Real Estate is About to Change
In 1946, the Canadian Mortgage and Housing Corporation was formed to assist with the housing of growing families after the war. It evolved over time to be the major underwriter and guarantor of loans to qualifying Canadians who require “non-conventional” or more than 80% mortgage financing. In short, this Crown Corporation sells default insurance to banks to underwrite their risks to borrowers who at some point only had to advance as little as a 5% down payment on a purchase, the amortization period for what at one time could have been as long as 40 years. The premiums for this insurance are paid for by borrowers. The bank therefore is essentially risk free in terms of default of the borrower.
By 2012, CMHC had significantly shortened the maximum amortization period on its insured loans to 25 years. In addition, further restrictions saw increases in the minimum down payment required, restricted maximum purchase prices, higher loan qualification standards to the lenders “posted” 5 year rate as opposed to the borrower’s actual interest rate as well as a few more restrictions. This was all in response to huge growth in property values and the perceived risk to CMHC who could be “on the hook” for defaults by Canadians on their mortgage loans in the event of a housing price correction.
The Office of the Superintendent of Financial Institutions (OFSI) sets lending policies for banks. Worried about the consequences of an increase in interest rates and the ability of Canadians to handle the increased costs of financing already in place as mortgage debt, OFSI has recently issued increasingly restrictive lending policies designed to “stress test” Canadian borrowers to ensure that they can afford higher interest costs. In short as of 2018, Canadian borrowers from banks, must be able to meet lending requirements as if their loan rate was 2% higher than what it actually will be.
A short example of the consequential math is necessary in order to grasp the magnitude of the impact this new policy will have on the entire Canadian economy.
Let’s start with a hypothetical mortgage of $750,000.
On line rates currently show up at 2.49%.
Monthly payment: $3,349.10
Approximate annual qualifying income: $91,336
Under the rules to be in effect in 2018, the following scenario would govern:
Monthly payment (assuming no change in 5 year rates) $3,349.10
Approximate annual qualifying income: $113,917.72
Canadians will need incomes approximately 25% higher to qualify for their mortgages in 2018.
It is a realistic assumption that on January 2018, Canadians will not be getting 25% pay increases. As such, our borrower will have to restrict his loan amount for which he will qualify to $601,329.35, even if he is comfortable paying a higher monthly mortgage payment. This represents a 20% reduction in the price of a property that he could be eligible to buy prior to 2018!
What are the consequences of this government policy?
- If people can afford 20% less house, and those needing mortgages account for a large percentage of buyers, look for a huge correction in the housing market. 15-20% would not be surprising.
- The “Wealth Effect” which is that glowing feeling Canadians have when they “feel” rich because their properties have moved up significantly in value will begin to dissipate. All those BMWs and Teslas out there likely came from greatly increased property values and large authorized lines of credit (HELOCS). Consumer spending will dissipate with it as that glow starts to subside with decreasing property values.
- The reduction in consumer spending will also accelerate as consumers and house shoppers will be required to save more and borrow less to acquire enough mortgage room to purchase the property they want.
- Since borrowers will not be required to requalify at the higher rate at the maturity of their loans if they remain with the same lender, banks will have greater leverage to raise their mortgage rates to captive borrowers who will be compelled to pay the rate or otherwise requalify at the higher rate, likely with income levels they have not yet attained.
- Single family homes will bear the brunt of the credit squeeze, being the most expensive type of property.
- Buyers will be forced to move down a level from their expectations. Lower end property values will hold better than higher end ones and the spreads between say townhouses and single family homes will diminish.
- Fewer people will be moving as their plans will have to be put on hold due to affordability.
- Retail business relating to housing, renovation etc., will suffer.
- There will be a general multiplier effect of the reduced credit flow which will negatively affect the entire economy. A huge dollar value of financing and lending ability will be shuttered as restrictions preclude transactions, renovations, inhibit construction etc.
- Housing vacancy will decrease to even tighter levels and rent pressure will increase.
- Look to increased rental restrictions from our provincial government in the near term which will also increase pressure on pricing.
If you have a significant equity position in your property holdings, you need to re-evaluate your options. Feel free to contact me to discuss what those options are and to formulate a plan to deal with this market.