October 19th, 2004

Rising rates starting to hit real estate
But housing market remains strong by historical standards

By Peter Diekmeyer o Bankrate.com

Higher interest rates are starting to affect the real estate market. Both housing starts and the resale sector showed weakness in September in the wake of the Bank of Canada's 0.25% rate increase. And yesterday's hike, which saw the central bank's key rate rise to 2.50%, will likely tighten the screws even further.

Higher interest rates increase the cost of home ownership by raising the monthly payments or the amortization period for variable rate mortgage holders. Although the Bank of Canada's key rates don't affect mortgage rates directly, their effects tend to eventually filter down, in part due to the signals that hikes send to the bond market, which influences mortgage rates.

The Bank of Canada had been signaling that rate hikes were coming long before it ended its 14-month period of looser money. But once the hikes came, it did not take long for real estate to feel the pinch.

Housing starts and resale market both hit

According to the Canada Mortgage & Housing Corporation, Canadian housing starts fell 4.2% in September, to an annual pace of 231,000 units, compared to a 241,500-unit rate recorded in August. Much of the drop was due to a 14 percent decrease in urban construction of multiple family dwellings, of which 98,000 units were started last month.

The resale market also began feeling the effects of higher interest rates. According to the Canadian Real Estate Association seasonally adjusted home sales via the Multiple Listing Service (MLS) in Canada's major markets fell slightly to 26,312 units in September, compared to 26,370 the previous month. Sales in the third quarter fell to 79,713, a 3.8% drop from the second quarter.

But the news isn't all bad. In fact, on a historical basis both housing starts and the resale market are doing quite well. MLS sales for the first nine months of the year (239,664 units), were up 4.2% compared to the same period last year, and house prices remain firm. The average MLS sale price rose by 7.3% (year-over-year) in September to $245,120 and by 6.6% (year-over-year) in the third quarter.

Even the housing starts data contain some bright spots when you look more closely. Despite their weakness in September, during the first eight months of the year, starts averaged 229,400 units per month, the strongest pace of home building since 1987.

Real estate equity: a key driver of Canadian household wealth

The continued strength of the housing market is good news for the economy because according to a report by Scotiabank Group, rising ownership rates and home prices remain a key driver of Canadian household wealth gains during the past three years.

"Since mid-2001, the value of household real estate assets has increased a stellar 27% nationally, roughly double the rise in household financial assets," wrote Adrienne Warren, a strategist with the bank's research group.

Warren estimates that average Canadian net household wealth has jumped 17% to $136,500 during the past three years, with real estate equity accounting for 34% of the total, compared to just 29% four years earlier. Much of the change has been due to the stock market implosion earlier in the decade, which has seen Canadians move a greater portion of their wealth from financial into non-financial assets.

Warren cites several additional factors that have favored real estate investment in recent years. These include low returns in equity markets since the beginning of the decade, low returns on interest bearing assets and appreciating home values, which have been helped along by renovations, quality improvements and square foot expansions.

More rate hikes likely on the way

But how long the real estate party will continue depends in larrge part on the interest rate picture, and signs are that money is likely to tighten up in coming months.

The Bank of Canada's interest rate hikes have been fairly slow and predictable so far, and in the statement announcing its most recent hike, the bank left a broad hint about its intentions.

"The Canadian economy is operating near its production capacity," said the statement. "Against this background (f)urther reduction of monetary stimulus will be required over time to keep inflation on target."

The pace of any eventual rate hikes will depend on the Bank's continuing assessment of the prospects for factors that affect pressures on capacity and hence, inflation, the bank said. The statements leave little doubt that if events unfold as expected, more interest rate hikes are coming. The only question is when.

The Bank of Canada's next interest rate decision will be announced on December 7th.


Previous Bank of Canada action:

Date Action Overnight rate (after announcement)

October 19, 2004 +1/4% 2 1/2%
September 8, 2004 +1/4% 2. 1/4%
July 20, 2004 No change 2%
June 8, 2004 No change 2%
April 13, 2004 -1/4% 2%

Upcoming Bank of Canada rate announcements:

December 7th, 2004



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