Real estate boosted the economy, now it could drag it down

The housing downturn that’s taking root across Canada will act as a headwind to economic growth this year, following a period in which real estate powered the economic recovery from COVID-19, but was also characterized by fervent speculation and worsening affordability amid ultralow interest rates.

Nationwide home sales fell 12.6 per cent in April from March, with even steeper pullbacks seen in the frothy markets of Toronto and Vancouver. The national home price index, which adjusts for volatility, fell just 0.6 per cent last month, although price drops were larger in some parts of Southern Ontario.

Rising interest rates have put a quick chill on a feverish rally. Given that more rate hikes are on the way, many economists say Canada could be in the early stages of a protracted housing slump, albeit one welcomed by would-be buyers who got priced out.

For an economy that increasingly relies on housing, the downturn will likely weigh on economic growth in the near future – not only through direct channels, such as reduced real estate commissions, but in indirect ways, such as weaker spending from households that gorged on mortgages and now face higher debt-servicing costs.

“Unfortunately for Canada, we’re in a pretty perilous situation now where our housing activity measures are extremely stretched. … The pandemic basically put what was already stretched on steroids,” said David Doyle, head of economics at Macquarie Group.

As home sales drop and interest rates head higher, “that does create significant downside risks for Canada’s economy,” he added.

Already the largest industry in Canada, real estate became an even bigger chunk of the economy during the pandemic, largely because of record-low mortgage rates that encouraged rabid buying.

Residential investment, as a share of nominal gross domestic product, soared to about 10 per cent at peak times over the past two years, amounting to more than $240-billion in 2021. That’s up from about 7 per cent of GDP before the pandemic – or double the equivalent rate in the United States. For housing bears, it’s a sign that Canadians have become far too infatuated with real estate, and that the country’s economic fortunes are too tied up with those of the sector.

Total residential investment is comprised of three items: new construction, renovations and ownership transfer costs, which include fees to realtors, land transfer taxes and other transaction costs.

This final aspect of investment is most directly exposed to a slump. Mr. Doyle said the April sales drop, if followed by flatter activity in May and June, could curb GDP growth in the second quarter by as much as 1.5 percentage points, on an annualized basis. If sales continue to drop, the drag would be larger.

And that’s before accounting for the potential knock-on effects of weaker home-buying activity, such as fewer renovations and purchases of household appliances.

In its latest forecast, the Bank of Canada estimated the economy would grow by 6 per cent in the second quarter on an annualized basis. “That feels like a stretch to me,” Mr. Doyle said.

Home construction is an aspect of GDP that could hold up well. The federal government wants to double the pace of home building over the next decade, and other levels of government say they also want to add supply. However, Bank of Montreal senior economist Robert Kavcic doubts construction can get much bigger. He pointed to already strong housing starts and a shortage of available workers.

“Physically, there’s no way we can actually double the rate of home construction from what is already the maximum amount of home construction that we can do in this country,” he said.

That said, Mr. Kavcic doesn’t see residential investment, as a percentage of the economy, heading back to the tepid levels of the 1990s. The fundamentals for housing demand are still strong, he said, in part because Canada is targeting a record intake of permanent residents in the coming years.

“I think the issue here is that through 2021, monetary policy was just too easy for too long,” he said. “So, the asset price just ran ahead of what was fundamentally justified.”

The Bank of Canada has raised its policy rate twice this year, taking it to 1 per cent from a pandemic low of 0.25 per cent. Bank officials have said they intend to raise the benchmark rate into a “neutral” range – which neither stimulates the economy nor inhibits it – of 2 per cent to 3 per cent in fairly short order.

The central bank has warned the Canadian economy is likely more sensitive to rising borrowing costs than it used to be. After taking on loads of new mortgage debt over the past two years, the average household now owes arecord $1.86 for every dollar of disposable income. During the pandemic, investors have pl owed into the housing market, and a growing share of borrowers have steep loan-to-income ratios.

Ultimately, the concern is that debt-addled households will be forced to tighten their belts and drastically reduce their spending.

“Rising interest rates are designed to slow the economy by making borrowing more expensive. That tends to slow sectors like housing,” Toni Gravelle, a deputy governor at the Bank of Canada, said in a speech last week.

“But this slowing might be amplified this time around because highly indebted households will face high debt-servicing costs and will likely reduce household spending more than they would have otherwise. Our base-case scenario includes a slowdown in housing activity. But we could see a larger-than-expected slowdown due to higher indebtedness and unsustainably high housing prices.”

How those financially stretched households react to higher interest rates could force the Bank of Canada to “pause” its rate-hike cycle, Mr. Gravelle noted.