What evidence is there that rising interest rates causes Canadian condo prices to go down?

Question

I live in Toronto Canada where condos are extremely expensive. I'm willing to wait 2-3 years to build up down payment to buy a condo. I'm hoping within the 2-3 years, interest rates will go up by 1-2% so condo prices will come down (I'm hoping a 10-20% drop). Am I unreasonable to think condo prices will go down by that much? What's the correlation between mortgage interest rates and condo prices? Please reference sources.

Just a FYI, Canada's real estate is reportedly the most overvalued in the world, and big Canadian cities like Toronto and Vancouver are among the worst (source).

Answer 1

Yes, it's unreasonable to think the prices will drop 10-20% in that time frame.

Housing prices are not an equation that can can be solved to "home prices are X% overvalued." You have 3 answers so far, Quanty's "prices are inversely proportional to rates," Rob's "there's no strong correlation between interest rates and house prices," and MB's, "rising interest rates create downward pressure on housing prices."

Any research into price history had better take every other variable into account. Articles that look at rates vs price don't always address a key item, income. Say we agree that the data show your city to be 10% too high. But if sellers like their high price and have some 'dig my heels in' power, prices won't drop. The seller simply stays put, and the supply/demand curves result not in a lower price, but in less supply. And the effect is to change the demographic of that area, i.e. attracting higher income earners.

Rob linked to an article with a nice set of charts. One chart showing the US30 yr fixed rate and 'Real House Prices'. What results is a chart that can refute the relationship between rates and prices. But that would ignore an historical point that's too important to forget. The tumble that started in Jan '06 had nothing to do with the 30 year rate. It was the result of a series of insane financial products including 'interest only option ARMs' which permitted buyers to get approved for a purchase based on a payment that wasn't fixed, and would change to a fully amortizing mortgage at a higher rate that was unaffordable. A product that was a financial time bomb. Canada Banks offered no such product, and when the US market got pneumonia, Canada experienced a mild cold. With respect to any answers that offer US centric data to prove any hypothesis, I don't feel such comparisons are appropriate.

Correlations, and the data used to prove them are an interesting thing. I can suggest that you take the US 30 year rate, along with our median income, or rather 25% of monthly median income. Calculate the mortgage that results. This translates nicely to the home a median family can afford. And I claim that long term this is the equilibrium price of that median home. But supply/demand has another factor, 'stickyness' or the more technical term, 'inelasticity of demand.' This means that for example, a 10% increase in the price of cigarettes does not cause a 10% drop in consumption. Each and every good has its own elasticity, and in the case of housing, a rise in cost would certainly impact the marginal buyers, but others will simply adjust their budgets. Not all buyers were planning to hit the bank's limit on what they could afford, so the rise doesn't change their mind, just their budget.

Last - I know that Canada does not have a 30 year mortgage, most common is a 5 year rate with 30 year amortization. (correction/clarification, anyone?) The effect of this is less volatility in the market, since I believe your rates are not poised for the 2.5% to 4% jump implied by another response. Small increases can be absorbed.

In a beautiful coincidence, the Federal Reserve Board sent me a link to The Interest Rate Elasticity of Mortgage Demand: Evidence From Bunching at the Conforming Loan Limit. It's a bit long but a worthwhile look at how the correlation isn't as instant as some might think.

Answer 2

If money is more expensive (costs more to borrow) then fewer people will be able to qualify to make the payments for a particular size of mortgage. This reduces the number of potential buyers for property at that price. As sellers still want to sell, they will move their prices down to where more people can afford to buy.

So rising interest rates create downward pressure on housing prices.

But Toronto is the biggest city in Canada. I'd expect part of the high prices there is the location: lots of people want to be close to lots of activities, action, and opportunity. Unless something catastrophic happens, I don't see Toronto losing that advantage. If anything, it's going to get a tad warmer up there in the coming decades.

Answer 3

In the US market at least, there is long-term evidence that there's no strong correlation between interest rates and house prices.

A less detailed Canadian study found that house prices tended to increase when rates increase. One possible reason: interest rates can increase when the economy is doing well (needs less help), which is also the time when people feel more confident about buying.

The are many reasons why Toronto condo prices may come down (such as oversupply), or may increase (empty nesters downsizing). But, by itself, a small increase in interest rates appears, based on history, to be unlikely to lead to a substantial drop in prices over a short timescale.

Answer 4

In general, prices are inversely proportional to rates; however, accurate interest rate prediction would make one worthy of managing a large credit derivative hedge fund.

This is not to say that interest rates cannot go up in Canada since the world is currently undergoing a resource bust, and the United States has begun exporting more oil, even trying to recently open the market to Europe, both of which Canada is relatively dependent upon.

Also, to say that Canada currently has the most overpriced real estate is an oversight to say the least considering China currently has entire cities that are empty because prices are too high.

A ten to twenty percent drop in real estate prices would probably be a full blown financial crisis, and since mortgage rates are currently around 2.5%, a one to two hundred basis point rise could mean a nearly 50% decrease in real estate prices if interest payments are held constant. Canada would either have to start growing its economy at a much higher rate to encourage the central bank to raise rates to such a height, or oil would have to completely collapse suddenly to cause a speculatively possible collapse of CAD to encourage the same.

The easiest relationship to manipulate between prices and rates is the perpetuity:

p = i / r

where p is the price, i is the interest payment, and r is the interest rate. In this case, an increase of r from 2.5% to 4.5% would cause a 44.5% decrease in p if i is held constant. However, typical Canadian mortgages seem to mature in ten years at a fixed rate, so i cannot be held constant, and the relationship between r and p is less strong at earlier maturities, thus the most likely way for prices to collapse is for a financial collapse as described above.