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 principle 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.

Canada House Price Index

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 neighborhoods, 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 less 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 owning 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 home ownership 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 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 on 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 like 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 onto 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 readers think? Is Canada poised for a major real estate correction?

Pin It on Pinterest

Share This