Canadian Real Estate’s Worst Case Is A 30% Price Drop, Still Down By 2027: RBC

Canada’s largest bank is bullish on the economy but not on home prices. RBC regulatory filings reveal they see home prices making a modest decline by next year. That’s if the economy encounters no unexpected hiccups. However, the bank warns they’ve placed more weight to the downside as the outlook darkens. In the downside scenario, home prices contract as much as 30% — rolling back almost all gains since 2020. Almost.

Macroeconomic Risk Scenarios

Financial organizations must produce forecasts to help plan how much preparation is needed. They’re broken down into 3 scenarios: a base case, which is what would happen if things hum along without a hitch. Then there are at least two alternative scenarios, including a downside and upside. Forecasts are a snapshot of the economy at that time, not responsive to changes. These are used to communicate management expectations if the economy deviates off course.

Macroeconomic forecasts like these play a big role, especially in terms of profit. Too bearish? Companies risk underexposure and underperform their peers. Too bullish? Lenders could be too exposed to risk, which can mean suffering big losses. To put it bluntly, these organizations put their money where their mouth is.

RBC’s Outlook For Canadian Real Estate Is Slanted To The Downside

Canada’s largest bank expects prices to fall in their base case scenario, but bounce back. A CREA benchmark composite home would show an annual drop of 3.6% by April 2023. Home prices are then forecast to show compound annual growth of 4.3% for the following 4 years. Over the 5-years ending in April 2027, home prices would be 14.1% higher. Only a minor correction followed by an increase in-line with long-term growth.

If you don’t measure your kid’s birthday by fiscal quarters, that might be a little too abstract. Using the benchmark price, a home would fall to $850,600 (-$31,800) by April 2023. The benchmark is then forecast to hit $1,006,700 (+$124,300) by April 2027. It’s still huge growth but might not seem like that to people who assumed there will be 30% increases forever. Still, a contraction in the base case scenario is something to watch.

“While our base case still calls for positive economic growth, we have increased both the severity and likelihood of our downside scenarios,” said Graeme Hepworth, RBC’s Chief Risk Officer, in an analyst Q&A on the day of the filings.

The “Worst Case” For Canadian Real Estate Is A 30% Price Drop

RBC’s downside scenario shows a big contraction similar to the 90s, and a long correction. A benchmark home would see prices make a 12-month drop of 30% by April 2023. Compound annual growth averages 4.2% the following 4 years. Over the 5 years ending in April 2027, prices would be 15.8% lower.

In dollars, the benchmark falls to $617,700 (-$264,700) by April 2023 and $728,200 (-$154,200) by April 2027. Hard to believe home prices would fall by that much but also hard to believe they’d increase as much as they did. It was also hard to see a 30-year high for inflation and bond yields bucking the 15-year trend.

Not recovering over 5 years might sound bad but it’s not necessarily. After the 90s crash, home prices failed to re-inflate in real terms for about 20 years. During that period, Canada became one of the best performing economies in the world. Capital sought more productive growth increasing national wealth in a more equitable way.

A “Best Case” Scenario Is Another Run Like The Past 5 Years

RBC’s upside scenario would see home prices boom and higher rates have no impact. Home prices are forecast to rise 10.9% in April 2023, when compared to the previous year. Compound annual growth then averages 9.5% for the following 4 years. Those numbers might sound small but home prices would have climbed 61.7% higher over 5 years. That’s a similar performance to the last 5 years, the distribution is just different.

In this scenario, the benchmark home costs $978,600 (+$96,200) in April 2023. It’s also a mind-numbing $1,406,900 (+$524,469) by April 2027. Homes across Canada would be roughly the cost of a home in Vancouver today. Of course, incomes will have increased, helping to mitigate some of the pressure. Hard to see this scenario since the upside would also mean higher interest rates provided no drag.

Anything’s possible but consider even the bank’s risk department sees a downside bias. They aren’t dismissing the recent run happening again, but it was problematic. Recent growth was driven by the same factors that created destabilizing inflation. The upside was also not mentioned once during the call, indicating it might not be on their mind.

One thing to note: RBC has been outspoken about the impact of higher home prices on the economy. The bank has presented significant downside scenarios a few times. What’s different this time is the bank placing significant weight on the downside.

RBC hasn’t addressed why their downsides are frequently so large. However, experts like Hilliard macbeth and Oxford Economics have shed some light on downside forecasts with their own research. Just because home prices should be correct, doesn’t mean policy won’t be used to try and prevent it. However, it’s not a tool that can be used forever.

Every time the trend is extended, the market gets closer to a financial crisis instead of just a price drop.

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