With mortgage rates reaching new heights in Ontario, it is important for prospective Toronto homebuyers to understand how this is affecting the city's real estate market. Basically, in real estate, there is a strong and inverse relationship in the fluctuation of home prices and mortgage rates - the higher the mortgage rates are, the lower the home prices tend to become.
Let’s dig into how the recent increase in mortgage rates are affecting the real estate market in Toronto. Let us first recap a fundamental concept of mortgage rates.
Quick Recap - What is the overnight rate?
The Bank of Canada (BOC) carries out monetary policy by influencing short-term interest rates. They do this by adjusting the target for the overnight rate on eight fixed dates each year. In simple terms, the overnight rate acts as a minimum fixed cost for major banks and lending institutions, so as this rate increases, so does the cost of the mortgage rate the lender provides the consumer (homebuyers in this scenario). .
Now, let’s figure out why these higher mortgage rates are hurting real estate prices.
Cost of Borrowing
As the BOC increases the overnight rate,, this invariably increases the interest rates for variable rate mortgages. When rates rise, the cost of carrying a mortgage increases, and as a result, the amount paid on interest towards a property increases, while the principal payments towards the mortgage loan decreases. This, invariably, extends the amount of time it would take to pay down a mortgage loan, as less of your payments go towards principal payments. Therefore, properties become less attractive for homebuyers to purchase, who may consider renting, and real estate investors, since their cap rates and margins would decrease due to the higher debt costs.
To break it down, there are two types of variable mortgage products.
Adjustable Rate Mortgage
Adjustable rate mortgages are likely to be more recognizable to a prospective home buyer. This variable rate dictates that, as the prime rate increases*, so will your mortgage payment. As the prime rate decreases, mortgage payment also does so.
An adjustable rate mortgage product is one that can leave a household in a tough spot financially if they are not budgeting correctly, if, like what is happening so far in 2022, the prime increases a substantial amount in a short period of time.
Being prepared for such increases and managing your money/budget effectively can go a long way.
*As mentioned above, the movement of the prime rate is decided by the Bank of Canada on eight fixed dates each year.
Variable Rate Mortgage
A variable rate mortgage with static payments differs from an adjustable rate mortgage in one main way.
With a variable rate mortgage, as the prime rate increases, your mortgage payment remains the same. However, a higher percentage of your mortgage payment is allocated towards the interest portion and a lower percentage of your mortgage payment is allocated towards the principal portion.
Conversely, as the prime rate decreases, your mortgage payment is likely to remain the same. However, a higher percentage of your mortgage payment is allocated towards the principal portion and a lower percentage of your mortgage payment is allocated towards the interest portion.
One key thing to remember though, is if prime increases substantially enough, you will reach a trigger point. A trigger point is reached when your current mortgage payment is no longer able to cover the amount of interest required. In this scenario, you would be required to make a lump sum payment and/or your mortgage payment must be increased in order to be able to pay off the necessary interest portion of your payments.
Please make sure to communicate with your mortgage agent and have them advise which mortgage product it is you are signing up for. As you can see, not all loans are the same.
Example of a Toronto Home Mortgage Costs
To help illustrate these concepts, let's look at to what extent interest rates impact mortgage costs and affordability.
In both examples below, let us assume that the property’s purchase price/value will be $1,000,000, with a down payment of $200,000, a mortgage amount of $800,000 and an amortization of 25 years.
In addition, we will have two separate mortgage rates that we will work with:
A monthly mortgage payment at 1.5% = $3,198
A monthly mortgage payment at 5.5% = $4,883
One thing to remember is just because a rate doubles (goes from 1% to 2%) it does not mean your payment doubles! Usually, doubling of the interest rate equates to a 30% monthly payment increase.
Lower Mortgage Qualification
As rates and costs increase, the mortgage amount a home buyer would usually qualify for also decreases. This deterioration in buying power not only reduces the pool of available buyers in the market, but also restricts the overall budgets of the buyers in the market as well.
Here’s an example of a decreased loan amount at higher rates
For ‘A’ lending, mortgage qualification is based on the higher of the benchmark rate of 5.25% or the contract rate + 2%. Due to the elevated interest rate environment we currently find ourselves in the latter, the contract rate + 2% is how client(s) are currently qualifying when it comes to mortgage financing.
In both examples below, we will assume the household income is $150,000 and that there are no liabilities/debts associated with the client(s).
A 5 -Year Fixed Mortgage at 1.5% - 25 Year Amortization
If the mortgage rate is set at 1.5%, that would mean qualifying at the benchmark rate of 5.25%, since that is higher than 1.5% + 2% = 3.5%.
In this example, one would qualify for approximately $750,000 in mortgage volume.
A 5-Year Fixed Mortgage at 5.5% - 25 Year Amortization
If the mortgage rate is 5.5%, that would mean qualifying at the contract rate + 2% (5.5% + 2% = 7.5%), since 7.5% is higher than 5.25%.In this example, one would qualify for approximately $625,000 in mortgage volume.
That is $125,000 lower mortgage than the rate at 1.5%, which would significantly impact a buyers home search. As you can see from the above examples, rising interest rates creates downward pressure on purchasing power* which then leads to a decrease in real estate value.
*Remember that depending on the property and property type (house v condo) the purchasing power may vary due to variable liabilities such as property taxes, condo fees, heating etc.
When real estate markets are unstable or unpredictable, due to fluctuations in the overnight rate, then other, more stable asset classes become more attractive. Higher mortgage rates eat at property investors’ profit margins, so the profitability of holding real estate assets decreases in relation to other assets with less fluctuation. One example of this are bond yields. There tends to be a correlative relationship between the overnight rate and bond yields, so when the overnight rate increases, the bond yields also increase. Thus, investments such as bonds start making more financial sense.
Renting Becomes Attractive
Due to the increase in carry costs of the mortgage component of home ownership - renting increasingly becomes more attractive. Speculation in real estate is far from rare, and many would-be homebuyers would rather either weather the storm of unstable home prices or would like to stay on the sidelines to hopefully “catch the dip” in prices. So instead of searching to purchase they search for a rental and would rather opt to sign a one year lease than a purchase agreement. It doesn’t sound like a bad idea to hold-off on a major decision while still saving to contribute to your downpayment. However, one should always keep in mind that just like the stock market, it’s always hard to time the dip.
How are prices holding up in Toronto?
According to the Toronto Region Real Estate Board’s (TRREB) data for the month of September 2022, the Toronto area average selling price is down 4.3%, $1,086,762 from $1,135,027 for the same month last year. In the same time span, sales are down a significant 44.1% and average days on market (DOM) are up 64.3%. However, changes in the average selling price vary significantly by type of home, so let's break it down by home type to get a clearer picture.
Houses (Freehold properties)
Over the past two years, which were also years of drastically low mortgage rates, houses experienced the highest appreciation rate in prices. For reference, in September 2021 detached home prices increased by 28.9% year-over-year (YOY), semi-detached by 20.8% and townhouses by 21.5%. It makes sense, that freehold home ownership suffered bigger losses as mortgage rates increased as of late.
For September 2022, compared to the september of the year prior, average home prices for detached houses decreased by 10.2%, semi-detached down by 4.2%, and townhouses decreased by a marginal 1.4%. The price depreciation is significant, considering that average home price are around the one million dollar mark - however when taking into account the price appreciation from previous year alone (not even the many years before) the losses thus are somewhat understandable. The market reaction to increased mortgage rates followed an inverse, but somewhat similar trend to the low interest rates of the last few years. The real estate asset classes (freehold properties) that experienced the largest jump in prices also experienced the largest drop in prices with increased mortgage rates. However,so far this year another type of real estate asset class, condominiums, have been holding steady thus far.
The appreciation rate for average selling prices for condos between September 2021 vs. September 2020 rose by 11.6%, less than freehold house prices, but a considerable amount nonetheless. The average sale price of condos rose from $634,756 to $708,521 in just a year. In 2022, how have condo prices and prospective buyers reacted to an increased mortgage rate environment? Let’s take a look.
Average Toronto area condo prices rose from the aforementioned $708,521 in 2021 to $730,818 in September 2022- a very modest 3.2% increase year-over-year. This stands in stark contrast to the fall in housing prices in Toronto. One major influence on this steady price appreciation could be that prices of condominiums are, on average, considerably lower than those of houses. With lower average prices, there still exists a larger pool of buyers capable of purchasing Condos if they cannot qualify for a loan needed to buy houses. It’s hard to pinpoint the exact reasons for why condos have fared better with the higher mortgage rates, or if this would even hold true for the coming months - especially with additional increases of the overnight rate by the BOC.). However, it does say something about the differences in these two real estate asset classes that Condos did not have nearly the same reaction to increased mortgage rates that freehold properties did.
With this information in mind, can we conclude that the Toronto real estate market has been hurt by the increase in mortgage rates? Most certainly, although some asset classes got the shorter end of the stick than others. On the whole, the real estate market has been greatly impacted. For example, across all the Greater Toronto Area listings, days on market have increased by 64% and sales volume has plummeted a staggering 44% in the month September 2022 (year-over-year).
How the future will play out largely depends on the upcoming rate hikes this month (October 2022) and in December 2022. Forecasters are expecting an additional two rate hikes between .5 and .75%, and if that is the case, alternative investments and rent will become even more attractive, while buying power will decrease further. Leaving the sellers with a smaller pool of potential buyers, and thus, putting a downward pressure on listing prices. At the end of the day, this will heavily depend not only on Canada’s economic situation and the financial policy makers at the BOC, but also on the global economy.
Are you and investor or first-time homebuyer interested in learning more about the Toronto Real Estate Market? Message us via the live chat on Dwelly.ca and start the conversation and get connected with our in-house mortgage broker.