Robert Hogue, Senior Economist, RBC
May 2010

Affordability erodes again in the first quarter of 2010
Canada’s housing markets started 2010 the same way they ended 2009; firing on all cylinders. While a boon to sellers, the resulting strong home price increases, however, have hurt housing affordability across the country. At the national level, RCD affordability measures rose for the third consecutive quarter, moving up between 0.4 and 0.9 percentage points, depending on the housing type (a rise in the measure represents a deterioration in affordability). A small decline in the average-mortgage rate that prevailed during the first quarter and further gains in household income provided minor offsetting effects. The cumulative rise in the measures since the middle of last year has reversed roughly one-quarter of the improvement in affordability that took place during most of 2008 and the first half of 2009. Overall in Canada, RBC measures are now moderately above their long-term average; yet they are still well below the most recent peaks reached in early 2008, suggesting that home ownership costs are starting to bite typical Canadian households but not dangerously so at this stage.

From a regional perspective, significant deterioration in affordability occurred once again in British Columbia (particularly for bungalows and two-storey homes), although the worsening trend was generalized across all provinces. Alberta was the sole exception, registering small improvements in the first quarter.

Looking ahead, further erosion in affordability is likely to take place in Canada in the coming 12 to 18 months. The main cause will be an anticipated rise in interest rates, which are currently exceptionally low – and clearly unsustainable – levels. As the Bank of Canada moves toward ‘re-normalizing’ its interest rate policy during the latter half of this year and in 2011, higher mortgage servicing costs will reverse much of their sharp decline last year in Canada. The five-year fixed mortgage rate (the benchmark used for the RBC affordability measures) has already initiated its upward march and climbed to its highest level since January 2009 in early May.

The resulting degree of housing un-affordability in Canada, however, is unlikely to exceed recent peak levels. First, we believe that the spectacular rally in housing prices in the past year will soon run its course. There is increasing evidence that supply (in both the existing and new home markets) is finally responding more forcefully to very strong demand and that local markets across the country are headed toward more balanced conditions – after having been very (and, in some cases, extremely) tight for the better part of the past year.

At the same time, that red-hot demand for housing is likely to cool during the second half of this year, as factors that fuelled it dissipate. The fulfillment of pent-up demand created during the recent market downturn, which brought in a wave of buyers has probably already ceased to be a driver. More recently, continued demand strength has been sustained by factors that either will start reversing or are transitory in nature.

As noted above, rock-bottom interest mortgage rates –undoubtedly the rally’s most powerful driver – are set to rise in the next year and a half. Consequently, their positive effect will progressively fade. At the margin, widespread expectations of higher rates might well have caused some buyers to hurry their home-purchasing (to lock-in low rates), thereby bringing forward some demand that would have occurred at a later point. Also, at the margin, the July 1 introduction of the HST in Ontario and British Columbia likely prompted some buyers to ‘beat’ the tax, shifting forward activity that would have taken place after July 1st in those provinces. The combination of increased supply and flat or easing demand is expected to stabilize housing prices in Canada – with outright declines possible in some markets.

Another factor contributing to keep un-affordability levels below previous peaks in the period ahead will be the effect of a recovering economy on household income. Sustained economic growth in Canada during the remainder of 2010 and 2011 is expected to support steady job creation and income gains. This should partially mitigate the effect of rising mortgage servicing costs on family budgets.