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The Canadian residential real estate market may have ended 2021 with its 12th consecutive annual increase in prices, with a year-over-year gain of 17.9 per cent, but there is a good chance that trend may be broken in 2022.

Indeed, as the Bank of Canada grapples with inflation at a 30-year high of 4.8 per cent year-over-year, interest rates are set to rise over the coming quarters; the market is currently priced for nearly seven rate hikes through the end of the year. This will likely serve to quell the investor-led housing frenzy that has gripped the nation throughout the pandemic.

So, with a record share of mortgage debt hitched to variable rates, the housing market (and the broader economy) could be in for trouble should this extended honeymoon period come to an end.

Overview of Canada’s home price bubble

We conducted an analysis earlier this month showing that affordability in Canada was the most stretched of its peers relative to its historic norm. Using data from the Dallas Fed, the country’s Real House Price Index was up 21.4 per cent year-over-year as of the third quarter of 2021 – a growth rate not seen since the horrible Canadian property bubble of the 1980s. And, crucially, Canada’s current home price-to-disposable income ratio, at 1.65, represents a three-standard deviation event, and a reversion to the mean would imply a catastrophic decline of over 40 per cent.

Of course, rock-bottom interest rates throughout the pandemic were the obvious catalyst for the near-vertical home price growth witnessed in recent quarters. As a result, investors ramped up purchasing big-time. Given their profit motivation and higher average levels of indebtedness relative to other types of homebuyers, this group tends to be the most sensitive to interest-rate changes. Indeed, according to a recent Bank of Canada study, investors were the fastest growing share of homebuyers, now accounting for approximately one-fifth of all purchases (while the share of first-time homebuyers has continued to trend lower).

Now, it’s important to note two caveats here.

Firstly, record low inventory could continue to put a floor under home prices. However, provincial governments in supply-constricted regions are attempting to add housing units to combat this problem. For example, Ontario’s housing affordability task force recently outlined a plan to build 1.5 million homes over the next 10 years. And with multifamily building permits up 22 per cent year-over-year, we should start to see supply-side inflationary pressures ease over time.

The other caveat is the potential postpandemic immigration boost, which will also be a wild card in determining the outlook on prices.

How vulnerable is the household sector?

Throughout the COVID-19 pandemic, Canadian households expanded their mortgage liabilities at the fastest pace in nearly a decade. By the third quarter of 2021, household mortgages were up 10.4 per cent year over year, not far off the peak of 13.9 per cent at the height of the mid-2000s housing bubble. But what’s especially alarming this time around as we stare the Bank of Canada tightening cycle in the face is that the share of home buyers opting to take on variable rate mortgages is at the highest level in recorded history. The share was at 52.4 per cent in November of last year and was above 50 per cent each and every month since July. For some perspective, the historical average since 2013 is closer to 24 per cent.

What this means is that a record number of Canadians will be in for a rude awakening as already highly indebted homeowners struggle to keep up with rising rates – a shift that could prompt a wave of selling. So, with mortgage debt accounting for over two-thirds of Canadians’ liabilities and real estate as a share of disposable income reaching a record high of 501 per cent, Canadians are exceptionally vulnerable to any interest rate-induced correction in the housing market.

Implications of rising interest rates

Of course, it’s hard to tell exactly how hard the market will be hit (and the associated lag) as the Bank of Canada embarks on its tightening phase. Obviously, it can be expected that rising interest rates will adversely affect price growth in the real estate market as demand cools due to higher borrowing costs. Previous work from the Bank for International Settlements analyzed this relationship and found that home prices in non-U.S. advanced economies are particularly sensitive to changes in interest rates when the U.S. Federal Reserve moves in tandem with domestic central banks. Indeed, the authors find that a 100-basis point rate hike in domestic short-term rates along with an equivalent move in U.S. rates would generate a home price decline of 3.5 percentage points three years out and five percentage points in five years.

Layer on the fact that (i) affordability in the Canadian housing market is at historic lows, (ii) the most interest rate-sensitive buyer group, investors, is adding to the frenzy, and (iii) the share of variable-rate mortgages has hit a record high, and we can expect the effects of the near seven rate hikes that are priced in to be substantial – despite the record low inventories and potential postpandemic immigration boost. And even if the Bank of Canada only gets to two or three interest rate hikes (as we predict), the extreme levels of froth in this market likely mean any negative catalyst will hit prices in a meaningful way.

David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Julia Wendling is an economist with the firm.

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