I’ve already written that an epic crash isn’t going to happen, if you’re sitting on the sidelines and hoping for a massive decline, you might be sorely disappointed. Yet there’s growing fear right now in the Canadian housing market. Every day large media centers are reporting huge drop in sales for real estate and an abundance of listings coming online in the surrounding Toronto area. Is it time to panic?
Measures meant to cool speculation was brought in by the Ontario provincial government to reign in rising home prices. Everything that we are seeing right now is completely psychological and emotional. At no point did the number of homes in Toronto or the surround area change dramatically. We didn’t make more land overnight, in fact the flooding due to Lake Ontario’s heightened water levels has actually made less land available.
That’s why housing is a completely unpredictable asset class. It’s totally driven by emotion rather than fundamentals, regardless of what real estate moguls say about supply and demand or lack of available land. That’s just marketing talk. If you really think Toronto lacks available land, someone please visit Hong Kong or New York City and then come tell me about the lack of available land.
But let’s get back to real fundamentals. What can really affect the affordability of housing? That happens to be interest rates. It’s actually something we can calculate rather than throwing random numbers in the air. With the recent announcement of interest rate hikes, the US Federal Reserve has signaled that the era of cheap money is over. Over the next several years there will be a gradual increase of interest rates from the rock bottom 0% rates that we’ve enjoyed over the last decade. So what does this all mean?
Higher Mortgage Rates
Higher interest rates by the US Federal Bank means that fixed term mortgages rates will rise. Yes, the US raising interest rates means our mortgage rates will rise as well. Why?
You need to understand that fixed term mortgage rates are financed by the major banks through bond sales. When any government decides to sell bonds at a higher yields, this makes bank bonds less attractive to an investor. Tell me why you would buy bonds from a bank that could fail, when you can get the same interest rate from the government who can literally print money? I’m sure I know what I would do.
For that simple reason, when the US Federal Reserve raises interest rates, it makes bond yields for everything go higher. This in turn makes bond prices go lower. Since a bank now has to pay a higher interest rate to the investor to buy the bonds, that cost will ultimately get passed down to homeowners through higher mortgage rates.
Too many people are ignorant to the fact that external factors to Canada can have an effect on our mortgage rates. You should understand these things before assuming that our mortgage rates will never rise because the Bank of Canada continues to keep our bank rate low.
OK. Hold on. Let’s not panic and expect our mortgage rates to rise through the roof like the 1980’s and 1990’s. That’s not going to happen. The great thing about the Federal Reserve is that they actually have a plan. What do you know??! At least someone has a plan for our finances.
The US Federal Reserve doesn’t plan to blast interest rates up to 10%. They are projecting gradual rise over the next 3 years. This means we will see a slight increase in the cost of borrowing money north of the border too. By 2019, the US hopes to have their bank rate between 2.5 – 3.0%. This is still very low for interest rates.
How Does It Affect Housing Prices?
If interest rates are gradually rising what does it mean for house prices? Let’s assume that most homeowners are trying to get the best house they can afford. Current home prices in the Toronto area average around $1M. With a 20% down payment that leaves $800K in mortgage. If you look around you might find a good mortgage interest rate around 2.2% for 5 years, so the payments would be $3465 a month. That’s our number. The maximum that home buyers are willing to pay on average is $3465.
If we fast forward a bit and interest rates rise by 1% per year in both 2018 and 2019, then the mortgage payments on a $1M home would look like this:
So each year if interest rates rise the mortgage payment on a $800K mortgage would increase from $3465 to $3868 in 2018 and $4295.00 a month in 2019. Let’s assume the population is tapped out and $3465 is the maximum monthly payment people can afford. What would home prices have to be at in order for the payment to be $3465 a month with higher interest rates?
A 1% rise in the rate would put a damper on affordability. If people could only afford to pay $3465 a month, then house prices would have to drop to an average of $895,750 in order to maintain the current mortgage payment amount.
If interest rates continue to rise another 1%, then average prices would have to drop some more to $806,750. That’s roughly a 20% drop from peak price that we see in 2017, but not a monolithic 50% drop that some people want or are expecting.
We can now see how interest rates could affect future home prices based on monthly carrying costs. Rising interest rates have a similar effect of letting the air out of the balloon rather than popping it with a pin.
A home sliding 20% in price isn’t the end of the world. In fact, over the long haul of 25 years the price will probably rise back up again. The most unpredictable impact on house prices won’t be interest rates, but buyer sentiment?
People have a herd mentality when prices are rising. Everyone wants to get in for fear of missing out and thus demand goes through the roof. When things aren’t going well we all run for the exit. Think fire in a building.
The net result of where housing prices is anyone’s guess, because real estate is price is driven mainly by emotional behaviour. I’ve never been able to put a dollar amount on happiness or fear, so for me to make any kind of prediction would be about as accurate as a monkey on a spinning wheel.
So how can prices fall further? When families decide that paying $3465 is too much per month. When families decide they would rather spend their money on other things than a house. When sentiment changes that living house poor isn’t a happy life. Or if we fear losing money.
All of these factors are unpredictable. If you’re still trying to judge the market then you should forget about it. Remember there’s more to life than just numbers.