[TD] Canadian Regional Housing Outlook: Government Policy and Soft Landings

by Yvonne von Jena | August 29, 2017

A recent report by TD Economics entitled 'Canadian Regional Housing Outlook Navigating a Soft Landing' provides good insights into TD's expectations of housing policy changes and higher interest rates on both house prices and market activity.

A recent report by TD Economics entitled 'Canadian Regional Housing Outlook Navigating a Soft Landing' provides good insights into TD's expectations of housing policy changes and higher interest rates on both house prices and market activity.

Federal Mortgage Rule Changes

Says TD, the impact of the recent rule changes on housing demand fell flat relative to expectations. TD estimates that the most recent federal rule changes may have only shaved 2% off demand nationwide while the first regulatory changes implemented in 2008 dampened home sales by roughly 10% (see chart below); that is, each successive regulation change at the federal level has left a smaller mark on home buying activity. This is partly because each round of regulatory changes disproportionately impacted borrowers who required mortgage insurance, which incented a shift away from high loan-to-value mortgages into conventional mortgages. TD estimates that new loans that require homebuyer's insurance now account for less than 20% of all new chartered bank mortgage originations, compared to 40% prior to 2008.

Provincial Policy

As federal policy changes became less effective, those implemented at the provincial level proved to have some bite.

The BC government triggered a sharp drop in housing demand when the provincial budget (February 2016) outlined measures to track foreign investment and discourage shadow flipping. Three quarters of the downturn in sales had already occurred by August 2016, when the province introduced a 15% non-resident land transfer tax in Vancouver. Typically, market activity bounces back within six to 12 months following such policy changes. True to form, markets in Vancouver and most of BC embarked on a modest recovery earlier this year. But TD notes, momentum has since petered out under the weight of higher mortgage rates. Although, typically market activity bounces back within six to 12 months following such policy changes (as was the case after the Vancouver land transfer tax was put in place).

Because the Ontario government's policy measures went further than BC's, the impact has been greater. Since Ontario's policy measures, existing home sales have tumbled 33%, with Toronto plummeting 44%; and the average home price in the GTA has fallen 13% peak-to-trough, with suburban areas disproportionately impacted by the policy changes. By comparison, single-family home prices fell 3% peak-to-trough in Vancouver over a six month period (July 2016-January 2017), but have since recovered.

OSFI's B20 and Other Expected Changes

Government policymakers are not done yet with regulatory changes on the mortgage market. TD estimates OSFI's proposal to subject all borrowers to income tests (2% higher than contracted rate) could depress demand by 5% to 10% in the year of implementation of TD, and shave 2% to 4% off of our current forecast for the average price level in 2018. This will be yet another force limiting price growth in the future.

Higher Interest Rates

TD expects that increased requirements of income testing should cause demand to be less sensitive to the immediate rise in mortgage rates, because insured mortgages are already income tested at the higher Bank of Canada 5-year posted rate (currently 4.84%).

In addition, TD expects that the impact of higher interest rates will be felt disproportionately within a few key markets where affordability is the most challenged: Vancouver, Toronto and Montreal. TD's affordability metric, which measure the market's sensitivity to higher interest rates, shows that Vancouver is the most sensitive to interest rates, but Toronto is not much better off.

Under TD's current rising interest rate forecast, existing mortgage holders, on average, have some room to absorb higher debt-service costs. As for prospective buyers, historical comparisons indicate that the pace of mortgage rate increases is consistent with a 7-10 percentage point drop in existing home sales. However, this relationship could be more muted this time around due to past regulatory changes.

Soft Landings

Although Toronto, Vancouver and Montreal may benefit less from this cushion due to higher interest rate sensitivity on reduced affordability, TD expects that a modest rise in interest rates should be well absorbed by markets across Canada.

In the last few years, many markets have already gone through a soft landing and are more balanced. In a soft landings, home prices slowed to sub 2% (or below income growth) for a sustained period. Allowing income growth to "catch up" is an argument for why higher mortgage rates will scale back the speed of the market, but not necessarily have the force to derail it.

  • Sharp and Short: A downturn in housing cycles can be divided into two camps: sharp and short versus sharp and long. In the former camp, the run-up in home prices can last between six months and two years, with home prices rising at an average pace of 15% to 20% per year. These cycles tend to be followed by moderate peak-to-trough home price corrections of 10% to 14%. Existing home sales and prices reset to a level in better alignment with underlying fundamentals. But the market can remain in a state of high valuations until an income shock comes along.
  • Sharp and Long: The second camp captures a sharp and long adjustments, resulting in more than a 20% peak-to-trough decline in home prices. These markets tend to be historically preceded by a persistence of double-digit home price growth for 4-5 years. The great Canadian crash of 1989 and the most recent U.S. experience both fall into this camp. The longer the period that home prices rise at a double-digit pace, the more they are likely to divorce from fundamentals and accumulate financial risks. In other words, it's not just the speed at which home prices rise, but the duration of the cycle that creates financial risks. These have been partially mitigated in the current cycle by regulatory measures, which were less evident in the previous two examples. Lastly, and most importantly, household distress needs to be accompanied by some broader distress in income or the financial system. This is not to say that Canadian households are free and clear of risks. Definitely not. Vulnerability is enhanced in the event that a recession forms. The case we are arguing is that these conditions have not materialized in the current environment as of yet.

Vancouver is the poster-child of soft landings says TD; the city has had five such cycles since 1990, all consistent with a soft landing scenario.

For the GTA market, the current cycle is likely to be classified as the sharp and short variety. TD expects a reset in home prices that would return the average price back to mid-to-late 2016 levels. The average home price has already fallen 13% peak-to-trough, placing it only back to early 2017 levels. TD's forecast embeds a 6% contraction in the average home price in Toronto in 2018 and stabilization thereafter. Ultimately, Toronto home prices will remain elevated, similar to the experience of Vancouver.

For most other markets, the combination of higher mortgage rates and moderate income growth set against balanced market conditions will help support annual home price growth of between 2-4%.