Buyer Beware – Mortgage Rates Set To Rise!
In my previous post, I had a poll that asked what the biggest perceived supply risk to the real estate industry in Calgary over the next three year horizon. This was a randomized poll, meaning that the order changed each time.
Well, the results are in and an overwhelming majority selected interest rates rising as the biggest supply risk!
Why is this a risk? Well interest rates can pull demand forward or push demand backward, but perhaps the biggest impact it will have is on affordability and investor appetite. What does this mean? Well if one has a mortgage, and in 5 years the rate is higher and is beyond what you can spend on shelter that means you will be forced into bankrutpcy. If you are a real estate investor, and your investment depends on leverage, then you may be forced into selling as well if your rent does not cover your increased mortgage costs. This would cause an increase in new listings, and decrease in sales simultaneously shifting the supply/demand curve for housing. If this point of equilibrium shifts too much, then it could tip the real estate market back into falling prices.
That being said, it’s not clear that this is a reason for a sharp bust either. Why? Well, modest increases in wages of 2% annually over 5 years, and that the loan amount will be reduced due to the principal that is repaid, and that mortgage rates will likely increase only 3%, equals that the majority of home owners who do so today with an understanding of the risks involved and borrow with prudence will likely not end up in arrears.
Buyers who do not understand that mortgage rates are likely to rise risk defaulting when their mortgage is up for renewal.
The following graph shows a forecast for the 5 year conventional mortgage rates over the next 5 years. The estimated mortgage rate is derived from the historical risk spread relationship over 5 year Government of Canada bond yields.
Note that this forecast is based on BMO’s August 5, 2009 rate forecast.
For more information about the historical relationship between 5 year mortgage rates and 5 year GoC bond yields, one can view this graph, courtesy of Kevin on the Edmonton Housing Bust Blog.
Inventory Zenith
As discussed in a previous post, leading indicators at that time had pointed to the balance of inventory tipping towards excess demand in the near term. That has now happened, and year over year inventory is down 7% in Calgary.
The following graph illustrates a potential medium term price point. It is based on two points wherein inventory was dropping on a year over year basis. Prices dramatically above these points may lead to excess supply, and prices below have tended to lead to excess demand.
[click above for larger view]
Also noteworthy is:
- Wave of speculators in 2006 & 2007 resale market now appears to be over and unlikely to be a source of supply for some time.
- Calgary single family home construction was the lowest since 1995 in 2008 and the low level of housing starts is expected to continue into 2009. This is lower than demographic growth and therefore resale inventory appears poised to continue siphoning off from it’s current high levels.
- Drop in interest rates is likely having an impact on inventory. As interest rates drop, the yield spread between rent and mortgage rates improves thus increasing affordability and relative investment value. Some investors and homeowners may choose to delist if they believe their is more value in renting, or that the resale market is likely selling at a bigger discount to the new home construction market. New construction inventory may not be able to be supplied at the current price point. Note: Buyers need to run various budget scenarios to determine the risk of rising interest rates.
- Mortgage arrears in Alberta, while expected to rise, are at cyclical averages. Mike Fotiou, at First Place Realty, lists approximately 2.3% of inventory on the market as a foreclosure or judicial sale. This contrasts to the situation in the United States where 45% of sales are distressed properties. Canadian banks had argued that only 5.4% of Canadian mortgage market originations were nonconforming, compared to 33% of the market in the US was subprime and Alt-A. To date, the reduced exposure to shady loan origination practices in Canada appears to have largely insulated our housing market from the same level of credit defaults. As in the US, the extent of credit defaults will not be fully understood until house prices find a bottom. As year over year inventory is already dropping, this does not seem to be a large source of supply.
- Absorption rate is a source of imperfect information that may results in real estate mispricing. For instance, the absorption rate was 3.1 at the peak of the market in July 2007 and could have been perceived as a ‘good time to buy’ or ‘balanced market.’ However, year over year inventory increases were greater than 100% at the time and should have been an extremely strong indication that the market was about to correct. I think that absorption rate provides a good estimation of how the market will behave in the near term. However, a comparison of year over year inventory changes may provide a better estimate of how the market will behave in the medium term.
Sources: Bob Truman – First Place Realty, Mike Fotiou -First Place Realty, CREB, CIBC, Bloomberg
Credit Junky Nightmare – Credit Cycles Effect on Housing Market (Part 3 of 3)
The cyclical average for mortgage arrears in Alberta has been about 0.4%. As affordability in Alberta is the poorest since the previous real estate peak in 1990, one would expect mortgage arrears to increase to closer to the cyclical average (or more). The current low rate of mortgage arrears is reflective of the fact that as house prices rapidly increase, people have more options available such as selling or refinancing.
As time passes, and more people have purchased properties that they can marginally afford and/or poorer economic conditions develops, the amount of mortgages arrears will increase. Credit risk typically appears after house prices have stagnated or begun to fall.
The following graph shows that Alberta mortgage arrears have only recently begun to increase:
I would highly recommend to compare this graph with Mohican’s at Langley Financial Planning and Personal Sanity who originally posted a similar mortgage arrears analysis for British Columbia.
As for timing real estate transactions, it is good investment advice to be, “fearful when others are greedy, and be greedy when others are fearful.” Look to mortgage arrears for help in timing peaks and troughs, as high amounts of mortgage arrears can indicate a good time to buy, whereas low amounts of mortgage arrears can indicate a good time to sell.
More specifically, trend direction changes in mortgage arrears from cyclical highs or lows can indicate an inflection point in the real estate cycle.
Credit Junky Nightmare – Credit Cycles Effect on Housing Market (Part 2 of 3)
Changing credit conditions impacts the demand for real estate. If credit lending practices are loosened, it allows new participants to purchase real estate. The increased demand for real estate creates upward price pressure until the demand can be satiated.
Likewise, if credit lending practices are tightened, less participants can purchase real estate which reduces demand for real estate.
So how have credit conditions in Canada changed over the past couple years?
The following is a timeline of roll-outs of new CMHC products which demonstrates the rapid loosening of credit that occurred in 2006 through mid 2007:
- February 2006: CMHC to insure 30 year mortgages on a pilot basis
- June 2006: CMHC introduces 35 year mortgage and interest-only mortgage insurance
- December 2006: CMHC introduces insurance for 40 year mortgages
- September 2007: CMHC offers insurance for 100% financed investment properties
Recently, due to the turmoil in credit markets, the amount of subprime mortgages funded in Canada has dropped substantially. As an example, Xceed’s (Canadian subprime lender) funded mortgages have plummeted from $340.0 million to $65.7 million. This one lender has resulted in a quarter billion less financing for real estate in Canada over the same reporting period last year. Tightened lending standards helps explain why YoY sales volumes are down considerably.
In summary, credit conditions affect the demand for real estate, so it is prudent to pay attention to how it impacts the supply/demand balance.
Credit Junky Nightmare – Credit Cycles Effect on Housing Market (Part 1 of 3)
When house prices are increasing, if a homeowner’s mortgage is delinquent they have the option to sell and preserve their credit rating. However, in a falling real estate market, the homeowner will often end up foreclosing due to lack of an option. Therefore credit risk typically only appears when house prices are falling.
Credit has become easier in Canada over the past few years and that has affected the supply/demand balance. The following three posts will cover some aspects of how the credit markets are changing and how risk to the mortgage markets only appears after house prices have started falling.
This rudimentary diagram shows how the credit cycle has positive feedback during the upward cycle:
And this diagram helps describe how the credit cycle unwinds:
