Jul 14, 2015

Canadian Real Estate-Boom or Bust?

By   Darren V Long     |   Category: Blog

Talking about Canadian Real Estate has always been a sore point for me. I certainly do not want to leave the impression that I have not participated because most people who know me, know full well that I have been an active participant.

In fact in looking over my connections on my abjured list of what Facebook calls friends I can clearly see that of the over 500 connections there are more than 100 involved in real estate, either directly or indirectly, as sellers and buyers.

So why do I bring this topic up at this point in time? What are the valid talking points of this subject matter? Well for one we know nothing about Canadian Real Estate except the prices themselves, which seemingly is the only thing that matters right?

What if Canadian home prices unexpectedly tumbled by 20 per cent, what percentage of homeowners would be at risk of foreclosure? We don’t know.

What if interest rates rose by one or two percent, how many Canadians would be too overextended to make their monthly mortgage payments? We don’t know.

Can we honestly say right now that there is anything analysts, policy makers, lenders and borrowers could do differently to shield Canadians and the economy against a crash, or at least prevent worsening one? We don’t know.

A dearth of concrete data on the financial position of Canadian homeowners has left those who study the mortgage market functioning in a dark realm with little or no direction.
For a number of years now, Canada’s housing market has been the strongest performing developed market, which has also made it the world’s most overvalued according to the Economist, the OECD, and Deutsche Bank.

In fact as recently as this year Deutsche Bank published their house-price-to-rent index and it showed that Canada has the most expensive housing market in the world; as much as 60% over-valued…Canada, for example, is very open to foreign investors, which means that in an age of unprecedented global liquidity cash-rich wealthy individuals who are looking for places to park their excess funds can do so in its housing market far more easily than in Japan, with its closed system.”-ZeroHedge

Industry observers have presaged for years that the market is headed for a big drop, that the levels of borrowing and continually rising prices are untenable. But so far they have been mistaken. Prices continue to rise while incomes stagnate, and in many cases also decline. With no end in sight, conflicting views of the health of the market flourish.
Unfortunately when you do your homework you will see that almost every single housing market indicator is now in the danger zone. If history is any guide, we could be in the midst of the largest real estate bubble in Canadian history.

First of all, it is unfortunate, but true, that Canadians have never been in so much debt. To finance their home purchases, Canadians are turning to snowballing amounts of debt. According to numbers compiled by Statistics Canada, household debt-to-disposable income hit a record 163 percent last year. This is approaching comparable levels to the United States in 2005 right before its real estate market buckled. As a whole, Canadians appear to be debt-mad even outside of mortgages. According to a TransUnion report, average consumer non-mortgage debt hit an all-time high of $23,900 at the end of the 2014.

In addition to this the Canadian economy has never been so weighted to real estate. Record low interest rates have fundamentally restructured the Canadian economy. With the country’s manufacturing sector slowly eroding, construction jobs have made up the difference. Thanks to a booming real estate market, 13.5 percent of Canadian jobs are now linked in some way to construction. This is the highest level in over 40 years that this figure has been. If this figure were to revert back to the mean, which is roughly 7 percent, the job losses would be measured in the hundreds of thousands.

With this entire boom in real estate we have also heard much about the explosion in larger residences. More house size on average in terms of square footage and property has been so ubiquitous that in fact the gap between house prices and income is the third worst in the developed world. Say it with me… “the gap between house prices and income is the third worst in the developed world.”

Canadian real estate prices have outperformed income growth for over a decade. Historically, Canadians paid between three and four times their average annual income for a new home. Today, that figured has ballooned to almost 8 times annual salaries. This is one of the most frightening variables and one reason why paying down your mortgage is the best investment you can make. Instead in this era of ultra-low interest rates, many buyers have been taking on much larger mortgages than they would be able to afford if rates were even a little higher.

When rates reset, and they will, overextended buyers could sink into insolvency, but just how many would be affected, and the extent to which this could impact the market, are unknowns because once again the market data just doesn’t exist!

In the void of official government data on everything from the average down payment to the average monthly mortgage payment to the number of condos owned by foreigners, which I have discussed is far greater, especially in Toronto, than anyone really suspects, the country’s top real estate scholars, and even the federal government themselves, continue to draw conclusions from fractional information, surveys and circumstantial evidence, which in my humble opinion is NOT a practical way to continue.

We need simple statistics that would be useful for forecast, including data revealing the average amount of a mortgage loan compared with household income, which could shed light on how much of our budgets those mortgages are eating up. In addition to this I would like very much to know more about those at high risk of default or those that have high ratio mortgages (which are mortgages that carry less than 20 percent equity in the home) and what percentage of mortgages are being amortized over the maximum allowable period of time to prevent the owner from paying larger monthly payments. Believe it or not, as simple as it sounds, this data simply does not exist.

By extension if our government were to even disclose data such as the overall amount of equity in homes it would reveal the strength of homeowners’ financial positions and go a long way towards discovering if we are actually in a bubble or not.

Another great concern which is now growing similar to our US counterparts is the gap between house prices and rent. This gap is the second largest in the world. In the rush to become a homeowner, Canadians are paying record premiums for the privilege of buying a house. Today, the average residential home sells for 25-28 times annual rental income; though in major centers, such as Toronto and Vancouver, this figure is well in excess of 30 and even as much as 60 times rental income. Historically, Canadian real estate traded between 15 to 20 times rental incomes nationwide.

This simply means that many people are making next to nothing in terms of income for their rental properties, instead assuming that the rise in the value of the home or condo will likely provide the majority of their speculative gain.

When a house sells in a few hours with multiple offers I am proud of my colleagues’ success. However it reminds me that when rigged numbers are the basis of our success, we have failed. To this end if you look around and consider what is discussed in this article you will surely see that the entire financial system in Canada is at risk.

The consequences of a housing correction would have a devastating set of consequences for the nation’s banking industry. In the event of a downturn, losses on uninsured residential loans could severely damage the industry’s capital bases.

In a report last year, Dan Werner of Morningstar estimated that, “In a worst-case scenario, if all of the uninsured loans were losses and residential prices fell 30 percent, we think nearly half of most banks’ tangible equity would be affected.” Werner thinks that the National Bank of Canada and Canadian Imperial Bank of Commerce would be the most devastated of Canada’s large banks. Institutions with a larger international presence would be less affected.

For the record if you think I am being too pushy per say or perhaps asking for too much or that I am likely just being a “sourpuss rally killer” please remember that some of the information the experts want to access is readily available in peer countries such as Australia and the United States, among others.

In the US banks are required to report much more information, including debt service ratios (the amount of income going toward a home) and loan-to-value ratios (the amount owed on a home compared to the amount invested). Though that information didn’t prevent the 2008 U.S. housing crash, it provided comprehensive insight into what, exactly, was happening — and a potentially valuable lesson for Canada considering the fact that US homeowners were in fact warned that what was happening was not sustainable from about 2005 onward.

What we need to understand is that there is valuable data out there which is not being shared. Banks do collect important information such as the credit scores of high risk borrowers and how much equity their clients have in their homes compared to how much they owe. But they refuse to share it, even with their own economists. Go ahead and ask any real estate agent for this data or your own bank for that matter. It will likely be a dead end.

Even the Canadian Mortgage and Housing Corporation, the government arm responsible for insuring high-risk borrowers, keeps a lid on most of its collected mortgage market information, while its annual review of the housing market relies partly on a survey conducted by the mortgage industry itself. In this environment, most of the focus turns to the scant data industry associations choose to make public.

The Canadian Association of Accredited Mortgage Professionals’ annual report includes some helpful data such as the average amortization period and average mortgage interest rate. But it is based on a survey of just over 2000 Canadians, which is surely not enough.

Meanwhile, the most closely followed metrics come from a monthly sales report by the Canadian Real Estate Association, an organization with a mandate to promote the health of the market and the importance of realtors. It releases only the information it wants, charges for a deeper dive into the market and holds back the rest. My colleagues in the industry have told me how difficult it is to secure detailed information about the housing market as a whole.

Buyers, analysts, sellers, economists etc. do not want month old sales reports any more than they may want to know what a stock did last month but if you could look at mortgage stats and levels of debt in real time or at least within a few days of happening, I think that would be a lot more helpful in making meaningful predictions about where the housing market is going to be a year from now.

Banks carefully track their own mortgage statistics, such as clients’ average debt service ratios and other data that would be useful to analysts, but keep them highly guarded. I can also tell you that upon talking to my own clients who work for banks that their own employers carefully guard that data.

So in lieu of all of this data can you find anything that can help in the search to find out what the housing market is really doing? The answer is a partial yes, but you must be creative in your sources. You can pay for deeper access to some data, such as reports from the CMHC or CREA, but it’s not cheap and it becomes cost prohibitive to the average home buyer or speculator.

You can use your colleagues and their access to the MLS listings database to find out information but that could be compromising their ethics and there is other types of data such as the Ipsos Reid household financial survey which can give you a small look at debt service ratios, from which you might be able to estimate the share of households that would be most vulnerable to a rise in interest rates but nothing concrete.

Housing policy and data collection are challenging because the federal government oversees immigration and finance, the provincial government controls land development, and municipalities set zoning bylaws and collect property taxes.

Banks and other lenders collect and submit some mortgage data to OSFI (Office of the Superintendent of Financial Institutions), the regulator for institutions that control some 80 per cent of the lending market. It “encourages” the big banks toward transparency, but keeps their details secret.

OSFI requires lenders to disclose the percentage of insured versus uninsured mortgages in their portfolios, a breakdown of the percentage of mortgages that fall within different amortization rates and the average loan-to-value ratios of uninsured mortgages.

The banks also report their average loan-to-value ratios (how much is owed versus how much is owned) for uninsured mortgages in quarterly results, but they are not required to do the same for insured mortgages, which often make up a majority of their mortgage portfolios.

Researchers, however, care more about the financial position of borrowers who are insured because they tend to have less equity in their homes and have less saved for down payments. Since insurance is required for anyone with a down payment of less than 20 per cent, those figures would provide insight into riskier borrowers and go further to reveal the health of the mortgage market.

In lieu of knowing without prejudice all of the details about our housing industry how can anyone continue to speculate and hope for the best? I refuse to do it but this being said the truth is that not knowing means this evolution of sustained real estate growth and speculation could be done tomorrow or it could roll on for years to come. I am not willing to risk my capital in that way.

I will continue to diversify my own portfolio with quality, tangible hard assets that include but are not limited to Gold, Silver and Natural Fancy Colour Diamonds. They are not the only things I will use but they are fundamentally way undervalued compared to real estate and have a fraction of the investing public interested at this point. This alone makes for a wonderful fundamentally driven long term market which I believe will provide results for investors for years to come.

Yours to the penny,

Darren V Long

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