Will Climbing Interest Rates Deflate Canada’s Housing Market?

January 25, 2022

For more than a decade, Canada’s housing market has been one of the hottest in the world, propelled in part by ultra-low interest rates. With inflation in Canada surging at the fastest pace in 30 years, Canada’s central bank is poised to aggressively raise interest rates, which could have serious consequences for the housing market.

Bloomberg ranks Canada as the second most overheated housing market in the world, behind only New Zealand. To manage rapidly rising home prices, a record number of Canadian consumers have taken out variable-rate mortgages, which offer lower initial rates than fixed-rate mortgages.

The problem is that these loans are pegged to the nation’s benchmark interest rate and rise automatically as it increases. The markets expect the benchmark rate to climb by a point and a half, and an increase of more than one percentage point would drive the cost of variable-rate mortgages above what is currently offered for fixed-rate loans.

The situation, where overextended buyers are hit with surging borrowing costs, may call to mind the 2008 housing crash in the U.S., but most variable-rate mortgages in Canada allow borrows to keep their monthly payment the same even as rates climb, meaning they just pay down the principal less each month. While this may help avoid a wave of foreclosures, it will still have a profound effect on home values and investors in the country.

Bloomberg spoke with David Rosenberg, an economist who predicted the 2008 crash, who estimates that if the Bank of Canda raises rates as much as expected, residential real estate values would plunge by at least 25%.

As home values fall, it will be investors who are most likely to sell. Investors accounted for 20% of all homes purchased in Canada as of mid-2021, according to data from the central bank, and research from Veritas Investment Research suggests that about 40% of Canada’s retail investors are only just breaking even. This means that they are entirely reliant on home price appreciation for their return and will have fewer qualms about selling if values fall.

In Rosenberg’s estimation, it is among investors “where the selling is going to initiate, but it will spread like dominoes.”

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