Will a rapid rise in interest rates finally cool down our housing market? We’ll soon find out.

Low rates stoked demand for years, opening the home-ownership door to many Canadians and greasing the wheels for move-up buyers and investors. But with inflation at a three-decade high, the Bank of Canada is now altering its course—signalling it will hike interest rates significantly in the year ahead. We think this will be a game-changer for the market.

Housing measures recently unveiled in the federal budget and by provincial governments in Ontario and Nova Scotia will provide more reasons for market participants take a step back. We now expect home resale activity to slow more quickly than previously anticipated and, perhaps more important, we see prices peaking this spring as market sentiment sours from extreme bullishness. In this altered landscape, local markets could experience a mild price correction, partly reversing outsized gains recorded in the past year.

Higher rates are real

The Bank of Canada began normalizing its monetary policy in March, making higher rates a reality, rather than a vague promise for a future time. And The Bank’s 50-basis point hike to 1.0% announced on April 13, signalled it’s keen to proceed forcefully to raise its policy rate to a neutral level by year-end. We believe this will add up to a further 100 basis points in just over six months to 2.0%, or slightly above pre-pandemic levels (1.75%). Canadians haven’t seen this large an increase in such a short period since the tightening cycle of 2005-2006.

Nowhere to escape

Fixed mortgage rates have gone up materially since the fall when financial markets began to anticipate the Bank’s new stance. The impact on mortgage borrowing has been muted so far because borrowers have instead gravitated toward variable-rate mortgages, for which rates remained exceptionally low. But the Bank of Canada’s hiking campaign will soon make variable rates more expensive too, leaving borrowers with no escape.

Shrinking purchasing budgets

The rate increase is now pushing up the mortgage stress test’s qualifying rate, removing stretched-out buyers from the market. But even those who still qualify for a mortgage will see higher rates reduce the size of the mortgage they can get—and the price they can pay. For households earning the median income, for example, the rise in fixed mortgage rates will shrink the maximum purchase budget by roughly 15%. That will more than reverse the increase in 2020 and early-2021 when declining rates provided substantial added budget room.

Major affordability squeeze

Looking at the situation through the affordability lens, higher rates will pose huge challenges for buyers. Having already fallen to a 31-year low point, RBC’s aggregate affordability measure for Canada is at risk of reaching worst-ever levels in the year ahead (see our latest Housing Trends and Affordability report). In fact, our simulation shows we could reach that grim point as soon as the third quarter.

And we don’t expect the 2022 federal budget to prevent this. New federal initiatives either won’t fully bring benefits for some time (for example, the first home savings account or the housing accelerator fund) or will offer only marginal support for homebuyers (for example, doubling the first-time homebuyer’s tax credit amount). We expect poor and worsening affordability to increasingly weigh on homebuyer demand across the country.

Revising our forecasts lower

Expectations for a more aggressive rate path from the Bank of Canada have prompted us to revise our housing forecasts lower. We now project home resales to fall 13% to 578,000 units this year and drop another 14% next year to 500,000 units Canada-wide (down from 580,000 units and 548,000 units, respectively, in our previous forecast). This implies a significant slowdown over the spring to fall period before sales stabilize in 2023 on a quarterly basis. We think this cooling will help the market return to balance.

Prices will likely peak this spring

We also project prices to soften as rising rates, deteriorating affordability and cooling activity dampen market sentiment. Extreme bullishness strongly contributed to the spectacular run-up in prices over the past year. A change of heart could quickly push property values in the opposite direction. We think prices will generally peak this spring before weakening modestly through the remainder of this year. However, stronger-than-expected gains so far this year will result in a higher annual average price for 2022 than we previously anticipated. We now forecast the aggregate benchmark for Canada to rise 8.1% (from 6.2% previously). The weakness will show up in the 2023 annual average, that we project will decline by 2.2% (it was forecasted to rise 0.8% previously). We think the national benchmark price could drop close to 5% on a quarterly basis from peak to trough.

Outlook varies across the country

Every buyer across the country will feel the pinch of rising rates. But those in the most expensive markets that will feel it most. We expect downward price pressure to be more intense in Vancouver, Toronto and other pricey markets. This will translate into larger annual price declines in 2023 in British Columbia and Ontario. By comparison, we expect activity and prices to be more resilient in Alberta, where local markets have more catching up to do following a prolonged slump before the pandemic.

Positive demographic factors provide a safety net

While it can’t be completely ruled out, we view the odds of a market crash as low. Solid demographic fundamentals will continue to support Canada’s housing market. Millennials—in their prime home-buying years—will remain a force, and growing immigration will further boost demand for housing. These factors will keep demand from falling into a deep-freeze.

Oversupply risk is low

On the supply side, the starting point is almost universally tight with inventories at historically low levels. There are essentially no signs of imminent oversupply or overbuilding anywhere in the country. We expect strong housing construction and cooling demand to rebalance the market over time, not send it into a tailspin.

It’s not all bad

Rather than pose a major threat, we think rising interest rates are likely to bring welcome changes to the market—including more sustainable activity, fewer price wars, more balanced conditions, and modest price relief for buyers. After the extreme price increases and heated bidding wars of the last year, this would be a positive shift.

Read the full Housing Trends and Affordability report for extensive market-by-market analysis.

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Robert Hogue is responsible for providing analysis and forecasts on the Canadian housing market and provincial economies. Robert holds a Master’s degree in economics from Queen’s University and a Bachelor’s degree from Université de Montréal. He joined RBC in 2008.

This article is intended as general information only and is not to be relied upon as constituting legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. Information presented is believed to be factual and up-to-date but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by Royal Bank of Canada or any of its affiliates.