The Bank of Canada is warning that high levels of household debt taken on during an extended period of low interest rates and a frenzy of real estate investment could destabilize the economy as rates start to rise.
Canadians who stretched their finances to buy into the white-hot real estate market are highly exposed to rising debt servicing costs, Bank of Canada deputy governor Paul Beaudry said Tuesday in a speech about the stability of the financial system.
The risk of a housing market correction has also increased over the past year as investors flooded into the market in a speculative rush, he said, driving up home prices and exacerbating Canada’s housing affordability problem. The average home price has jumped more than 30 per cent since the start of the pandemic.
The central bank is preparing to raise interest rates to counter galloping inflation, which hit an 18-year high of 4.7 per cent in October. The bank expects to raise its policy interest rate, which has been at 0.25 per cent since the start of the pandemic, perhaps as early as April.
“The debt that households accumulated at unusually low interest rates will stay with them well into the future. In the meantime, interest rates can be expected to rise as the effects of the pandemic dissipate and excess capacity in the economy is fully absorbed,” Mr. Beaudry said.
The financial system itself remains in good shape, with well-capitalized banks able to withstand major shocks, he said. But a housing market correction would severely affect the broader economy.
“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,” Mr. Beaudry said.
“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,” he added.
Canada’s overall household debt picture is mixed. On the one hand, Canadians managed to increase their savings during the pandemic and pay down consumer debt on credit cards and lines of credit. The bank estimates Canadians saved an additional $8,300 on average since early 2020, and the share of households falling behind on debt payments or filing for personal bankruptcy fell to historic lows.
At the same time, however, mortgage debt ballooned, and the share of new mortgages with extremely high loan-to-income ratios increased markedly.
“The deteriorating quality of new mortgage borrowing during recent quarters is now likely the bigger driver of household indebtedness. By the end of 2021, the share of highly indebted households will likely have more than reversed its initial improvement and topped its 2019 peak,” Mr. Beaudry said.
Mr. Beaudry pinpointed real estate investors as a potential problem – the first time the Bank of Canada has called them out for their role in driving up home prices. It said investor buying has doubled since the start of the pandemic, while purchases by first-time homebuyers have increased about 45 per cent.
“A sudden influx of investors in the housing market likely contributed to the rapid price increases we saw earlier this year. In such a case, expectations of future price increases can become self-fulfilling, at least for a while,” he said.
“That can expose the market to a higher chance of a correction. And, if one occurs, the damage can spread far beyond the investors.”
The central bank said it is doing “a lot of work to assess” how investors are affecting housing-related vulnerabilities. In Toronto and Vancouver, the country’s two priciest markets, investors are major players. For example, in Toronto, almost 40 per cent of condos are not occupied by their owners. That is quickly spreading to other parts of the country, as buyers get priced out of major cities and try to get into slightly cheaper markets. In Barrie, about 100 kilometres north of Toronto, the share of condos not occupied by owners is now more than 40 per cent, according to the most recent data from the Canadian Housing and Statistics Program.
Housing experts and economists have struggled to quantify the investor effect on home prices. Many have pointed out that investors have contributed to the flood of new condo buildings, as developers need to sell a certain amount in order to get construction financing. At the same time, the majority of new condos are one-bedroom units or studios, not suitable for most families.
Douglas Porter, chief economist with BMO, said the central bank’s comments further increase the likelihood of some kind of measure to dampen investor demand in real estate.
The federal Liberals promised in the recent election campaign to put a temporary freeze on foreign investors buying residential properties. They also promised to review the tax treatment for real estate investment trusts, “while protecting small independent landlords.”
Mr. Beaudry was asked after the speech whether Canadian investors or foreign speculators are driving the surge in real estate investment.
“These are Canadians buying these investment properties … potentially putting them on the market to rent or just holding them,” he said.
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