July 24, 2023

Key Impacts On Canada's Heated Real Estate Market

The Canadian real estate market has been arguably overpriced, especially in cities like Vancouver and the Greater Toronto Area (GTA). Housing prices have skyrocketed as inflation, supply chain setbacks, the pandemic, and other economic factors continue to drive costs up.

As policy interest rates continue to rise, there has been speculation about what impact this would have on the real estate market in conjunction with the 2022 federal budget.

Before delving into the potential impact of policy interest rate spikes on the real estate market, here’s a little recap of the interest rate situation since the pandemic-induced shutdown in 2020.

The Direction Of Interest Rates In Canada

In order to support the struggling economy due to the harsh impact of the Covid-19 pandemic, the Canadian government applied corrective monetary policies by reducing the policy overnight interest rate to a record low of 0.25% in 2020 (which brought the prime rate for most banks to 2.45%).

Policy interest rates increased from 0.25% to 0.5% in March and from 0.5% to 1% in April. A 50 basis point increase was a significant one-time increase in interest rates (pushing the prime rate for most banks to 3.20%).

Will rising interest rates decrease house purchase demand?

Rising interest rates will lead to higher lending rates, making mortgage interest payments higher now and in the long run. With variable mortgages, homeowners may expect to see more increases in mortgage interest payments due to the further prime rate increase(s). For fixed-mortgage homeowners, the rates may have no immediate impact until it is time to renew or refinance their mortgages.

While the increase in interest rates is expected to curtail inflation and rising costs, the impact on housing demand may not be drastic, given that mortgage interest payments are spread over 25 to 30 years.

However, as interest rates increase, the number and value of homes that Canadians can qualify to purchase through a mortgage are expected to reduce due to the mortgage stress test. The mortgage stress test assesses whether homebuyers can afford mortgage payments when interests increase.

At this time, the mortgage stress test is calculated using the higher of 5.25% or the contractual mortgage rate plus 2%. The current fixed mortgage rates are 2 to 2.5% higher than the time they were at their lowest point.

With the current higher rates, homebuyers would be stress tested at higher rates than the mortgage qualifying rate. For example, applying for a 5-year fixed mortgage, a 4% mortgage rate plus 2% is 6%, which is higher than the 5.25% benchmark rate.

While increasing interest rates may not necessarily decrease home purchase demand, it reduces the purchasing power of the average Canadian, making it more challenging to qualify for higher-priced homes.

Federal Budget 2022: Combating The Housing Crisis

In addition to monetary policies and rising interest rates, the government is also adopting fiscal policy measures to address Canada’s heated real estate situation.

As disclosed in the 2022 federal budget, one of the ways the Canadian government aims to make living conditions better for Canadians is to make housing more affordable with a six-year $10.1 billion budget allocation.

To support the government’s affordable housing agenda, the proposed budget aims to achieve the following.

• Construct more affordable homes.

• Help Canadians buy their first homes.

• Protect buyers and renters.

• Curb foreign investment and speculation.

The 2022 federal budget proposes to incentivize more construction of homes by introducing a new Housing Accelerator Fund. By providing a $4 billion expenditure to the Canada Mortgage and Housing Corporation, the federal government projects a creation of 100,000 net new housing units over the next five years, starting in 2022-23.

Also, the newly created First Home Savings Account (FHSA) would provide $725 million in home affordability support over five years. First-time home buyers can save and invest up to $40,000 in the FHSA tax-free. Even more beneficial are the tax deductions that Canadians can claim on their FHSA contributions.

The Federal Budget’s Impact On The Real Estate Market

Home affordability in Canada is a lingering concern that needs fiscal policy intervention. One survey shows three-quarters of respondents interested in purchasing a home cannot afford to do so due to rising housing costs.

Cities in provinces like Ontario, British Columbia, Nova Scotia and Quebec have home prices between 30% to 50% above the affordability rate for the average Canadian.

By doubling the current rate of new construction, the government estimates that 3.5 million newly built homes will fill in the rising demand and supply gap.

Also contributing to the low housing supply and affordability issues is the prevalence of local and foreign investors in the real estate market. “Housing should be for homes,” the budget report stipulates.

To address the rising cost of houses, the government is considering potential changes to the taxes on investment residential real estate owned by large corporations and other investors.

Lastly, the new tax-free first home savings account can make the possibility of the average Canadian affording a home more feasible. A tax-free registered account with tax-deductible contributions is a great savings option for a house downpayment.

Looking Forward

Despite increasing interest rates and potentially higher mortgage payments, housing demand may not dwindle to the maximum extent. The need for homes would continue. However, as purchasing power reduces, homebuyers will navigate toward lower-priced homes.

The government believes that banning foreign real estate investors and protecting individual homebuyers from institutional investors can help reduce the artificial surge in real estate prices, but the impact of this policy is yet to be observed.

The government believes that coupled with the tax-advantaged first home savings account (FHSA), the other housing-related budget proposals can make residential housing more affordable for Canadians in the long run. This could have an adverse impact on the lower price category of homes.

The fundamental goal should be centered around helping Canadians afford homes while also enabling the real estate sector to contribute to economic growth, which is tough to attain in a supply constraint environment. ​​

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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