Is Canadian Real Estate Getting Riskier?
Economists measure risk in terms of volatility and uncertainty. If a market has more volatility and uncertainty then it is considered risky. Let’s first look at volatility in Canadian real estate.
Volatility In Canadian Real Estate
The Vancouver, Toronto, Victoria and Hamilton property markets have consistently shown large upside price growth and would be considered upwardly volatile. At present, the Canadian housing market is more volatile than blue chip stock indices like the S&P 500, which would be considered a safe investment by most. From an economist’s standpoint, a market that swings wildly upward has a higher likelihood of swinging wildly downward, hence growing concern that years of record breaking highs could lead to a period of declining prices.
How volatile is Canadian Real Estate? Toronto home prices rose $400,000 between 2015 and 2017. Vancouver house prices rose $600,000 from 2015 and 2017. Vancouver has subsequently shed almost $200,000 while Toronto has dropped $100,000. Low risk real estate doesn’t jump around like this.
As property prices distance themselves from local incomes and economic fundamentals they become more dependent on market sentiment which increases the uncertainty in the industry. Since the price movements and size don’t make sense to most people, we start reaching for explanations.
For example, if the market were slow and steady, like Ottawa and Montreal in the chart above, then nobody would be tempted to read this article about risk. People would think this article was pointless and of little value. Uncertainty prompts people to read an article like this and it also prompts them to take a “wait-and-see” approach when they see a hot the market softening significantly. In essence, potential homebuyers are waiting around for news that inspires more confidence of upwards movement in prices.
Who else believes there is risk?
Some of the most respected and conservative economic analysts in the world believe there is concrete evidence that the Canadian real estate market is at a high risk of a major correction.
Of course, there are also experts like the CEO of Scotiabank and the Chief Economist for CIBC, who feel that these risks are much less likely to affect Canada. It is worth noting that these banks have very large mortgage portfolios and are therefore closely watching these risks and managing their shareholders’ concerns. These same banks have been tightening their mortgage rules.
What does the Canadian Government think?
The Canadian Mortgage and Housing Corporation (CMHC) is the federal housing agency mandated to help Canadians buy homes. In their words, “A high degree of overall vulnerability is maintained for Vancouver, Victoria, Toronto and Hamilton” because of of price acceleration and overvaluation. Most notably, high evidence of overvaluation is still observed in Vancouver, Victoria and Toronto where house prices remain higher than levels supported by economic and demographic fundamentals.
They’ve been saying that for two years now...will they still be saying it in 2020?
Concerned by real estate market risk, CMHC and the Canadian Federal Bank Regulator began enacting policies as far back as 2008 to reduce how much Canadians could borrow.
2008: Reduced the maximum lifespan of a mortgage from 40 years to 35 years.
2010: Applied a stress test against the 5-year contract rate for mortgages with a down payment of less than 20%.
2011: Reduced the maximum lifespan of a mortgage from 35 years to 30 years.
2012: Reduced the maximum lifespan of a mortgage from 30 years to 25 years on mortgages with a down payment of less than 20%.
2016: Applied a stress test against the 5-year posted rate for mortgages with a down payment of less than 20%.
2016: Banned default insurance on refinances, mortgages greater than 25 years, and single-unit rentals.
2018: Applied a stress test to mortgages with a down payment of greater than 20%.
The July 2008 change was presented as part of a "responsible and measured approach by the Government to ensure Canada’s housing market remains strong and to reduce the risk of a U.S.-style housing bubble developing in Canada."
Recently, the federal regulator OSFI mandated that the 6 Canadian Banks with the largest mortgage portfolios set aside more cash in case a financial stress event happens. If you see headlines saying Canada is safe from a financial crisis, it means they believe the banks will come through a housing crisis unscathed. It isn’t offering an opinion on how households will fare.
What does the Bank of Canada think?
In the Fall of 2017, the Bank of Canada issued a report where their analysts calculated there is a 35% to 55% chance of a “high financial stress event” in the next 2 years. Though they were only 50% confident in their assessment of the risk, essentially the Canadian economic future could be as precarious as a coin toss - a 50% chance of a disastrous outcome for Canada’s housing market. Since this report was written by the Bank of Canada, housing affordability has worsened and the economy has weakened.
In a 2013, the Bank of Canada published a paper that provides past examples of financial stress events. Keep in mind these impacted financial markets and often resulted in recessions, but they did not necessarily result in a significant house price drop. The past high financial stress event listed by the Bank of Canada were:
2007 - Lehman Brothers bankruptcy leads to Great Recession
2001 - Bursting of dot-com bubble
1998 - Long-Term Capital Management collapse
1994 - Mexican peso crisis
1992 - Black Wednesday, European exchange rate mechanism crisis
1989 - Toronto house price collapse
1987 - Black Monday, October 1987 stock market collapse
What about other Central Banks?
The Bank of Canada analysis is supported by an October 2017 International Monetary Fund (IMF) Report pointing to Canadian vulnerability, and also by the U.S. Federal Reserve who in a February 2018 presentation identified Canadian housing as so overheated that it exceeded their “Evidence of Exuberance Scale.” The IMF and U.S. Fed were looking at Canada as a whole. Vancouver and Toronto are well above the Canadian average.
On March 11th of 2018, the Bank of International Settlements (BIS) issued a warning that the “indicators” they use to predict financial stress are flashing red for Canada. Most recently, in March 2019, they shone a spotlight on the high debt levels seen in Canada and Australia. Likely as a result of people stretching their finances to buy homes. Did we mention prices of houses in Sydney and Melbourne have dropped 10% and 9% respectively in the past year? It appears that the foreign money that caused their housing crisis has retreated.
Based on BIS’ analysis Canada has a better than 50% chance of a financial correction (BIS would call it a “stress event”).
They are concerned that we have a lot of debt relative to our income, that our regular debt payments are too high relative to our income, and that the situation will worsen as interest rates rise to their natural levels.
At the core of these warnings is a belief that people’s loans should not exceed their ability to repay them. As interest rates rise, repayment of debt will become more costly so the only way for Canada to improve the situation in the face of rising rates, is to borrow less. Since most Canadian debt is to support home purchases, this means smaller home buying budgets.
Cause for optimism
A risk event is, by definition, never guaranteed to happen.
In July 2008, the benchmark price of a Greater Vancouver house was $800,000 and today it stands close to $1.4 million. The growth in Greater Toronto has been less dramatic rising from $380,000 in July 2008 to $907,000 today.
Although the government’s intervention hasn’t succeeded in moderating house prices and mortgage debt, without its intervention over the past 10 years Canada would be in an even more precarious situation. It is hoped that the stress test enacted in January combined with rising interest rates will bring about a “soft landing”.
This article is important in the spirit of transparency because many in this industry avoid discussing the risk of home ownership, which we believe home buyers should be aware of. People should consider risks when borrowing money, but ultimately the only way to mitigate the risk of investing in a home is to buy it as a place to live. If you buy a condo and it drops in value between the purchase and the date when you want to trade-up to a townhome, the price of the townhome you’re hoping to buy next will have dropped in value too. If buying a home primarily as an investment, the short term market outlook is a much more important consideration.
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