What Will Higher Interest Rates Do to Home Prices?

The Bank of Canada indicates that rate hikes are likely to come soon. What does that mean for the market?
Over the past year, economists have disagreed on the future path for inflation (a general increase in prices for goods) with some arguing that any increase in inflation is likely due to Covid-19 related problems, such as delays in global supply chains for producing and delivering goods, that are short-term and transitory, and others arguing that this inflation will be more persistent.

Last month, the Bank of Canada was very clear about which side of the debate the Bank is on:

“The main forces pushing up prices — higher energy prices and pandemic-related supply bottlenecks — now appear to be stronger and more persistent than expected.”

- Bank of Canada Governor Tiff Macklem

The Bank of Canada ended their aggressive form of monetary policy referred to as ‘Quantitative Easing’ (QE) (purchasing particular securities such as bonds in order to expand money supply to encourage economic activity), which pushes down the interest rates that fixed rate mortgage rates are based on. 

In addition, the Bank indicated that they will be raising their policy rate, which variable rate mortgage interest rates are based on, much earlier than they originally planned, with many expecting the first rate hike to come in April. CIBC’s Benjamin Tal noted that the bond market has priced in no less than 6 rate hikes in 2022. 

Given this news, I’ve heard from a number of home buyers who are worried that an increase in rates might lead to a “correction” (read: a drop) in home prices as it would reduce what buyers and owners could afford. 

I see this as a very unlikely outcome (at least in the short-term) for a number of reasons.  

Firstly, most homeowners in Canada have five-year fixed rate mortgages so most homeowners are unlikely to feel the impact of higher interest rates next year.  

Secondly, home buyers in Canada over the past five years have been qualifying for their mortgage at a ‘stress test’ interest rate, which is much higher than what they are paying. These tests were introduced by our authorities precisely for this situation of rising interest rates; home owners who qualify under these tests should be able to handle the costs associated with a higher interest rate on their mortgage when they do need to renew.

But even those households that might have a hard time with these extra costs, perhaps due to high balances on their home equity lines of credit which are directly impacted by the Bank of Canada’s rate increases, we are still unlikely to to see any widespread ‘distressed selling’ (when home owners have to sell their homes due to their inability to pay their mortgage), which can pull down home prices, any time soon. Before a homeowner defaults on their mortgage, they will typically cut other expenses, take on more debt or get help from others to help in the short-term or sell and downsize first.

However, there are two more likely effects that higher rates might have on the housing market in the coming year.

The first is that it will likely take some demand out of the housing market, from both investors and end users. Variable interest rates in the 1% range have been a key driver of demand from real estate investors and it’s this segment that will likely see a disproportionate decline in demand should we see multiple rate hikes in 2022.

Higher interest rates could also have an impact on investor outlook and confidence. If investors start becoming less optimistic about the future growth in homes prices, thinking that double-digit home price growth is behind us in the wake of higher rates, this may lead to more investors selling their properties. 

But are either of these factors going to lead to a decline in house prices in 2022?  

I think that’s very unlikely.

Toronto’s housing market continues to be a market where demand significantly exceeds the supply of homes coming on the market for sale, particularly given our immigration policies (see my previous months reports for more than this issue).

As I’ve said before, it’s like our housing market is going 200km/h on the highway — before it can reverse, it needs to slow down considerably first. If we see a lot of demand come out of the market and more homes listed for sale, our market will start to slow down, but will continue to remain in seller’s market territory, with prices growing at a more modest rate than we are seeing now.

Read our full monthly Move Smartly market report for Nov 2021 here

John Pasalis is President of Realosophy Realty, a Toronto real estate brokerage which uses data analysis to advise residential real estate buyers, sellers and investors.

A specialist in real estate data analysis, John’s research focuses on unlocking micro trends in the Greater Toronto Area real estate market. His research has been utilized by the Bank of Canada, the Canadian Mortgage and Housing Corporation (CMHC) and the International Monetary Fund (IMF).

Follow John on Twitter @johnpasalis

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