Is Canadian housing in a bubble?
Over the next few weeks, I’m going to a series of posts about whether certain asset classes are overvalued. I call it the bubble series. First up: Canadian housing.
Over the past decade, real estate has been one of the best performing sectors in Canada, if not the best. There are countless stories of people who have made hundreds of thousands of dollars simply by owning a house in the right location, during the last decade. And since gains on a principal residence are tax-free, there are all sorts of people who have significant wealth stored in their house.
Let’s check out a pretty chart, provided by My Friend Fernando, a Realtor out of Calgary.
As you can see, prices have gone up drastically over the past decade or so. Prices have more than doubled during that time. Interest rates have declined during that time as well, meaning the cost to service a mortgage hasn’t really gone up with prices. If you combine that with longer amortization periods, the average Canadian homeowner is still making a reasonable mortgage payment. In fact, it’s allowed them to take on all sorts of other debt, perhaps to their detriment.
Can Canadian real estate prices continue to rise? This observer doesn’t think so. Here’s why.
Cheaper To Rent
Especially in major centers like Toronto and Vancouver, it’s cheaper for someone to rent than to buy. In certain neighbourhoods, the difference between renting and buying is significant – to the tune of 25-50% savings for the renter, especially in the condo market.
Why is this happening? It’s simple. All sorts of people are buying up condos, with the hope of cashing in on the inevitable capital gain. All these landlords care about is getting some of their costs back in the meantime, so they rent out the units, for whatever they can get for them.
With more and more young Canadians buying their own condos, (partially influenced by how well real estate has done) this drives rents down since fewer people are doing it. Supply is high, while demand is low. And as prices have gone up, so has the cost of servicing that mortgage. So the cost of ownership has surpassed renting.
A metric which can be useful is to look at the home price to income ratio. Normally, at a national level, this hovers at around 4. In certain areas of the country, the ratio has risen to 6 or 7. From that perspective, these are overvalued.
Everybody Loves Real Estate
While there’s a small minority of people who are certain Canada is headed toward some sort of real estate meltdown, it’s still an incredibly popular asset class to own. Young people are hitting up their parents for loans for down payments. You often hear people talk about buying before the market goes up again and they get priced out. The level of homeownership in Canada has reached record highs, even surpassing the levels seen by the United States during the peak of their real estate mania just a few years ago.
And really, who can blame people for having confidence in real estate? Often, someone’s house is the only investment of any significance. Memories of a stock market collapse are fresh in our minds. Investment returns have been disappointing. For many people, their house has been far and away from their best-performing investment.
Emboldened by recent success, people are quick to jump on the real estate bandwagon. But are they committing a classic investing sin by loving something only after it’s had a terrific gain?
What Can Go Wrong?
What would have to happen to soften the real estate market? Unfortunately for bulls, any one of several factors could put the kibosh at this party.
Interest rates are at record lows, which allows people to buy more property than they’d be able to afford if rates were at more traditional levels. As mentioned above, this keeps mortgage payments reasonable, even as values continue to climb. Many homeowners are in ultra-cheap variable-rate mortgages, meaning they’ll be hit immediately by rate increases, which will happen sooner or later. Homeowners in fixed-rate mortgages will have a bit of a buffer until they renew their term, but they will eventually feel the pain of higher rates as well.
Meanwhile, Canadians have record debt levels. It’s going to be difficult for many homeowners to afford an extra few hundred bucks a month since they already carry all sorts of other debt. This is not good for the market.
Most mortgages in Canada are recourse loans – meaning you can’t just abandon your obligation as so many Americans did. The bank has every right to sue you into the stone age if you decide to mail your keys back to the lender. This could cause a situation where many homeowners would like to move, but can’t get out of their current place.
As cracks appear in the market, public sentiment will shift. People won’t automatically associate real estate as the ticket to wealth. They’ll move on to the next popular investment. This will reduce the sea of buyers. Combine that with an increase in sellers, and you get a potentially toxic situation.
There are all sorts of factors that could cause the market to fall. What do you think? Is Canada poised for a major real estate correction?
Comments
Nelson,
This is a topic that must be investigated.
I am a bear on most real estate in Canada. I think most cities are severely unaffordable for first-time buyers and renting is not a bad option.
The problem is the enticing variable rates at the moment. If you can lock in for a long rate you could probably do well when it comes to appreciate the asset and with leverage.
If you think the bubble is about to burst and you want to sell your house, then contact me because I’m always buying. Personally, I don’t expect any bursting. But if the “powers that be” rapidly increase interest rates, then there will definitely be downward pressure on house prices. It’s educational to look at a graph of house prices in the late 80s and early 90s. House prices rose rapidly in the late 80s and there were geographies where house prices doubled in 3 years. Then prices declined in the early 90s. Now in the 2000s house prices doubled over 10 years, so any decline shouldn’t be as bad as the 80s/90s scenario.
I live in the Greater Vancouver Area and this is a very common subject. In fact, it probably started 5 years ago … It was a bubble then for many that still hasn’t burst.
I won’t disagree that the prices are becoming out of reach for many but I will also say that the expectation of what a dollar buy you has changed over time as well. Many buyers expect a castle for their first place in the hot neighborhood for the fairy tale life. If you just drive out 30 minutes, you’ll find a cheaper place.
With that said, I would expect many areas to stay relatively flat. Down a year, up the next … Areas with a lot of movements probably will see more fluctuations.
I think that the catalyst for a crack in the market to appear may be rising interest rates. Right now the rates are low and people are not feeling too much pain. Should rates begin rising, people will start to feel it and it will be much harder to justify spending $350k on a condo with the rates at a more “normal” 4% – 6% after the discounts.
Personally I agree with most, Vancouver and Toronto will probably see a 10-20% correction over the coming years but most parts of the country will be exempt as prices aren’t too crazy in relation to income. Alberta should see prices go up just because of how strong the economy is.
Umm well I disagree with Alberta is in line . Many are over priced not to mention poorly built as to standards in previous years .. yes some incomes are high .. but still when figure in other costs out here still not in line . Alberta also has a high bankruptcy rate too . Many have set themselves up for disaster to come. For the rates most go up for its the interest rates that are hurting our economy.