Irrational Exuberance in Canadian Real Estate

Canadian real estate has been a topic on my mind for quite a while. It’s dear to me as I live in Canada. Over the last few years, I believe some of the real estate markets in Canada have become price bubbles, particularly the Greater Vancouver and Greater Toronto areas.

I think two words sum up the real estate activity that has occurred in these two areas over the last few years: Irrational Exuberance. Alan Greenspan, former Chairman of the Federal Reserve Board, coined the words, Irrational Exuberance, during the dot-com bubble indicating that stocks at that point in time may be overvalued. Irrational exuberance refers to investor euphoria that drives asset prices to the point where they become dislodged from fundamentals. I think this perfectly sums up what is occurring in Vancouver and Toronto. This isn’t just based on anecdotes or opinion. Rather, cold hard evidence shows the irrational exuberance in these real estate markets.

Looking at the Data

When looking at real estate, you can’t just look at the absolute price of a property. For example, people often say Vancouver and Toronto prices are low compared to cities such as New York, London, and San Francisco. Yes, that’s true. However, people forget that, like valuing stocks, you need to look at fundamentals. You need a metric to be able to compare real estate prices with other cities on an apples to apples basis. One measure is taking the median cost of a home and dividing it by the median income. Similar to the price/earnings ratio when valuing a stock to see if it is a good deal. Demographia produced a study with such a comparison and listed Vancouver as the third most expensive city in the world. More expensive than New York, London, and San Francisco. Only less expensive than Hong Kong and Sydney. Why? Because median income levels in Vancouver are much lower than those in New York, London, and San Francisco. Note that this study came out in January 2016. I’m not sure if a revised one will be posted this month but if it is, you may see Toronto added to the list because of the significant price appreciation there throughout 2016. [Update – Demographia just posted its 2017 housing affordability survey: Vancouver is third most expensive again but Toronto didn’t crack the list yet]. In September 2016, the UBS Global Real Estate Bubble Index listed Vancouver’s housing market as the most at risk from a housing price collapse.

One of the most important measures to examine when assessing the health of an economy is household debt to income. Currently, the household debt to income ratio is around 167% meaning we owe $1.67 for every $1 we earn. Obviously not a good position because we’re not earning enough to cover off our debt. But this number alone doesn’t mean much. What really stands out is when you adjust the household debt to income ratio to how the US measures it, the Canadian household debt to income ratio is 162%. Before the US housing bubble burst, the ratio was 166% in the US in 2007. However, the US ratio now only stands at 136%. Thus, we are getting close to the same ratio as the US near its peak. The scary part is that our ratio is so high at a time when interest rates are at rock bottom whereas the US household to debt ratio peaked when the US federal reserve rate was in the 5% range. The Bank of Canada’s overnight rate is currently 0.50%. Therefore, a rise in mortgage rates in Canada would increase the household debt to income ratio as the debt would become harder to service because of higher interest payments. Note that mortgage rates are already increasing in Canada because of new federal mortgage rules and increasing bond yields (primarily in response to Donald Trump’s election win in the US).

Another important metric is the debt service ratio which is the amount of disposable income required to cover debt payments. The debt service ratio is currently 14 in Canada compared to 10 in the US. The higher the ratio, the worse. Note that the US ratio topped out at 13 during the US bubble peak in 2007. This is another concerning fact since interest rates are at rock bottom in Canada currently while they were relatively much higher in the US in 2007. So an inevitable increase in interest rates, particularly mortgage rates in Canada, will make this ratio ever worse. The data for this paragraph and the preceding paragraph were obtained from Maclean’s – see the 5th and 6th charts.

One argument is that the above two metrics don’t matter because debt is evenly distributed across all households or only the wealthy bear a high burden of the debt so there is no real danger. However, in its latest Financial System Review, the Bank of Canada noted that highly indebted households have significantly increased over the last three years, particularly in Vancouver, Toronto, and Calgary. Play the three videos in this link and you will see the increase in leverage of households. The increase in leverage makes sense however. House prices have seen gains in the 30 – 50% ranges in Vancouver and Toronto over the last few years while real wage growth has been stuck between 0 – 1% over the same time period. As people’s incomes have stagnated, they’ve had to borrow more and more which is exactly how households have become more leveraged. Particularly concerning is the increase in the number of households where debts are more than 450% of their annual income (i.e., they owe $4.50 for every $1 they make). This data clearly shows that numerous households in the Vancouver, Toronto, and Calgary areas are exposed to employment shock (already happening in Calgary) and/or interest rate shock (mortgage rates are already increasing). One interesting thing to note in the three videos is that most of the most highly indebted households are in the suburbs of each city where incomes are lower and people have more precarious employment. In the book, House of Debt, the authors studied the correlation between elevated household debt and elevated house prices in the US before and during the Great Recession. They found that those areas with the highest household debt and the most significant house price appreciation had the greatest price contractions and greatest economic fall out. Could we see the same things in the suburbs of Vancouver and Toronto?

The only bright spots left in the Canadian economy are real estate and financial services which account for about 20% of the economy. An unhealthy reliance on these two connected industries does not bode well in the long-run. A balanced economy needs to be diversified which includes substantial contributions from manufacturing, resources, and various service industries. Real estate and financial services’ share of the Canadian economy exceeds the same measure in the US before the US real estate bubble burst in 2007. Another ominous sign.

How about looking at the price to rent ratio? The price to rent ratio is simply the list price of a property divided by its annual rent. The price to rent ratio helps determine whether it is better to buy or rent at specific point in time. It can also help understand macroeconomic trends such as where the overall housing market in a region stands. A price to rent ratio of 1 to 15 indicates that it is better to buy than rent, a ratio of 16 to 20 indicates that it is generally better to rent than buy and a ratio of over 21 indicates that it is definitely better to rent. In February 2016, a BMO economist, calculated the price to rent ratios in the Greater Vancouver Area and found ratios as high as 110 in West Vancouver while the lowest in the region was 40 in New Westminster. These ratios clearly show a renters market. The only way a buyer would benefit from this market is buying for the purposes of price appreciation without consideration for rental yield which in other words is speculation. Note that house prices peaked in the Greater Vancouver area in spring/summer 2016 depending on where you live in the region and have since started to come down but these ratios should still be pertinent. There are only two ways to get the price to rent ratio to a more reasonable valuation – prices drop or rents increase. If rents increase, wages need to increase as well. However, as discussed above, real wage growth has been extremely low. So if rents increase without wage growth, people will just move. So a more likely outcome are price drops across the board.

Foreign buyers are often blamed for the elevated house prices in Vancouver and now Toronto. I discuss the impact of foreign buyers below.

Government Intervention in Real Estate

Government intervention plays a significant role in Canadian real estate. The Canada Mortgage and Housing Corporation (CMHC), a crown corporation (essentially a taxpayer-backed entity), insures mortgages where borrowers can’t come up with a 20% down payment. For example, say a person buys a home for $100,000 but he can only come up with a $5,000 down payment, resulting in a $95,000 mortgage. CMHC will insure that mortgage (assuming the home buyer is qualified to get a mortgage). The CMHC charges a premium for this insurance however which should be about 4% on the $95,000 mortgage. The premium is usually tacked onto the loan so the borrower ends up with a $98,800 mortgage leaving him with equity of only $1,200 which is leverage of 80 to 1! The odd thing about CMHC insurance is that it doesn’t insure the borrower. The insurance covers the bank. So the borrower is paying the premium to insure the bank is made whole in the event the borrower defaults. To me it seems like a perverse type of system. In the event of mass defaults, if the CMHC does not have enough equity to cover mortgage losses, taxpayers are on the hook. I believe the CMHC has certainly propped up the housing market by bringing in buyers who otherwise may not have received mortgages. If you take CMHC out of the equation, a bank is inclined to scrutinize a mortgage application more carefully because it will bear the costs of any losses.

It looks like the CMHC and the Canadian federal government are finally realizing what impact a significant housing correction could have on the Canadian economy. The Canadian government introduced a new stress test for buyers who can’t come up with a 20% down payment. This was done in October 2016. In order for these buyers to receive a fixed five year mortgage (which is the most popular type of mortgage in Canada), they need to qualify for a mortgage based on the Bank of Canada’s qualifying rate which is currently 4.64% instead of the lenders posted rate which can range from the low 2’s to 3%. As expected, this will weed out buyers without adequate down payments who wouldn’t be able to withstand a substantial interest rate increase based on their current income. The government also increased capital requirements for certain lenders that provide insured mortgages. This had the impact of increasing CMHC premiums for borrowers in January 2017. The government and CMHC are also considering loss-sharing with lenders on insured mortgages in the event of default so the banks shoulder at least some of the loss. More information on this should probably be released in the Spring of 2017.

Evan Siddall, President and CEO of CMHC, acknowledged these changes in this contribution to the Globe and Mail. I remember reading this and commending him because so many, particularly in the real estate industry, came out against these measures. But they are clearly needed to slow down the significant price appreciation in Vancouver and Toronto.

While the federal government tries to slow down the real estate train, the provincial and municipal governments are introducing their own measures. For example, in BC the provincial government introduced a 15% foreign buyers tax. Anyone who is not a Canadian citizen or permanent resident is slapped with a 15% levy on a purchase. This is in addition to the existing transfer tax. The effect of this has been a significant drop in foreign purchases of real estate post implementation of the tax (1% in August and September 2016 vs. 13% in the seven weeks leading up to the tax’s implementation).

Foreign buyers have often been blamed for Vancouver’s real estate woes (and now in Toronto). Their numbers have been pegged at anywhere between 5% to 10% of total sales. Not that significant but I believe foreign investment does make a difference because those %’s can move a market to a certain degree. For example, in the US, it only took 7-8% of households to default on mortgages and this had a ripple effect. So a 5% – 10% range of foreign buyers could certainly create some kind of a ripple effect leading to higher prices throughout the surrounding areas. But I believe debt is a more significant contributing factor to the large increase in real estate prices. I believe the psychological “threat” of foreign buyers has also created euphoria among the locals which makes them think that if they don’t buy now, they’ll never be able to buy.

The city of Vancouver also revealed an Empty Homes Tax towards the end of 2016. The tax applies at a rate of 1% of the property’s assessed value to homes that are deemed empty. There is an issue of vacant condos and houses in Vancouver and nearby suburbs such as Richmond but it has been difficult to quantify. A review of BC Hydro data revealed as many as 10,000 empty condos in Vancouver (nearly 1 in 8 condos). I’m not certain that this tax will help housing affordability.

Just last month the BC provincial government introduced a new loan program to help first time home buyers enter the real estate market. The new loan program counters much of the work that the federal government is trying to do to cool the market. Under the program, a buyer’s down payment will be matched up to $37,500 on insured mortgages (i.e., where the buyer can’t put 20% down). The house purchase price must be $750,000 or less. This may have an inflationary impact on the market as it effectively subsidizes sellers. At the same time, it saddles buyers who aren’t prudent savers or not yet ready to get into the market with even more debt. For example, say you have a person wanting to buy a $100,000 condo. The person has $2,500 to put down and the government fronts him the other $2,500 to reach a minimum down payment of $5,000 (5% of the purchase price). The $2,500 the government gives you is debt but nothing is payable on it for the first five years. At five years, the $2,500 becomes payable at the going interest rate at that time. So the buyer ends up with a $97,500 mortgage and $2,500 equity. But wait, there’s the CMHC premium of 4%. Suddenly the mortgage becomes $101,400. The condo is only worth $100,000. So you’re under water on day 1. If the condo drops in value at the time the mortgage renewal comes up and the person is under water, he should have to make up the difference.

Conclusion

I think the data clearly indicates elevated real estate prices in Vancouver and Toronto. The prices are completely detached from local income levels. Coupled with high household debt, this has the makings of a disaster. Prices are already starting to come down in Vancouver while Toronto continues to boom. Sales have significantly dropped off in Vancouver compared to prior year figures and the 10-year average. Generally, a decline in sales precedes a decline in prices.

Some argue that foreign investment can sustain the gravy train. But foreign investors have all but left Vancouver. Toronto? There’s no solid data on their influence. Many blame Chinese investors. China is clamping down on capital controls again as its foreign exchange reserves continue to fall. This may impact Chinese real estate investment abroad as China tries to keep its money at home. China also has their own property bubble to contend with. Usually foreign money aka “hot money” is the first to leave when there is trouble at home. So a downturn in China could have existing Chinese investors pull out of Canadian real estate.

So what can happen in Canada?

  • Incomes rise substantially to support elevated house prices. There is no evidence of this happening as the Canadian economy struggles and inflation is below 2%. Canadian GDP is forecasted to grow in the 1%-2% range over the next few years, making significant real wage growth pretty much impossible; OR
  • House prices eventually come down to reasonable valuations (i.e., income levels that support prices). This is more plausible than income levels rising. This may not happen tomorrow or next month or even in the next year as prices can stay at irrational levels for long periods of time. But eventually, prices will revert to levels that are supported by fundamentals. It’s uncertain whether a price drop will be sharp or if it will drag on for a long period of time. Real estate is illiquid so prices generally decrease at a slower pace than stocks. Stocks can be sold at the click of a button, real estate can’t. People also like to hold on to their homes as long as possible which slows down price decreases.

What will cause a house price decline? It may be a trigger such as an increase in mortgage rates which we are already seeing because of increasing bond yields. This puts stress on the finances of highly indebted households. Another shock could come from loss of employment. This generally happens during recessions. This is isn’t a matter of “if”, it is a matter of “when”. If substantial employment loss occurs during a period of high household indebtedness, this could put significant downward pressure on real estate prices. This is already happening in Alberta where sales listings have substantially increased, prices are dropping,  commercial real estate is a mess, and many people are still out of work. As severance packages and Employment Insurance runs out, it could get worse.

Coming back to the book, House of Debt. The authors provide compelling evidence behind the cause of the Great Recession in the US and other countries around the world. Most importantly, they point out that elevated real estate prices combined with high household debt are often followed by recessions. And the higher the household debt levels, the more severe the recession. They call the relationship between high household debt and high real estate prices, and eventual economic contractions “so robust as to be as close to an empirical law as it gets in macroeconomics.”

I believe there will be a decrease in house prices and deleveraging of Canadian households. How it will happen and in what order is yet to be seen. The federal government and the Bank of Canada are stuck between a rock and a hard place. If households start paying off debt, it means less money will be spent in the economy which will slow down the economy and lead to job losses. This will lead to a further reduction in spending meaning more job losses and real estate prices should come down as people are forced to sell. A vicious cycle on the way down. Just as there was a vicious cycle on the way up.

If house prices decline on their own because people can no longer afford housing, the one bright spot in the economy, real estate, will take a big hit which may slow down the economy (lower realtor commissions, fewer lawyers and accountants working on deals, banks handing out fewer mortgages, less new construction). This leads to job losses which begets a further decline in real estate prices.

Some argue that if borrower’s finances are stressed (e.g., they default on their mortgages), the government may intervene. If the government intervenes and reduces the principal on borrower’s mortgages, taxpayer’s are on the hook which is probably politically unpopular and would further increase the government deficit. But by this time, the credit ratings of these borrowers would probably be damaged. You also get a moral hazard problem – if over-leveraged borrower’s are bailed out, they’ll keep over-leveraging themselves in the future thinking the government will always bail them out. Thus, never really solving the issue.

How to get out of this mess? I have no clue. There will probably be some pain. I hope to avoid it. My goal is to stay liquid, stay out of debt, and wait for an investment opportunity.

I think people may one day look back and shake their heads and think why someone would have paid $1.5M for a crack shack in Vancouver or $1.5M for a slanted semi-detached house in Toronto.

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