Housing Is a Tale of Two Markets

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Benjamin Tal, deputy chief economist, CIBC. 

The big question of course is when the Bank of Canada will start cutting interest rates and by how much. We know that the Bank of Canada is done raising interest rates. The big question is, when they are ready to start cutting. 

I believe that if the Bank of Canada was an AI machine, they would have stopped 50 basis points ago. I think that the Bank of Canada is already overshooting. Usually, the gap between the Bank of Canada and the Fed in terms of interest rates is about 75-100 basis points. Today, the gap is only 25 basis points, which means that either the Fed is undershooting or the Bank of Canada is overshooting, and I don’t think that the Fed is undershooting. So, the Bank of Canada will cut first. 

Clearly, the U.S. economy is doing much better than the Canadian economy. And the big question is, how much the Bank of Canada can divorce itself from the Fed? Namely, if we have a scenario in which the Fed does not move and the Bank of Canada starts moving, by how much the Bank of Canada can take interest rates lower without the Fed moving. And I think the answer is roughly 50 basis points. So, we see the Fed on hold in June, July, August, maybe starting in September to cut, while the Bank of Canada probably will start cutting in June. 

So, the economy is basically in a per capita recession. Inflation is behaving nicely. There is no reason not to cut at this point. The latest numbers that we got from GDP clearly showing that the economy is slowing down. So, there is no reason whatsoever not to cut. And remember the gap between the U.S. and Canada is only 25 basis points. So, you have a green light from the market to go for 50 basis points without the Fed. 

If the Fed stays in neutral after that, that’s a problem because then what’s happening in the U.S. will start impacting what’s happening in Canada. We are not there yet.  

So bottom line, the Bank of Canada will start cutting in June. We see it cutting three times during the course of 2024. And if you look beyond that, we see the Bank of Canada taking interest rates roughly to about 3% from the current 5%. So, it’ll be significantly higher where interest rates were before the crisis, but clearly lower than where it is now. 

Now the question is what does it mean for the housing market? Because we have seen in early 2023, whenever the Bank of Canada is hinting about the possibility of stopping to raise interest rates, housing market took off the spring of 2023 was very, very strong. 

The question is whether or not we’re going to see it again.  

In fact, we’re already starting to see it. The market is tweeting about the possibility of the Bank of Canada cutting interest rates and we are seeing the low-rise segment of the market, detached segment of the market, starting to wake up. We don’t have enough supply. The demand is coming, especially for properties over the three or four million threshold. 

However, the condo market, the condominium market is much weaker. Why? Because pre-sale activity is very, very weak. It’s actually not happening. Developers cannot justify building at this point, which means that we don’t see any supply coming to the market, new supply. So, whatever you see in terms of construction is actually completing previous engagements but not new engagements. And that’s extremely important to understand why. Because two or three years from now, the demand will still be there, interest rates will be lower. The supply that’s supposed to come now will not be there. You don’t have to be an economist to suggest that the prices will go up. So, in a funny way, condo space is now a weak market but maybe the best time to get the condominium from a perspective of a decade or 15 years from now. So, I think that’s the way to look at the situation. 

So, the housing market will be a tale of two markets. The detached segment of the market will do fine. The condo space will take a while to clear before getting stronger with reduced demand. That’s the way I read the market. It’s a very interesting market, asymmetrical. And the gap between new construction of condos, the resale market is at a record high. That’s something that cannot justify increased supply of new construction activity, and that’s exactly why there will be shortage of supply. 

In addition, of course, the government has done a lot to reduce demand in terms of impact, or the changes, on non-permanent residents. That will lower demand in a very significant way. But it’ll take a while. We still have a pool of people in the country that need shelter and they simply don’t have it, and that will keep prices elevated. 

I think that if you look at what the government has been doing so far, it is actually very positive, a step in the right direction. We knew first that the demand is a major issue. We have seen the Canadian population rising by 1.3 million people last year. Most of them were non-permanent residents putting a significant pressure on the rental market. Since then, the government changed its course and now they’re saying that the number of non-permanent residents is going to go down from 6.5% of the population to five. That’s significant. That’s going to reduce population growth from about 3% to 1%, and will ease the pressure on the rental market. It’ll take a while, but that’s clearly a step in the right direction. 

The government is also encouraging increased supply in many, many ways, and that’s another factor that will lead to some easing in the market. 

Now, make no mistake, Toronto, Vancouver and many other cities in this country will never be affordable because population growth is still very strong and we simply don’t have enough supply. But the steps taken by the government over the past few months and especially during the budget, has been very, very positive, a step in the right direction. For the first time, governments, all levels, are understanding that we have to treat this situation as an emergency because it is an emergency. And if we don’t wake up, we’re going to see some pockets of civil unrest. We’re going to see anti-immigrant sentiments. We’re going to see renter’s strike. We have to wake up and realize that this is a major crisis. They move in the right direction, but it’s not going to be easy. 

When it comes to the budget and its impact on the housing market, I think that many of the steps that were taken were steps in the right direction. However, a lot more needs to be done. We look at the purpose-built rental segment, namely apartment buildings. We need to encourage developers to build more and more rental units because that’s where the pressure is. We know that the government cut the GST/HST and that’s very good, but we need much more. One thing that we advise the government to do, and I hope they will do it, we are meeting with them actually on a regular basis to make sure that they understand the issue, is to change the taxation on capital gain and commercial real estate. What I mean by that is that if you’re a developer and you have an apartment building and you sell it, you take the profit and you move this profit to another commercial real estate unit or asset. 

That’s exactly what’s happening in the U.S. In Canada, you pay the tax immediately and therefore there’s no motivation to do so. So, we advise to actually follow the example of the U.S. and remove the capital gain tax on apartment building sales and therefore that will generate momentum. 

Another factor is to provide developers with incentives to build what we call a self-financing house, namely a house that is designed to have a unit for rental. Therefore, it’s a win-win situation because the homebuyers can get the home that they want, but also can get help from a rental unit, while the rental unit is providing more supply to people that are seeking rental units.  

So, I think that there is a lot of things that can be done, so a step in the right direction, but more should be done. 

So, the question is what’s the risk for the housing market? I think that the number one risk is that inflation will become more sticky, and interest rates will not be falling in any significant way. Interest rates will remain high. That will lead to a recession in the economy as a whole, and that will lead to a significant correction in the housing market. So, that’s the number one risk: inflation. 

If inflation is not behaving, doesn’t go down to 2%, and the Bank of Canada and the Fed will find themselves in a situation in which they have to actually raise interest rates again, or keep interest rates high for longer — that will be recessionary unfortunately, and that will be negative for the housing market. So, that’s not the main case scenario at this point, but it’s definitely a risk.