to Dream |
Policymakers are putting a full-court press on the supply side of the market, with the federal goal of doubling the rate of construction over the next decade met by provincial measures, such as Ontario’s More Homes Built Faster Act. We continue to believe that these government supply targets are unrealistic. First, the industry has already been building all-out, with the number of homes under construction hitting a record high this year, both in absolute and per-capita terms. Job vacancies in construction have hit record highs, and the unemployment rate hit a record low. While completions have lagged, that’s partly a function of more multi-unit activity that comes with longer lead times (Chart 4). Meantime, market conditions have deteriorated sharply and many investors sitting on presale contracts could have trouble closing or assigning. As such, presale demand has all but dried up, and market conditions—not government policy—ultimately determine supply. So, it might disappoint many to see new housing starts actually fall in 2023. Further along, a wave of completions should take some pressure off rents. Prices: Onward and DownwardOur longstanding view is that the benchmark Canadian home price will fall 20%-to-25% peak-to-trough this cycle. With prices already 10% off their high, we could be halfway there in terms of depth, but the bottoming process could be drawn out right through 2023. Local conditions vary greatly, and some regions have already cracked the 20% threshold, while some look to hold firm. Consider three straightforward ways to judge housing valuations: Affordability When mortgage rates jump from 1.5% to 5%, maintaining affordability while holding income, downpayment size and amortization length constant would require a 25% cut in the price of the house. Chart 5 shows affordability over time, accounting for incomes, mortgage rates and house price changes. The froth in 2021 was obvious, and the path back toward a more reasonable affordability environment is underway. Using our baseline forecasts, this affordability model only approaches the upper end of the pre-COVID range by the end of 2023. In this context, an even deeper or more drawn out correction is possible, especially if mortgage rates don’t back off. |
|
Inflation-adjusted price trends |
Real home prices in Canada have historically grown about 3% per year dating back to the early 1980s (Chart 6). In the recent episode, even as inflation accelerated to multi-decade highs, real home prices surged by more than a third in the span of two years, opening the widest deviation from its long-run trend in at least 40 years. Fundamentally, housing is a good inflation hedge, so persistent pressure, along with rising building, labour and overall development costs could help put a floor under the resale market, and have already contributed to closing much of this gap. The regional story is also key, and the most froth accumulated in the suburbs and exurbs of Toronto. While Toronto prices rose 41% above trend, Ontario markets outside Toronto ran ahead by more than 70%, and they will continue to see the most challenging conditions. Some regions, however, barely looked frothy at all. Calgary is a good example where, after five years of declining prices leading into the pandemic, the market had just caught up to its long-term baseline. Other markets like Vancouver, Montreal and Atlantic Canada were frothy, but not to the extent of Ontario or the GTA. Cap rates With expectations of price growth now deflated, cash flow is king again for investors, but the economics don’t make sense at current prices and interest rates. Setting aside the highly speculative presale/assignment market, longer-term investors too are watching valuations reset to reflect higher interest rates—this is evident across a wide range of asset classes, not just Canadian real estate. Using Toronto as an example, residential cap rates (think rental condos or multifamily properties) have historically traded roughly 1.5-to-3.5 ppts above 10-year GoC yields. But, this year’s massive backup in bond yields has all but vapourized any meaningful spread, which ordinarily accounts for the fact that real estate is risky, subject to vacancy and landlord-tenant laws, and highly illiquid. If history is any guide, cap rates that shrunk to around 3.5% at the market peak would likely need to reset to around 5% based on our current interest rate outlook. That would be roughly equivalent to a 25%-to-30% price cut, all else equal (Chart 7). Strong rent growth assumptions could temper the adjustment somewhat if built into investors’ models. |
|
Longer-Term ProspectsBMO Economics has been a long-term Canadian housing bull, with gains over the past decade deeply rooted in demographic fundamentals. The millennial cohort has been the biggest driver of housing demand, with population growth in the 24-34 age group running at the strongest pace since the late-1980s in recent years. This cohort is a good representation of incremental housing demand, as these are prime household formation years. |
Today, the peak millennial is 32 years old, so housing demand driven by this demographic wave is set to crest in the next few years. To the extent that substantial demand was pulled forward during the pandemic, that timeline might have been sped up. That said, aggressive immigration targets are expected to continue adding to demand in the coming years (Chart 8). In StatCan’s low-growth population projection, this age cohort would indeed contract in the coming years. But, in the high-growth projection (where the immigration rate is set to be more consistent with new federal targets), this cohort continues to expand, although the growth rate does slow by around 2025. To put it another way, aggressive immigration targets could serve to forestall what would otherwise be a coming demographic lull for housing demand in Canada. This is an important distinction when compared to the deep and prolonged 1990s downturn, which saw population growth in this key cohort collapse. Table 1 breaks down past and expected growth in this cohort by region. Meantime, the tailwind of declining interest rates is likely tapped out, and suppressed borrowing costs of the past decade could be resetting to higher neutral levels. The simultaneous combination of peak demographic demand and historically-low interest rates that we saw in recent years was an extraordinarily bullish combination that is going to be very hard to repeat. |
|
Key Takeaways
|