Is the Canadian Real Estate Market a Bubble?
Here Are the Risks to Consider
The Canadian real estate market has been very volatile in recent years, but there are some risks that investors and homeowners should be aware of. This article explores the key risks to the Canadian real estate market, including high household debt, rising interest rates, and a potential recession.
Last Updated May 2, 2024.
HIGHLIGHTS
Prices peaked in the Spring of 2022, and according to our analysis, many Canadian housing markets are already bursting bubbles. There has been a price turnaround, but purchases are well below the 10-year average.
In a December Reuters poll, the average analyst expects Canadian house prices to remain unchanged throughout 2024 — a downgrade from a similar survey conducted in August 2023.
In its vulnerabilities assessment, the Bank of Canada has expressed the greatest concern with inflated real estate prices (real estate market imbalances) and high household debt because they make Canadians more vulnerable to an economic crunch.
Fixed five-year interest rates have risen over 3% since the pandemic's lows, and higher rates lead to higher homeownership costs.
With most cities exhibiting moderate or high-risk indicators, Canadians should buy homes as a shelter and lifestyle choice rather than considering real estate a low-risk and high-return investment.
What is Risk?
Economists measure risk in terms of volatility and uncertainty. Volatility occurs when prices in a market move dramatically (e.g., up or down). Uncertainty occurs when price movements are unpredictable (e.g., not connected to local economics and not following the seasonal real estate cycles). This article will examine Canadian real estate price volatility and uncertainty, but we want to address the elephant in the room before forging ahead.
What is a Bubble Burst?
A bursting bubble is a market correction that leads to a drop in values greater than 20 per cent. Anything less than 20 per cent is considered a market correction.
A record-breaking rise in purchase activity during the pandemic led to a spike in suburban and exurban house values.
The pandemic bull market was initially dominated by people upsizing. They needed more space to work from home and segregated spaces for two parents to work and kids to learn.
A November 2023 survey found that only 11.7 per cent of Canadian workers have adopted hybrid work arrangements. This indicates a likely reversal of the migration to the outer suburbs, exurbs, and cottage/cabin country. All of these short-term changes in behaviour increase property market volatility.
Property Price Volatility
In the past two years, Toronto and Vancouver’s prices have risen, fallen, and risen once again. In Spring 2022, ‘benchmark’ house prices in both cities peaked and trended downward.
Was Canada in a real estate bubble? Did the bubble burst in 2022, or was that simply a mild correction? Do all bubbles eventually burst?
The Toronto and Vancouver housing markets (which touch almost 1 in 3 Canadians) are very volatile and currently on an upward swing. From an economist’s standpoint, a market that swings wildly upward is likelier to drop downward. Hence, there is growing concern that the recent upward swing, if it overshoots, could lead to another sizeable downward swing.
According to The Teranet-National Bank House Price Index™ prices across Canada are over 5 per cent short of the Spring 2022 peak.
Uncertainty
As property prices distance themselves from local incomes and economic fundamentals, they become more dependent on market sentiment.
The gap between economic fundamentals and property prices has widened dramatically, with the economy still plagued by persistent inflation. This gap between sound economics and property values increases the potential for uncertainty and doubt. In times like this, people start reaching for other explanations for why prices will remain high.
The most persuasive argument suggests home values will remain high because there is very little housing supply, Canada’s population keeps growing, and supply will never catch up to demand.
However, population growth slowed during the pandemic and the 6 year average population growth is well within a normal range.
However, if the population continues to grow at 2023 levels, it is difficult to see how housing stock can grow quickly enough to support the population. Supply is more complicated than total housing stock. New listings can drive up supply in the short run. Currently, active listings are low, but they are trending upward.
The cost of ownership has risen to levels not seen in decades, and even though many people may want to buy, very few will be able to at current prices. Also, many existing owners facing rising costs might choose to cash in their equity instead of subsidising their real estate investment from their savings.
Recent reports suggest that many immigrants are quitting Canada due to the high cost of living. At the same time, the Federal government is reducing its immigration targets. These policy changes, along with record construction levels, mean that supply could sync up with demand in the long run and make prices affordable to the median household.
Taking a long-term perspective, a Scotiabank report suggests that Canada is chronically undersupplied and the least capable G7 country for providing housing to its citizens.
Price growth reduces affordability and creates downward pressure on prices. As a rule of thumb, homeownership costs are considered unaffordable when they exceed 40% of household income. Recently, affordability has worsened across Canada because mortgage rates have increased.
Vancouver homeownership costs are 103% of median household income.
Toronto homeownership costs are 88% of median household income.
Hamilton homeownership costs are 71% of median household income.
Ottawa homeownership costs are 45% of median household income.
Montreal homeownership costs are 46% of median household income.
To put it plainly, we could argue that 100% of Canadians want to own a home, but higher borrowing costs and higher prices mean ownership is out of reach for most younger Canadians.
If economic fundamentals reassert themselves, according to the International Monetary Fund (IMF), that would lead Metro Toronto and Metro Vancouver home prices to drop significantly.
When buyers see a hot market softening significantly, they begin to fear a crash, and these feelings of uncertainty prompt them to take a ‘wait-and-see’ approach. They want to avoid buying at a peak when waiting a few months may save them five per cent or more on the price of a home.
In a weak market, potential homebuyers wait for news that inspires more confidence in an upward price movement.
Buyers can almost always wait, but sellers facing financial challenges may not have the luxury to defer their home sale until the market recovers.
Who else believes there is risk in Canadian real estate?
Before the recession, some of the most respected economic analysts in the world believed there was concrete evidence that Canadian real estate was at a high risk of a significant correction.
The Bank of Canada
In early December 2023, the Bank of Canada released a report that delved into two housing-related vulnerabilities: the elevated level of household indebtedness and high house prices.
Bank of Canada Vulnerability #1: High household debt
Canadian Debt to Disposable Income Has Been Rising Steadily
“Turning to high indebtedness, a key concern here is that financially stretched households have little breathing room to absorb any disruption to their income. A job loss could force many to drastically cut their spending to keep servicing their debt. A drop in housing prices could also reduce household consumption because many people use their home as collateral to secure a home equity line of credit or refinance their mortgage. And an increase in unemployment or drop in house prices would have worse effects on the economy today because both debt levels and the share of wealth concentrated in housing have risen over time”
In a speech to the Ontario Securities Commission, the Bank of Canada Governor Tiff Macklem acknowledged rock-bottom interest rates are inflating house prices and that The Bank is monitoring Canada’s heavily indebted households.
“Let me sum up our current assessment of the housing market. House prices have increased significantly over the pandemic. The moderation that we saw until recently pointed in the right direction, but housing remains very expensive. And the risk of a correction in some markets is a concern that we need to watch,” Macklem said.
So far, because of record-low interest rates, Canadians have been able to continue supporting these very high debt levels. What will happen as homeowners renew their mortgages at higher rates? Interest costs on variable-rate mortgages have more than doubled since the beginning of 2022.
Insolvencies have returned to the long-term average and are trending upward.
Equivax reveals significant increases in mortgage delinquency rates across Canada. Ontario and British Columbia witnessed the most substantial surges, with delinquency rates jumping by 135.2% and 62.2%, respectively, compared to the fourth quarter of 2022. These figures surpass pre-pandemic levels. The impact of rising interest rates on mortgage renewals continued to intensify in Q4 2023. Following renewals, average monthly mortgage payments rose by $457. Notably, Ontario and British Columbia experienced even steeper increases, exceeding $680.
A recent study by TransUnion Canada found that nearly a third (33%) of Canadians anticipate difficulty covering their bills in full. To manage these financial pressures, this group is considering increased reliance on credit (33%). The study, titled "Q4 2023 TransUnion Canada Consumer Pulse," also reveals that Canadians are adjusting their spending habits in response to rising living costs. Over half (57%) plan to cut back on discretionary spending, while 22% are exploring credit options like applying for new cards or refinancing existing ones.
Bank of Canada data highlights that loan arrears are rising - typically, there is a waterfall effect. People first fall behind on consumer loans (buy now pay later deals), then credit cards, followed by auto loans and mortgages. This is because most people need a car to get to work and a house to live in so debt is the last to fall behind.
With record-high debt and rising interest rates, Canada could be headed for a high financial stress event.
In 2013, the Bank of Canada published a paper providing examples of financial stress events. Remember, these impacted financial markets and often resulted in recessions but did not necessarily result in a significant house price drop. The past high-financial-stress events listed by the Bank of Canada were:
2020 - The Coronavirus Pandemic resulted in government and Bank of Canada emergency intervention.
2007 - Lehman Brothers bankruptcy leads to the Great Recession
1994 - Mexican peso crisis
1992 - Black Wednesday, European exchange rate mechanism crisis
1989 - Toronto house price collapse
Bank of Canada Vulnerability #2: Imbalances in the housing market
Okay, the Bank of Canada’s biggest concern was Canadians taking out large mortgages to buy homes, so it’s no coincidence that their second most pressing concern is the housing market.
“When house prices grow at a faster pace than can be explained by economic fundamentals, a price correction that leads to financial stress becomes more likely. This can be serious when buyers are highly indebted.
Overall, imbalances in housing have diminished but remain an important vulnerability. Froth from rising expectations of house price growth has declined in housing markets in the Toronto and Vancouver areas over the past two years. While the Toronto market appears to be stabilizing, prices and resale activity continue to decline in Vancouver. Ongoing difficulties in the oil sector are weighing on housing markets in oil-producing provinces.”
They are saying that if homes become too unaffordable, then there is a risk that eventually, prices will drop to an affordable level so that all the properties for sale can find a buyer…eventually.
Commercial Banks
The CEO of Scotiabank and the Chief Economist for CIBC feel that these risks are much less likely to affect Canada. These banks have huge mortgage portfolios and are closely watching these risks. These same banks have been tightening their mortgage rules.
UBS Bank
According to UBS, a Swiss bank that serves the world's ultra-wealthy, eight financial centres are in bubble territory. Toronto and Vancouver are two of the ‘bubble cities.’
NOTE: UBS issues their updated Bubble Index in early October each year.
The Economist Magazine
Frontier Centre for Public Policy
The Urban Reform Institute and the Frontier Centre for Public Policy, in their Demographia International Housing Affordability Survey, found that the affordability issue is particularly critical due to the strong increase in remote working (telework) during the pandemic.
Mortgage Sandbox Analysis
Our risk assessment concludes that most of the larger Canadian cities are moderately vulnerable, a few are highly vulnerable. Ottawa and Edmonton are the least vulnerable.
Concerned by real estate market risk, CMHC and the Canadian Federal Bank Regulator began enacting policies as far back as 2008 to reduce how much Canadians could borrow.
2008: Reduced the maximum lifespan of a mortgage from 40 years to 35 years.
2010: Applied a stress test against the 5-year contract rate for mortgages with a down payment of less than 20%.
2011: Reduced the maximum lifespan of a mortgage from 35 years to 30 years.
2012: Reduced the maximum lifespan of a mortgage from 30 years to 25 years on mortgages with a down payment of less than 20%.
2016: Banned default insurance on refinances, mortgages greater than 25 years, and single-unit rentals.
2018: Applied a stress test to mortgages with a down payment of greater than 20%.
2020: Raised the credit quality requirements for mortgage applications.
The continued government interventions show unabated concern about elevated household debt levels and potentially unsustainable home values.
Office of the Superintendent of Financial Institutions (OSFI)
The Office of the Superintendent of Financial Institutions (OSFI), the government agency that oversees bank risk, says “key vulnerabilities include Canadian household indebtedness.” On June 4th, 2019, raised the amount of capital that Canadian banks need to hold to weather a financial crash. Essentially, the regulator ordered Canadian banks to take out a bigger insurance policy against a financial crisis.
OSFI is the same arm of the government that, in January 2018, required Canadian banks to apply a stress test when Canadian borrowers apply for a mortgage.
What about other International Economic Institutions?
An October 2017 International Monetary Fund (IMF) Report also suggests Canadian real estate vulnerability. As well, in a February 2018 presentation, the U.S. Federal Reserve identified Canadian housing as so overheated because it exceeded their “Evidence of Exuberance Scale.” The IMF and U.S. Fed were looking at Canada as a whole, but Vancouver and Toronto are well above the Canadian average.
Based on BIS’s analysis, Canada has a greater than 50% chance of a financial correction (BIS would call it a “stress event”).
Finally, in June 2019, the IMF said that in the event of a downturn, the Canadian banks will be fine, but Canadian households are vulnerable. The impact on households would be significant as the share of households with debt at risk (defined as households with mortgage payments greater than 40% of income) would increase from 17% to 29%. If that happened, defaults would rise, and the Federal government would have to inject C$15 billion into the Canada Mortgage and Housing Corporation (CMHC).
Canada was risk-laden before the pandemic. Our regular debt payments are too high relative to our income, and the situation will worsen if the 5-year interest rate continues to rise.
At the core of these warnings is a belief that people’s loans should not exceed their ability to repay them. In the short-term, this means smaller home buying budgets since most Canadian debt is to support home purchases.
Canadian Confidence in Real Estate
The Ipsos-Reid and Nanos Canadian Confidence Index have shown a noticeable improvement in confidence. Lower than before the pandemic. Still, half of Canadians do not believe home values will be higher in 6 months.
Will home prices drop? For how long?
If past economic patterns are good predictors of future economic mechanics then we can use the 2008 Financial Crisis as an example.
In the financial crisis, local markets behaved differently and we see that price drops ranged between 7% and 50%. In some cases, it took a decade for home prices to reak their previous peak.
What should I do?
This article is important in the spirit of transparency because many in this industry avoid discussing the downside risks in real estate values. Buyers and Sellers need to be aware of the risks to make well-informed decisions.
Should Homeowners Sell?
If you will need to sell within 3 years, or your retirement savings are tied up in real estate, then you may want to sell now. We recommend you discuss this with a real estate agent and a financial advisor first. Your local market may be insulated from a housing correction.
Is it a Good Time to Buy?
A wait-and-see approach may be prudent. It can take two or more years for real estate values to hit bottom. If your family is growing, then go ahead and buy, but be sure to drive a hard bargain.
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