On December 7^th, the Bank of Canada delivered the latest in a series of interest rate hikes. The overnight rate increased by 50 basis points, up to 4.25%.

What does this mean for the real estate market in Canada, and are we heading into an economic recession? A few specific market indicators can help you get a better picture about what to expect.

New Construction Developments

Looking at new construction starts can give you a good idea about the health of the real estate market. A reduction in new construction starts is an indicator of a coming recession.

While new constructions starts are still holding steady at the moment, this is expected to change in early 2023. The driving forces behind that change are lowering residential housing prices and the increased cost of financing for homebuyers.

Residential Housing Prices Dropping

Although house prices have been red hot and growing in Canada for years, the trend is slowing down and is now expected to begin reversing across the country. Some experts go as far as predicting a nearly 8% slump in residential home prices in early 2023. Tamer predictions assume a house price of around 1% by the end of 2023.

As house prices fall, new constructions will naturally slow down as developers shy away from potential future losses from continued price reductions.

Falling prices also impact pre-purchases of condominiums. In larger metro areas, some condominiums are purchased as far as 3+ years in advance by investors who hope to resell the property for a profit. This has been a good way for developers to secure buyers before projects are finished, encouraging continued construction. Without the steady increase in housing prices, buyers are unlikely to entire into these types of pre-purchase contracts, which will end up increasing the risk that developers have to take on in construction.

Buyer Difficulty Securing Financing

Every interest rate increase leads to a mortgage rate increase, and this latest rate hike was no different. Homebuyers are now looking at higher mortgage rates to purchase a home, with many larger banks increasing mortgage rates by 0.50%, from 5.95% to 6.45%.

Mortgage rate increases inevitably price some buyers out of the market. The silver lining is that this is likely to be the final rate hike. If inflation slows as expected, home prices may reduce enough to make it easier for homebuyers to enter the market despite higher mortgage rates.

Rising Capital Costs

Interest rate rises also bring about an increased cost of capital for developers and investors. As mortgage rates rise, debt funding becomes more expensive, cutting into the potential profits for some new investments. This makes investing riskier, especially as price levels are expected to take a turn downwards in the coming year.

When investors are more hesitant to enter the market, there’s a rippling effect on jobs, market supply, and available capital.

Limitations in Supply Chains

Reduced construction and increased cost of capital both end up putting pressure on the supply of residential houses available in Canada. This makes the market shaky and unstable, leading to a feedback loop where more and more investors, developers, and homebuyers refuse to enter the market until prices reduce enough or capital becomes more available again.

Tightening Lending Requirements

As the economy slowly constricts during a recession, banks switch into a more protective state and tighten their lending requirements. This helps the banks hedge their bets and cut losses, but it makes it more difficult for others to enter the market at all, either as a homebuyer or an investor.

Recession is a natural consequence of inflation. After a long period of high inflation, there’s always a recession to bring the economy back into a more stable and sustainable level of growth.

While recession is likely in 2023, it’s a planned consequence to counteract worsening inflation rates from 2022. The Canadian housing market may see a short-term drop, but investors, developers, and homebuyers will be looking to rejoin the market again as conditions become favorable again down the road.