I must start off by admitting that I own a house in the GTA so I may be a little bias, and that my personal position is that you can never own too much property in a rapidly growing rich city. I believe that Canada offers the people of the world with a safe clean country to live in, and that cities like Toronto and Vancouver are priceless exports that millionaires around the world will pay a premium for. That being said there are cycles in real estate, and good/bad times to enter the market.
Most news articles are pointing to rising interest rates and foreign buyers tax as a cause of an end to the real estate market in Toronto/Vancouver. However, qualifying rates for borrowers putting under 20% down on the purchase of a new home have been made to qualify at a much higher rate (posted rate) for a few months now. This change effectively resulted in an increase of the qualifying rate for first time borrowers that didn't have a 20% down payment , from the 2.5% range to the 4.7% range. This was a very drastic move.
And that was just the first step. Regulators are now considering making everyone who purchases a new home qualify at the posted rate rather than at the rate they are going to have to pay. This will result in sidelining the BofC in determining when the real estate market has to come to turn with raising rates. It will also result in the market having to adjust to an effective rate increase of approximately 200 basis points (or 100% increase/doubling of the rate).
If this change takes place, there is a good chance the real estate market will reverse course in the short run. I don't believe that the result will be a crash of the housing market in the GTA, although I do believe smaller cities that have had run ups in the real estate prices may be at risk of a bigger correction. However, it will cause a much bigger price drop in the GTA than we have grown accustom to. This can play out in two ways; buyers who have been sidelined may decide to enter the market propping it up (if they are able to qualify at the posted rates); or the market may balance out forcing GTA real estate owners to become accustom to the norms of not being able to sell a house in a matter of days (it will take a couple of months to sell a house).
As this change is occurring during a switch in the BofC interest rate policies, the impact will be compounded when/if rates rise. The hope is that the BofC will permit rates to remain lower for longer, as rates will have effectively risen in the housing market. To understand how this works we have to take a look at the arbitrage trade that has been available for some time.
The BofC removed housing prices from the inflation calculation they use to measure inflation in Canada and consequently to set interest rate. However, the rates set by the BofC do impact the rates at which Canadians can borrow to buy their house. This results in a situation whereby when house prices are rising faster than the rest of the economy, Canadians are able to borrow at a rate that is lower than the expected appreciations of real estate.
Historically this would be self correcting, since the rise in housing prices would result in a rise in inflation which would in turn result in a rise in interest rates reducing the returns form the arbitrage trade. Overtime, the rise in housing prices would be calmed by the rising rates. This is no longer the case. In today's world, one can borrow at 2.5% annually (compounded semi-annually), and buy an asset (real estate) which is expected to compound at 7% (on average). This is a clear arbitrage resulting in an on paper gain of approximately 4.5% p.a. And there is no self correcting mechanism to cause the borrowing rate to rise reducing your expected gains.
Does making people qualify at a higher rate remove the arbitrage that exists? No. So what does it do? The changes that have occur (and may occur on a broader scale) will result in Canadians of lower means having to reduce leverage. That is, the rich or upper class Canadians will be permitted to continue to take advantage of the arbitrage trade, while those of lesser means will be forced to reduce leverage. These rules are meant to protect the lower class and poorer Canadians from risks their government doesn't believe they are capable of understanding (similar to rules regulating investments in hedge funds preventing anyone with under a set amount of investable capital from investing).
Are they protecting the poor or lower class? No! People will never actually face the situation whereby they will be forced to pay the qualifying mortgage. That is, even if interest rates were to rise to the qualifying rates, people with a 5 year fixed mortgage (people with variable mortgages always had to qualify at the higher rate) will only borrow against the outstanding balance at the new rate. Over 5 years approximate 20% of the principle would be paid off (assuming the maximum 25 year amortization for a down payment of under 20%). Since they would have over 20% equity, they could amortize over 30 years when renewing. This means that their mortgage payment at the higher rate would remain unchanged.
So why is Canada's government and regulators considering these changes? If we take a look at home ownership rates in Canada, we can see a trend which is occurring. Mainly, the richest 20% of Canadians have over the past couple of decades, have increase the likelihood of buying. That is, more than 70% (historic norm) of the richest 20% of Canadians now own homes. By reducing the leverage of the poorest Canadians, the hope is that the market can level out.
For Canadians aged 20 - 34
Home ownership of the lowest 20% of income earners dropped from 30.8% in 1971 to 22.6% in 1986 to a bottom of 15.5% in 1996, before attempting to turn around. At the same time, the highest 20% of earners home ownership rate has increased from 37.9% in 1971 to 76.7% in 2006.
For Canadians aged 35 - 54
Home ownership of the lowest 20% of income earners dropped from 62.3% in 1971 to 45.7% in 2006. While the highest 20% of earners home ownership rate has gone form 73.8% in 1971 to 90.2% in 2006.
This trend causes a big problem, and is a large part of why housing has become unaffordable. It's not that the poor are borrowing more to buy, but rather that the rich are becoming much more likely to buy. Keeping this in mind, the solution posed by the government and regulators may work. As it will result in the poor being unable to borrow to buy housing, and subsequently reducing the percent of the bottom 20% of earners home ownership rate back to the low levels seen in 1996. While permitting the highest 20% to continue to buy.
My advice is, if you are in the bottom 20% of homeowner, try to payoff your home and keep it forever. If the economy continues on its current path, and regulators/government continues with its regular path, you may not be able to afford a house in Toronto for a long time if you exit the market here.
Dahlsom