Canada's Housing Bubble

Analysis of the real estate bubble in Canada --

BMO's Canadian Housing Outlook; Speculative fever still reigns in Toronto condo market Print E-mail

Sep 30, 2011 Ben Rabidoux

BMO's Canadian housing outlook:

BMO is set to release its updated Canadian housing outlook.  It will be posted on their website tomorrow.  Here's a sneak peak at their conclusions, with a few of my own thoughts.

Low interest rates have fuelled Canada’s housing market in the past decade, pushing prices to new highs in most regions. However, a weaker economy and new mortgage rules have dimmed activity recently.

Nothing to disagree with here, though I would add that readily-available credit and a new and prevalent mass perception towards real estate (and renting) have also been major factors in our boom.


On the strength of the resale market:

Sales are now close to their past-decade norm, and well below pre- and post-recession peaks (Chart 1).

I find this an interesting graph.  I particularly love the 'linear trend line'.  Wouldn't it be a much more telling chart if we controlled for population?

Like, say, this chart?

Interesting how once we control for population, we can see just how unusual our home buying activity has been over the past decade.  We have a love affair with real estate here in Canada.  We're either in a 'new paradigm', or this probably won't last, and resales relative to population will fall back in line with long-term norms.  Given our propensity to understate the role of shifting mass psychology in asset bubbles, and given our tendency to extrapolate future events from our recent experiences, I'd suggest most market pundits would happily buy into the 'new paradigm' story.  Don't be one of them.  Given the aging population set to weigh on demand, and given our unprecedented home ownership rate in Canada, I have a pretty good idea of which outcome is more likely.


On housing affordability:

A weak global economy and Europe’s debt crisis will likely keep the Bank of Canada on the sidelines until early 2013, while further easing measures by the Federal Reserve should suppress long-term rates in both countries, thereby supporting affordability.

Hard to disagree with their statement, but they have taken some liberties with their assumptions in their Housing Affordability Index.  The big one is that they assume a typical down payment is equal to one year's household disposable income.  We know that the average house sold in Canada is roughly $350,000.  I'm not sure what measure of household disposable income they've used, but if it's for families of two or more people, the after-tax income is roughly $75,000.  This would imply an average down payment of 21%, meaning that the average new home buyer would not even need CMHC insurance.  If this strikes you as laughable, it should.  Even the Bank of Canada recently chimed in on this topic, noting the following:

Allen (2010–11) shows that from 1999 to 2004 most households with insured mortgages borrowed up to, or near, the maximum LTV ratio available at the time they purchased a home. Thus, in that period, the typical LTV ratio for a newly issued insured mortgage was in the range of 90 to 95 per cent.

Now I recognize that they are talking specifically about new, insured mortgages, which means the total down payment of all purchases is obviously higher, but the point remains: The average first time buyer puts no where near 20% down.  When we are talking about sustainability and stability in the real estate market, you can't have it without having prices within the reach of new home buyers.  Sure they seem well within reach according to BMO, just as long as the new buyers have an average down payment of 20%.  I've previously discussed why these 'affordability' measures are inherently misleading.

Did you also note how they inverted the affordability reading?  I bet at first glance, you thought affordability was below its long-term mean (i.e. more affordable).  Look again.  Sneaky, sneaky!


On Canada's price/income ratio:

Prices have risen twice as fast as incomes in the past decade, lifting the current ratio 16% above its norm (Chart 4). Although the current overvaluation is below levels that triggered price corrections in Canada in 1989 and the U.S. in 2006, it will remain a thorn in the side of first-time buyers.

Something's not right with this graph.  Are they suggesting that house prices are at a similar multiple of personal income as in the late 80s?  That's how I read it, and that's totally false.  Here's the truth:

Why would they need to make it into a trend and set it at 100?  In what year did they normalize it at 100, and why?  It's a ratio!  Just show it like it is!  Funny how when you actually look at the ratio itself, it tells a vastly different story.  This reeks of data manipulation.


On the gap between Canadian and US house prices:

For bargain hunters, Canadian houses, on average, cost a record two thirds more (in local currency terms) than U.S. houses.

I'm curious why such a premium should exist, particularly given our comparable income levels.  Graphs like this also make me scratch my head and wonder why any foreign investor would buy a higher-priced, lower yielding asset in Canada when deals are abundant in the US.  I've suggested before that much of the foreign investment in Canadian real estate is nothing more than momentum chasing that will disappear in the event of a housing correction, exacerbating the downward trend.  Maybe I'm missing something.  What justifies a premium of this magnitude?


BMO's conclusion:

Because housing is moderately overpriced in most regions (and considerably so in Vancouver), it’s vulnerable to a correction. The biggest threat stems from the perceived one-in-three chance of a recession, and the attendant loss of jobs. Another risk, though far smaller, is if interest rates spike higher next year.

...Even a moderate 2-ppt increase in rates would severely impact affordability. Low rates are a threat too, since they could cause the market to heat up again, only to correct when rates eventually rise. More buyers are turning to variable-rate mortgages on expectations that rates could stay low for some time, or even decline.

After cruising at high altitudes for most of the past decade, Canada’s housing market is on track for a soft landing in the year ahead, though turbulent global economic skies could make for a bumpy ride.

I agree on the risks, but see different odds of a 'bumpy ride'.  Buckle up!


Speculative fever still reigns in Toronto's condo market

I have to briefly comment on a story in the Toronto Star: Toronto becoming a town of renters as investors dominate condo market

It's quite fitting that this article is published today, since I'm actually doing an interview with CBC regarding the Toronto condo market later this evening.  It's increasingly in the spotlight.

Let's have a look at some key quotes:

With Toronto’s condo market among the hottest in the world right now — almost 68,000 new units are now in the planning stages or under construction across the GTA — investors are cashing in big time on what looks like a sure bet compared to battered stock markets.

Some 45 to 60 per cent of all new condos planned for the GTA are being snapped up by investors, says market research group Urbanation. That number is believed to be closer to 80 per cent in the downtown core where 12 new highrises, with 5,707 new units, are creeping floor by floor into the Toronto skyline right now.

That frenzy of investor activity is now being seen — and felt — as developers try to keep condo prices down by building more, and smaller, units meant to maximize investments for people who will never have to live in studios smaller than hotel rooms.

The surge of investors is part of the reason new downtown units are now averaging just 749 square feet — about half the 1,440 square feet average being built in crowded Manhattan.

While there are growing concerns about where Toronto’s condo market is heading, the activity here comes as a shock to Jonathan Miller who monitors the U.S. as president and CEO of Manhattan-based Miller Samuel Real Estate Appraisers & Consultants.

“If this isn’t a bubble, I don’t know what is,” says Miller. “This is going to end badly.

“You can’t have such a rapid influx of supply without this going too far. One thing I’ve learned is that builders will build until they can’t build anymore.”

Ben Myers disagrees. The editor and executive vice president of Urbanation has recently started tracking rental demand for those condos.

“This (condo building spree) is providing the city’s rental stock,” he says, adding that some 100,000 new people are flocking to the GTA each year.

“We are one of the only markets in the world that is catering to renters and first-time buyers by creating these smaller suites. In my view, this is absolutely the best approach. Great cities grow and expand, they have people walking around and you can only do that if you have a lot of people living downtown.”

Interesting.  From the data I've seen, the price-rent ratio for condos in the 416 is in the 25 range, or quite high.  I've posed the question before, but it's worth asking again:  Rents and house prices typically move in tandem as the factors that push one higher similarly affect the other.  Only a handful of factors can push house prices significantly higher while rents creep along.  Which are they and are they sustainable?

Let's note that condos in the 416 are virtually all cash-flow negative, a fact even Mr. Myers agrees with.   Now why in the world would an 'investor' hold on to a cash-sucking investment that is guaranteed to cost them money every month? gains.  With that in mind, I have two major concerns regarding the Toronto condo market:

First of all, in addition to being overvalued based on fundamentals, this extremely high 'investor' participation runs the risk of causing a great deal of inventory to hit the market in the event of a price correction.  Speculators are NOT long-term investors.  No one buys a cash-sucking investment to hold for the long term unless they are completely incompetent with their money.  You can't count on speculators to have a rational response in the event of a sustained downturn in housing, when their very purchase is made on an irrational basis.  Speculators can't possibly have a long-term view of their investments when their only possible means of making money is in capital gains and those capital gains become increasingly unlikely.

Secondly, with the glut of inventory in the pipeline, should the market experience a downturn, will the demand still be there for these new units when the demand side is dominated by 'investors' seeking capital gains?

This is one market that is overinflated to begin with, but of more concern is the fact that this market is overly-reliant on speculation to maintain price and demand momentum.  I wouldn't touch it.


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