Canadian housing prices likely to contract on annualized basis in 2023

The tide has clearly turned in Canadian housing. Earlier this year, new and existing home prices were soaring. Median home prices in many markets across the country were growing by $100,000 CAD in a matter of months. But by summer, these prices were erased and the bulk of buyers who were rushing to market in the months prior began to disappear. A combination of a lack of suitable inventory, high prices, and newly expensive financing costs have increasingly pushed buyers away. Sales volumes have collapsed even more than they had at the beginning of the year.

In our outlook from January we noted that growth in home prices could decelerate down to 6% annualized in 2022. The logic behind our note was simple: 1) record price growth has never been sustained; 2) inventory was starting to rebuild from unsustainable record lows; and, 3) record low inventory was itself collapsing demand. The latest national data from Statistics Canada and Teranet-National Bank shows that both new and existing home prices are down to around 6% annualized growth.

Today, the outlook is markedly worse for housing prices: 1) price growth is now trending downward; 2) inventory is starting to build; and, 3) demand has collapsed further on high financing costs. Looking ahead, we estimate that national prices could contract on an annualized basis next year in 2023.

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CURRENT SITUATION IN CANADIAN HOUSING

The latest data from Statistics Canada shows that home prices are still growing on an annualized basis but that growth is slowing significantly. In September 2022, new home prices were up 6.33% year-on-year, down from peak growth at 12.17% in August 2021. The slowing growth momentum didn't really kick in until April 2022. Since then, growth has been slowing quickly.

New home prices are slowing due to a buildup of new supply. As of July 2022, there were more unabsorbed new construction homes on the market across the country than during the same period the previous year. As of September 2022, unsold new homes are up over 9.4% since September 2021. What's more, data for September 2022 from Canada Mortgage and Housing Corporation (CMHC) shows that housing starts were annually up over 18% while homes under construction were up almost 14%. This means more supply is scheduled to come online in 2023. Some of this new supply will also be built at lower cost as labour shortages resolve and since construction material costs have come down.

The inventory buildup situation is largely due to a collapse in demand. The latest data from the Bank of Canada shows that bank mortgage issuance was down over 24% in August 2022 from August 2021 (sales volume was down over 32% in September 2022). The number of bank mortgage dollars outstanding (circulating in the economy) is now starting to fall as mortgage payments have started to outpace mortgage issuance. Annual growth of bank mortgage credit outstanding decelerated to 8.3% from a peak of 11.5% in September 2021. Fewer bank mortgage dollars circulating around in the economy means there will be fewer dollars available to be spent on soaking up housing inventory (or even other things in the economy).

It's important to note that demand started to contract in August 2021 before inventory levels started to build. This was due to a super low amount of homes for sale across the country, especially in new construction. Effectively, demand was suffocated by a lack of supply in 2021. This was evident at the time from bank mortgage issuance and sales volume figures (in August 2021 bank mortgage issuance and real estate sales volumes began to contract on an annualize basis even though the economy was booming and mortgages were cheap).

Unlike last year where supply was largely suffocating demand, this year the demand story has been complicated by an exponential rise in financing costs. Last year when demand started to collapse (August 2021), the average interest rate on bank issued mortgage credit was falling on an annualized basis (with the average rate for variable and fixed mortgages coming in around 2%). As of August 2022, the average rate on issued mortgages was over 4.4% - more than a 100% annualized increase.

This rapid rise in financing costs is slamming the brakes on bank mortgage issuance and real estate sales volume, and is in fact now incentivizing mortgage repayment. If rates stay high for any extended period of time, it may make the demand situation progressively worse as it leads to a rise in debt repayments, insolvencies, and maybe even some distressed selling in housing markets across the country (something Canada's bank regulator has warned).

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DEMAND MUCH WEAKER NOW COMPARED WITH PRE-GREAT FINANCIAL CRISIS PERIOD

The pace of the latest slowdown in new home prices is very similar to what unfolded in the run-up to the Great Financial Crisis (GFC). New home price growth has slowed from 12% to 6% in about 13 months (August 2021 - September 2022). In the run-up to the GFC, new home price growth also slowed in about 13 months from 12% to 6%, and it even happened during the same period of the year (August 2006 - September 2007). However, there are a few different underlying characteristics between these two home price slowdown periods.

In the run-up to the GFC, new home price growth slowed alongside a buildup of supply. Supply started to build in October 2006 when prices were still growing at over 11.5% annualized. This time around, new home price growth was decelerating when inventory levels were still contracting on an annualized basis. We got down to 7.5% price growth by the time inventory started to grow on an annualized basis earlier this year. In other words, prices have yet to really feel the impact of the inventory buildup that has really only just begun.

What's more, new home price growth in the run-up to the GFC slowed down alongside a relatively strong demand picture. Price growth started to slow as demand entered contraction in 2006, but by the start of 2007 demand was back to annualized growth. Indeed, price growth did start to slow as demand entered contraction in 2021, but so far in 2022 the type of demand we saw back in 2007 has been absent in the market. We're witnessing a housing market in 2022 experiencing much less demand when compared to the housing market in 2007.

Part of the difference can be attributed to the fact that, in the run-up to the GFC, the supply shock was smaller. The unabsorbed inventory contraction between 2004 and 2006 reached a maximum of -18.34% year-over-year, whereas the contraction between 2019 and 2021 reached a maximum of -46.3% year-over-year. The massive drop in inventory levels in 2021 is, at least in part, responsible for the different demand picture that has formed in 2022 compared to 2007.

The other part of the difference can be attributed to the fact that financing costs increased much less in 2007 than they have so far in 2022. We don't have access to reliable data for bank mortgage credit costs going back to 2007, but we can look at the 5-year Canadian bond yield to get an idea.

The 5-year yield rose at an annualized rate of about 10% by mid 2007 after interest rates fell somewhat in 2006 and early 2007. This provided support to demand conditions in 2006-07. This time around we have not seen this type of support for demand from rates. The 5-year yield jumped by over 200% annualized in September 2021 and subsequently jumped by almost another 200% a year later in September 2022. This effectively translated into a 350 basis point increase to the Bank of Canada's policy rate and a 100% increase in the average interest rate for bank mortgage credit so far.

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IF TRENDS CONTINUE PRICES WILL LIKELY CONTRACT ON ANNUALIZED BASIS BY END OF 2023

The comparison between the latest Canadian housing market and the pre-GFC period is a revealing one. The demand strength that was around in 2007 wasn't able to stop prices from sliding further in 2008 and from eventually contracting on an annualized basis in 2009. Currently, this type of demand strength is absent from the market and the pressures on prices from rising inventory levels have yet to really translate into prices.

It's worth thinking about what might change these trends and shift demand up and supply back down. For supply to come down it's likely important for the right type of supply to come online in order to overcome the issues buyers faced by the supply shock in 2021 where there simply was little to buy, even if you had the money. At the same time, for supply to get soaked back up it's likely important for financing costs to come down significantly for it to make sense to take a mortgage, maintaining debt repayments at a minimum, prevent insolvencies, and holdback any distressed selling in housing markets.

So, the conclusion we can draw is that, if trends continue, prices will likely contract on an annualized basis on a similar or shorter timeline than that of the GFC. This would translate into a contraction as soon as the tail-end of 2023 and, at best, the start of 2024. Given the absence of demand this time it might arrive much sooner, perhaps Q2 2023.