The Stress Test Is Here...Now What?

June 1, 2021 was an impactful day for Canada's real estate market. For the first time since 2017, the stress test was updated in the hopes of cooling down the heated market. It is a speed bump that was necessary for a market that experienced a meteoric rise during a turbulent year. The term "stress test" has been loosely thrown around, but now that the new regulation is in place, what exactly is the stress test? Who has been most affected by this? And how will this affect the next generation of homeowners?

In Lehman's terms

The stress test was utilized by lenders to ensure that uninsured borrowers, those putting 20% or more down, could qualify for a home loan. Before June 1, Canada's mortgage stress had a minimum qualifying rate of 4.79%. As of June 1, this threshold was bumped up to 5.25%. An increase of nearly 50 basis points seems like an immaterial amount, right?

Not exactly. As a potential homebuyer, your mortgage pre-approval application involves your lender looking at two crucial ratios: gross debt service (GDS) & total debt service (TDS).

Simply put, if the implied mortgage rate increases to 5.25%, your numerator in both ratios will increase. An increased numerator is going to increase that ratio and result in qualifying for a smaller mortgage.

The June 1st rat race

The announcement of the June 1 stress test was made on April 8th. At this time, the GTA market had already been on fire since June 2020. The usual slow season of real estate (December - March) was being replaced by increased volume at a higher price point.

The concept of a rat race is that there is an influx of demand trying to secure a finite supply of a certain asset. It's not that there were a limited supply of houses; however, the main issue was securing that asset before June 1st. The housing market (pictured above) shows that the prolonged demand of real estate continued in the two months following the stress test announcement. It will be interesting what happens in the upcoming summer months. With residential units purchased at a premium, will we see volume and prices stabilize?

New homebuyers are at the forefront

For those thinking that these new regulations would not effect first-time homebuyers, I'm sorry to tell you that this is incorrect. If millennials thought that getting pre-approved for a mortgage was hard enough, this new stress test continues to make the idea of home ownership a fantasy.

Let's use an arbitrary example of a 30-year old couple making a combined annual income of $100,000. According to Ratehub.ca, a 20% down payment with a 5-year fixed mortgage rate of 1.78% amortized over 30 years would qualify for $651,000 at the old implied mortgage rate of 4.79%.

Under the new stress test rate of 5.25%, this same couple would only qualify for a home worth $618,000. That represents a difference in purchasing power of roughly 5%.

Those 50 basis points now seem a lot more significant than you thought. For any new homebuyer that was looking to qualify for their first mortgage, you'll either have save a little longer, or lower your budget.

What happens next?

The millennial generation will continue to face an uphill battle when it comes to owning real estate. According to the 2021 Millennial Homeownership Report, 18% of millennial renters say they plan to rent forever, which is an increase from 12% in the previous year.

The disparity between salaries and the cost of real estate only feeds this pessimistic mindset. Mix that in with the June 1 stress test, and the reality is that the idea of millennials owning a home seems more and more unrealistic.

Going forward, our generation will have to get more creative in finding strategies to invest in real estate. Pre-construction condos will continue to be a hot commodity going forward. The capital appreciation that comes attached with buying an asset in the future is very inviting for a first-time homebuyer. Couple that with the extended deposit structure, and you have a low barrier to entry in the real estate market. The concept of group financing is another idea that could be a realistic scenario for owning investment properties. With so much upfront capital required in any freehold purchase, there is always strength in numbers. Find yourself three trustworthy friends, and the four of you can own a property together.

It has only been 10 days since the stress test was officially put in place. Time will only tell how the market reacts to the stress test, but as for now, any idea of home ownership for first-time homebuyers is nothing more than an afterthought.

Article written by Andreas Tassios