What is most likely to cool the Toronto market right now?

A closer look at the most likely factors – although they remain to be seen.

As featured in our monthly Move Smartly Toronto Area Market Report – Read the full report here

An eternal question

The start of a new year is the perfect time to address what has become one of the most common – and still important – questions I receive about the Toronto area housing market – What is going to cause the market to cool down and when will it finally happen?

When most people ask this question, what they want to know is when prices are going to go down, but first we need to think about how the market is going to cool down – starting from a market where 3 4 homes receive multiple offers because there is less than a month of available inventory (MOI) in a market where nearly 1 in 4 homes receive multiple offers and the MOI is 2-3 months.

In other words, before house prices can reverse and fall, the market must first slow down.

So what could cause the market to slow down?

A slowdown in the housing market usually starts with a drop in demand (as opposed to an increase in supply) and I think there are several factors that can lead to a drop in demand this year.

Buyer fatigue ahead?

This first factor that could lead to lower demand is buyer fatigue due to high home prices. First-time buyers are an important driver of housing demand, and among these buyers, those looking for a 3-bedroom family home are in particular pressure.

Buying a home for less than a million dollars is becoming increasingly difficult, and many first-time buyers in this price range are losing hope.

The sub-$1 million price is important for first-time buyers because homes over $1 million require a larger down payment, a minimum of 20% (compared to as low as 5%). Buyers with less than 20% down payment in Canada are required to purchase mortgage default insurance through Canada Mortgage and Housing Corporation (CMHC) or a private insurer and the maximum price of home for this insurance coverage is $999,999. This means that a home buyer spending $999,999 needs a down payment of $75,000, while a buyer spending $1 million needs a down payment of $200,000.

When we look at the number of 3 bedroom homes that sold for less than $1 million in the last quarter of 2020 compared to the same in 2021, we see that the number of sales fell from 8,196 in 2020 to 2,460 in 2021.

While some buyers who were initially looking for a 3-bedroom home might end up buying a condo instead, many families don’t see an 800 square foot condo as a substitute for a 3-bedroom home.

Given this, many of these buyers will eventually give up on the dream of buying a home or start looking for a home outside of the GTA in cities where homes are more affordable.

It should be noted that the federal Liberal government promised to increase the insured mortgage threshold from $1M to $1.25M during the last federal election in Canada. If the Liberal government keeps this promise, the drop in demand I describe above will likely be somewhat delayed since this type of policy change will stimulate demand. But such a political move in an already overheated market would be very misguided. Policies that boost demand and indebtedness are not solutions to housing affordability because they drive up home prices in the short term, again adding pressure to the budgets of first-time buyers and don’t leave them better off.

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A ceiling for investors?

Moving on to another group responsible for significant demand in the market, we come to our second potential cause of market downturn. In response to Bank of Canada warnings regarding the disproportionate impact of real estate investors on the housing market and the risks this poses to Canada’s financial stability, the Liberals have indicated that they are considering a increased down payment requirements for investment properties.

If such a change were to occur, it would be more difficult for investors to buy homes, which would eliminate a considerable amount of demand from the housing market.

Such a policy change would also likely boost supply, as many of the investors we see today are not actually buying investment property, but keeping their existing home as an investment property when they move to a bigger house. Higher down payment requirements make it harder for people to keep that existing home, which can lead to a moderate increase in the supply of new listings.

The impact of higher interest rates

The other major factor that could cool demand in 2022 is rising interest rates. Money markets are waiting the Bank of Canada to raise interest rates by 0.25% to 1.5% by the end of the year.

Canada’s Mortgage Stress Test requires buyers to qualify for their mortgage using the higher of the benchmark rate which is currently 5.25% or their actual mortgage rate plus a 2% buffer.

This means that if today’s buyer gets a 5-year fixed mortgage at 2.25%, they actually qualify using the benchmark rate of 5.25%. If 5-year mortgage rates increase this year to 3.5%, buyers will see their borrowing power slightly reduced as they will have to qualify for their mortgage using an interest rate of 5.5%, their rate mortgage plus a 2% buffer.

But where we will see the biggest impact of higher interest rates is not how much buyers will be able to borrow, but how much they will be willing to borrow.

Let’s assume for a moment that 5-year mortgage rates increase by just 1% and that has no impact on how much a buyer can borrow – the buyer who qualifies to borrow $800,000 today with a rate 5-year fixed rate of 2.25% can still qualify to borrow $800,000 later this year when the rate on 5-year mortgages drops to 3.25%.

But even if this buyer’s borrowing capacity has not changed, his borrowing costs have changed significantly. The cost of borrowing $800,000 will drop from just under $3,500 today to just under $3,900 when rates hit 3.25%. While some buyers will be comfortable spending an extra $400 a month on their mortgage, many won’t and will either have to spend less or find themselves out of the GTA real estate market.

Higher interest rates will also push more real estate investors away, as historically low interest rates have been a major driver of the strong demand from real estate investors in 2021.

Now, I must point out that while we see some or all of these factors come into play this year (e.g. buyer fatigue, higher interest rates, tighter credit for investors, etc.), given current market competitiveness and how much headroom it could take in terms of reduced demand, I don’t expect to see any impacts on the ground until the second half of 2022.

An annual cooling model

Beyond the special factors, there is a more familiar phenomenon that will likely cause some market cooling later this year, and that is the seasonal nature of the real estate market.

The first quarter of each year is usually the most competitive and 2022 will be no different.

Most people assume that the spring market is the most competitive because it sees the most sales, but it actually contains a few different trends in the field.

Most buyers who want to buy a house in the spring usually start their house hunting in January or February, because they know that it will take them several months to buy a house. But the first quarter of each year also has a relatively low number of new listings, so we end up with many buyers competing for very few homes available for sale.

As we head into the spring market, tens of thousands of buyers are leaving the market because they have already purchased and thousands more homes are being listed which means the market tends to get very busy, but less competitive than it is in the tighter market conditions at the start of the year.

This annual trend will continue into 2022 and will likely be worse than previous years given the low inventory currently available for sale. If the market returns to those familiar annual patterns, we should start to see some cooling between late spring and early summer.

Cooling does not fall – yet

All of the above factors can cause the market to cool down, but as I explained above, that doesn’t mean prices are going to go down right away. Given the market turmoil in favor of the sellers, what you will first see in a cooling is a gradual shift to a more balanced market.

In my next article, I will discuss the likelihood of the Toronto market cooling to the point where house prices begin to fall.

Top image credit: Getty/iStock

John Pasalis is President of Realosophy Realty, a Toronto real estate brokerage that uses data analytics 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 used by the Bank of Canada, Canada Mortgage and Housing Corporation (CMHC) and the International Monetary Fund (IMF).

Follow John on Twitter @johnpasalis

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