Welcome to this month’s installment of Dear Urbaneer where we engage with our readers by tackling some of their more challenging real estate questions. House hunting in Toronto is tough already due to high demand, high prices and low stock; when you add climbing interest rates to the mix, increasing expense and reducing options, it can get even more daunting, which is what is troubling one of our clients.
With the high price of real estate in Toronto, along with the high cost of living, I’m a little concerned about taking on a significant mortgage, especially if interest rates are going up. I have homeowner friends that have had to take out additional debt just to cover monthly expenses and they are really feeling the pinch of rising interest rates. I’d always just considered taking on as much mortgage debt as I could as a means to an end in order to buy a home in Toronto, but now I am nervous. I really value the dream of homeownership, but is it wise to buy a home while interest rates go up?
Here's my reply:
Dear Homeownership Dreams:
After years of ultra-low interest rates, it can be hard to wrap your head around how much more it may cost to borrow money. The function of the low-interest rate environment was to encourage consumers to spend and to give a boost to a sluggish economy. We have almost a whole generation of homebuyers who have framed their entire borrowing experience around unusually low-interest rates. It’s been "Buy now, pay later", but that dynamic is changing.
"I'm Debt Serious..."
According to this article from MacLean’s “This Is How The Housing Correction Begins”, Canadian household debt has risen by 80 per cent since 2008, just at the cusp of the sub-prime crisis and global recession. In Toronto alone, the debt-to-income ratio stands at 208 per cent.
Higher interest rates - even 1.25% higher than they were 18 months ago - are taking a bigger bite out of household income, especially in Toronto, where household debt levels are extremely high. I talked about this and the other impact of interest rates on the Toronto housing market in detail in Part Two of my recent real estate forecast.
Specifically in relation to real estate debt, in a hot market, where bidding wars had been the norm, Buyers used cheap debt in order to have the ability to pay any price. Budgets were set on what they qualified for because paying top dollar was pretty much required in order to secure a home, as opposed to what you might reasonably be able to handle with wiggle room to account for market changes.
There has been both psychological and material impact as many homeowners scrape the top of their debt ceiling. Those that are preparing to enter homeownership have the unique vantage point for the market. Does it make sense to jump in now?
Rates have slowly crept up over the last 18 months. While some analysts are predicting that the speed and amount of rate increases may slow in the short term from what was originally predicted, given the current economic volatility, and many banks have actually dropped their mortgage rates recently, it is expected that there will be more increases to the benchmark rate at some point in 2019/2020. The cost of debt will creep up in tandem.
Click here to read: “Your Debt In 2019: Trends That Will Affect Your Finances And How To Prepare For Them” “46% Of Canadians $200 Or Less Away From Financial Insolvency: Poll” and “Poloz Says Future Bank of Canada Rate Moves Are Data Dependent”.
For homebuyers intent on pursuing that dream of home ownership, there exist opportunities, but Buyers need to be especially savvy now.
What Happens To Housing Prices When Interest Rates Rise?
There is a direct relationship between housing prices and interest rates. Because as interest rates go up, Buyers must offset those higher carrying costs by buying a less expensive dwelling. Whereas housing prices in Toronto were escalating consistently for years, the market did effectively stabilize over the last year and a half or so, due to the introduction of a number of measures including the Fair Housing Plan, stricter mortgage qualification criteria and five 0.25% mortgage rate increases.
However, in much of the original City of Toronto, although the interventions and mortgage rate increases are reducing the number of Buyers it hasn't resulted in bringing balance between the supply of property for sale. And because real estate, like any other commodity, is worth what people are willing to buy at any given point in time based on supply and demand, the lack of product - in particular in price points under $1.4mil - means bidding wars remain common. Now that access to the money is more limited, demand should decrease because the ability to buy is decreased; that said, I'm still not seeing that happen where I sell real estate - which is in 42 neighbourhoods spanning from The Beaches west to The Kingsway, and from Lake Ontario up to Yonge/Sheppard in an inverted T that encompasses the original City of Toronto.
When/if demand slows to align with the supply side of real estate, housing prices could fall. In price points over $1.5mil and up, values are stable, in some instances dropping, but most properties are not escalating in value. This is the market to monitor, as real estate values will adjust from the top down. Buyers, in particular the middle class who need shelter, are buying less property and/or adjusting their shelter wish list to accommodate the new costs of carrying debt. This means the higher price points are seeing fewer Buyers, which invites negotiating the list price, while the higher interest rates are channeling more buyers into lower price points. This primes the market for bidding wars. Over the next 6 to 12 months, we'll get a more accurate picture, as supply could increase as more homeowner’s mortgages come up for renewal. Re-financing at today's higher rates may not be affordable for many homeowners who purchased over the past 2 to 5 years, possibly pushing some more stock into the market, which could help to ease prices as well.
As we know in the City of Toronto, a pullback in the market does not result in instantly affordable housing prices. The average price of homeownership vastly outpaces income (just look at Toronto’s debt-to-income ratio) which is the true measure of affordability. Although home prices have cooled slightly in the wake of interest rate hikes, the amount of money that you can theoretically borrow within your household has reduced as well, making homebuyers feel like they’ve still got hurdles to cross. Admittedly, this can seem unfair to beleaguered Buyers whose stamina in the market has been tested over the years. Although on the surface it may seem unjust, maintaining that gap between what you own and what you owe is essential to your financial health.
On a bigger scale, it is important to the overall health of the economy locally - and because real estate plays such a large part of the national economy- nationally as well. High debt = high vulnerability.
House Hunting Strategy
Certainly, with the shift in the direction of the housing market, which may be perceived as dramatic, only since the market in Toronto has only known a single direction (wayyy up) for so long, house hunters are perhaps more keenly aware of how their strategy might need to shift alongside the market. However, truth be told, all house hunting should require a strategy that is tailored to the market, in order to get the home that you want as well as create wealth through real estate investment.
In short, rising rates should certainly factor into your decision, but don’t let the rising rates be the single focal point in your house hunt. There are other components to build into your house hunting strategy.
In addition to setting the rates for Canadians, the Bank of Canada has house hunting advice: “buy a smaller and less expensive house, as is evidenced in this article, “Canadians Should ‘Buy Smaller’ Homes In Response To Interest Hike, Bank Of Canada Head Says”. No question, that is one strategy, but that may not be the most viable patchwork solution in Toronto, given that homes are still unaffordable for many.
Here are some other tips for your hunt:
• You Need To Set Your Budget As Your First Step
Make sure to leave substantial wiggle room to accommodate for future increases in interest rates. While the value of your property will likely rise over time, depending on a number of factors, interest rates may rise as well, eroding the return on your investment as well as drawing back on your disposable income in your home (which can impact your wealth by forcing you to carry extra debt).
Once you’ve established your budget, then you move to pick property type and neighbourhood. What we’ve seen already in the wake of the mortgage changes and interest rate hikes is that people are shifting their searches geographically to less expensive neighbourhoods, which I touched on in my recent real estate
• Consider Your Timeline
As I have talked about before, there are a number of costs involved with buying a home (click here to read Dear Urbaneer: What Are The Closing Costs For A Property Purchase?). Obviously, carrying costs of a mortgage will increase while you are carrying a mortgage. If you are planning on moving around in the short term (i.e. less than 5-7 years) you will want to factor that into your budget and your house hunting strategy. In most cases, you need to stay put for that time period just to break even on your home purchase, and with rates being higher and the rate of price appreciation slowing, this is even more critical. Here's my post How Long Does it Take to “Break Even” After I Buy Property?
• What Expenses Will You Have In The Near Future?
Think ahead to any potential expenses that may be waiting for you in your likely tenure as a homeowner. Are you planning a family? Factor in the cost of childcare and the potential disruption or reduction of salary during a leave. Will you have children entering college or university? Those are expensive years if you are assisting with their education. Do you plan on another major spending, like autos, electronics or travel, which may require financing? This will all detract from your household income over the coming years, so factor these costs into your budget. Also, be cognizant that whatever property you purchase, it will require maintenance and repairs or, if it's a condominium, you could see an increase in your common fees or a special assessment. Here's my blog Dear Urbaneer: We’ve Moved Into Our New Home. Now What? that outlines a program to prepare for on-going housing expenses, chosen or otherwise, and for condo buyers here are Five Points to Ponder Before Buying a Condominium.
• Secure Your Financing
Most people begin their house hunt with a visit to their lender in order to secure their rate and get a ballpark idea of what their budget might be. Given the current interest rate environment, it is crucial to lock down your rate guarantee for as long as you can in order to stay true to your budget. This also lets you act more swiftly when you do locate a home that fits the bill.
• Grow The Gap
The other way to accommodate rising rates into your house hunting strategy is to build up wiggle room elsewhere in your budget to accommodate for the rising costs of borrowing. That means paying down existing debt and/or growing your savings. The bigger your wiggle room in your household budget, the less sensitive you are to interest rates and other market influences. It also helps you to build equity more quickly.
It's not a bad idea to consider purchasing a property with an income supplement (or can easily be converted into having a potential source of revenue ), which could be helpful if you encounter financial hardship and/or your budget gets too tight. You can generate some temporary income that could stop a forced sale. Not everyone is cut out to be a landlord, however, and there are risks and/or expenses. Here are my posts exploring this in Can I Have An Income Suite In My Residence? and How To Strategically Purchase An Income Producing Property.
So... Should I buy?
The true answer to this question lies in your own personal levels of affordability and what sort of sacrifices you are willing to make it. Regardless of the interest rate environment, there are certain fundamentals that you should engage in with your property search to make it successful and profitable in the long run.
First, set a prudent budget. Second, subscribe to the “location, location, location” mantra of real estate. Buying a property close to amenities like public transport, good schools, green space, shopping, and other lifestyle amenities is a tried and true way to maintain and increase your home’s value. Freehold property in the original City of Toronto will most likely continue to increase in value, simply because of a lack of stock and a scarcity of land. When seeking a condominium look for features that would make it most unique and therefore more likely to garner top dollar: thoughtful space plan, high-end finishes, parking, and quality outdoor space. Check out How To Search For Your Next Property Purchase. And always subscribe to the "Buy and Hold mantra of real estate. Remember, the only people who lose money in real estate are those who 'have to sell, or choose to lose." If your purchase includes a strategy or contingency that can help weather any unexpected hardship, in the long term the forced savings account that paying down a mortgage represents will secure your financial future.
For more on how to manage in a high-interest rate environment, read my post: How To Adapt To Canada’s Rising Interest Rates.
Buying a home is about having shelter, but it is also about navigating market conditions to create wealth and happiness for you today and tomorrow. We are here to help!
Steven Fudge, Sales Representative
& The Innovative Urbaneer Team
Bosley Real Estate Ltd., Brokerage - (416) 322-8000
- we're here to earn your trust, then your business -
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