Canadian Housing: God’s Gift to the World

by JT McGee

Just a few years ago Canadians laughed as Americans tolerated a financial crisis, high unemployment, low minimum wage, and a President who could hardly put a sentence together.

They mocked America’s banking system for failing in the realm of conservativism, pointing to Canada’s strong “big five” banks as experts in safe mortgage lending. Canada’s housing was perceived to be God’s gift to the world; something that could never go down in value, despite being just as overpriced as American housing.

For what it’s worth, Canadians are still in the lead in terms of wealth. According to a report, the net worth of the average Canadian household in 2011 was $363,202, compared to around $320,000 for Americans. What put Canada on top? Housing, of course!

Real estate held by Canadians is worth more than $140,000 more on average and they have almost four times as much equity in their real estate investments.

The Difference Between American and Canadian Housing

Go through all the rules and regulations on American housing and then those of Canadian housing. You’ll find small little differences like requirements for down payments, or the simple fact that Americans have access to 30 year fixed loans and Canadians do not. These tiny little things are just that…tiny little things.

America’s housing burst was propelled by the negative amortization loan, which once issued in mass and refinanced all at the same time, would result in tons of foreclosures all at the same time. The media often refers to negative amortization loans as adjustable-rate mortgages. Negative amortization loans are ARMs, but ARMs are not negative amortization loans. Squares are rectangles, but rectangles are not squares – you get the idea.

A negative amortization loan is one in which the principal goes up with each payment. When all the negative amortization loans were up for refinances at higher rates and higher principal amounts to people who could not afford an actual amortizing loan, the housing market collapsed as homes were quickly sold by those needing to escape. Those who couldn’t sell went into foreclosure. Then the housing market went into free fall.

Canadian Housing Lacks a Catalyst

The American housing bubble had a built-in needle, a catalyst in the form of negative amortization loans. Canadian housing does not have that catalyst. It doesn’t have a bunch of negative amortization loans outstanding. It doesn’t have a bunch of loans made to people with no jobs, no income, or no assets. Canada’s lenders, as any Canadian will happily tell an American, are far more conservative in their lending practices.

But just because Canadian banks lend only to people who “can afford their homes” doesn’t mean that home prices are justified. Sometimes people can “afford their homes” only because home prices are going up.

As I talked about on Monday, we all basically work for the housing sector. In the United States and at the height of the bubble, Americans withdrew home equity worth 8% of their annual income year after year. Therefore, a not so insignificant amount of all American spending from 2002 to 2008 was financed with home equity – home equity from overpriced homes.

In Canada, I’ve found that “every $1 rise in the price of a house has an economic impact equivalent to 6 cents’ worth of increased consumer spending.

The same article also says that while lines of credit are 85 times higher in Canada today than in 1980, personal incomes grew by a multiple of 3 during that period.

I could not find a source for home equity withdrawals in Canada, unfortunately, but these statistics reveal that Canadians are funding purchases with home equity. The Bank of Canada does say the following in a report about household debt:

In 1995, secured PLCs represented about 11 per cent of consumer credit; by the end of 2011, this share was close to 50 per cent. It is likely that the factors contributing to the growth in home-equity borrowing…led to stronger growth in total consumer credit than would otherwise have occurred.

I also found this chart, which shows the value of Canadian resales as a percentage of GDP:

If Canadians cannot get a loan from the bank against their home equity, they’re clearly quite capable of selling their home to someone and extracting the equity that way.

My point here is to simply demonstrate how easy it is for Canada’s home equity to flow into every other facet of the economy without aggressive lending practices. I think I’ve done that; Canadian consumption is propelled by the tailwinds of ever increasing home prices.

The loans we make are unimportant – a distraction. The extent to which we rely on housing for economic growth is important; it should be the focus. No matter the loan type, Canadians are using their home equity to spend just like Americans were.

Reality Hurts

Canada’s housing prices are entirely out of whack on the basis of price to rents. Right now, Canada’s price to rent ratio is 76% higher than the historical normal average. Just like we saw in the American housing bubble, the worst ratios are in the most densely populated parts of the country.

Here’s an index of prices relative to rents in Vancouver, for example:

Vancouver is the most overheated market. I want to stress the point that it is in the most densely populated areas (like Vancouver) that housing is the priciest. This is important.

In the most densely populated areas you find the priciest homes, and where you find the priciest homes, you find the areas that have the highest share of construction employment. Hence, you find the areas that will have the worst unemployment if housing prices dip. Alternatively, you find the most people who can afford to buy a home only because they are employed in the business of building homes.

Think about that for a second. Housing booms fuel themselves. People who make a living building homes can afford to buy a home only because they are employed in building homes because home prices are expensive. Infinite loop, engaged.

You can see a very clear relationship between sky-high housing prices and construction employment:

Construction employment is a derivative of housing prices, and interestingly, also a driver of housing prices. It’s a double whammy when construction slows – fewer people can afford their homes, economic growth dips, employment dips, and naturally this happens right about the time that housing prices take a dip, slowing everyone else’s ability to consume with money from home equity.

Just one Tremor

As I said before, Canadian housing lacks a visible catalyst necessary to send its home values to more reasonable levels. I really do believe that the Canadian bubble will burst; it is not a matter of “if,” but a matter of “when.” Given that Canadian economic growth is so levered to housing, it’ll take only a small shake of the housing market to kick off the correction. From there, I think we can expect construction employment, housing price ratios to rents, and GDP growth to turn downward – a chain reaction of economic contraction.

Yesterday the IMF did warn that it was worried about Canada’s future economic prospects citing slowing housing and record levels of household debt.

Canadian housing wasn’t picked as some anomoly in global economics. It just lacked a catalyst for correction. It still lacks that clear catalyst. The American boom was a ticking timebomb with negative amortization loans acting as the timer. We had something embedded in our housing bubble that made us realize how ridiculous our home prices were. Canada does not.

Just give it time. Canada’s sky-high household net worth and incredible ever-increasing real estate market has to return to the mean…eventually. Would I bet on a correction? Absolutely! I’m already looking for that bet.

{ 19 comments… read them below or add one }

Financial Uproar October 14, 2012 at 22:07

Canadian real estate is more bubbly than a case of Dubble Bubble. And this is coming from a Canadian who owns multiple properties. I agree with all of this, and I’ve been pounding the table on this for years.

I think the condo market in Toronto/Vancouver is going to be the epicenter of all this. I was just in Toronto, and there’s condo developments everywhere. There’s a huge glut of units that’ll enter the market in the next two years. I spent the better part of a day searching for a publicly traded condo builder, but I couldn’t find one.

What’s the best way to short the market? I have a few ideas:

Canada’s third largest real estate brokerage, Royal LePage, trades on the TSX. (BRE) The other 2 (Century 21 and Remax) are everywhere, they can whether a downturn in the Canadian market. Royal LePage barely makes enough to cover their generous dividend.

Home Capital (HCG: TSX) is Canada’s largest B lender. The vast majority of their loans are not CMHC insured. Most of their loans do have 20% (or more) equity, but that can evaporate quickly.

Also, I’m currently researching MCAN Corp (MKP:TSX) which is one of Canada’s only publicly traded mortgage REITs.

If you do find a way to play this, write a follow up post. I’d like to hear your thoughts on it.

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JT McGee October 14, 2012 at 23:10

From a quick look at BRE’s annual report I already like what I see – huge financial leverage (with adjustable rates!), debt covenants to enforce technical default, fixed royalties based on number of real estate agents, and 63% of their royalties come in from fixed royalties per agent so any decrease in the number of agents will seriously cut royalty payments to the company. The dividend is annoying for a short trade, but if they have to cut it, it could provide some serious leverage for the equity on any bad news.

Their own chart on page 19 shows just how well real estate agents and home values correlate.

I’m going to poke through BRE more. Definitely the most interesting of the list, IMO. Thanks for this – I’ll be sure to let you know if I make a move on it.

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Martin October 14, 2012 at 23:53

Hey JT, great piece man. You’ve really done your research here. I actually own two condos downtown Toronto and have noticed that the rent has gone up once again. I’m now charging $1,450 to rent out a one bedroom, bare bones condo.

In your opinion, what would you do in this situation? Would you continue renting? Would you sell ASAP?

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JT October 15, 2012 at 10:24

Thanks, Martin – this post was actually a few months in the making. I just kept finding more and more data points that I wanted to include and couldn’t find a good place to stop adding to it.

Personally, I regard the price-to-rent ratio as the most important thing in real estate. Historically and all around the world, it has been a guiding light for finding under- and over-valued real estate. It’s also tipped off many recessions, credit events, and housing bubbles in a ton of international markets.

A little more information is needed here. Given the price to rent ratio in Toronto, I don’t see how you stand to make money on rental real estate in the current environment. If I were banking solely on appreciation for income, I would sell. If my properties were cash flow positive at all reasonable rates, then I’d hold on. It comes down to what you’re in the market for. Canadian housing is tricky because you guys don’t have fixed rates for the life of the mortgage.

What’s your cash flow look like if mortgage rates go back to 5%? More importantly, what do Canadian finances look like if rates go up, period?

Have you seen the US price to rent ratio chart? http://therealdeal.com/wp-content/uploads/2012/02/PriceRentNov2011.jpg The reversion to the mean is pretty incredible.

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Squirrelers October 15, 2012 at 22:50

Totally agree on the Canadian bubble, and I’ve thought this for the last couple of years. I know a few folks in Ontario, and on a visit just a few years ago, I was surprised at how expensive housing was. More than that, I was surprised by the run up in prices, as well as some of the things I heard about how expectations with some were that prices would continue to rise at these annual rates. While the underlying fundamentals might be a bit different, and the macro environment a bit different, the mindset had eerie similarities to that of the U.S. not that long ago.

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JT McGee October 19, 2012 at 12:31

Thanks for sharing that, Squirrelers. The mindset is so incredibly important. I still have magazines like Smart Money and Money magazine from 2004-2006 that have cover stories about ever rising real estate and how to get rich in real estate. It’s funny to look at them now, knowing full well how that all panned out for the United States.

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Darwin's Money October 16, 2012 at 09:19

These are some really great (and scary) charts and data. I’ve seen my share of Canadian bloggers deriding the foolish Americans and their housing bust, but it’s looking like they’re approaching an unavoidable crash as well. Theirs may be more muted and controlled, but a correction certainly appears to be in the works in the large cities.

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JT McGee October 19, 2012 at 12:34

Yeah, I’m a big believer in the idea that housing cannot diverge from its fundamental value (the cost of rents) for a very long time. Eventually, it has to correct. Either through years and years and years of rising rents and stagnant housing (unlikely) or falling housing prices and rising rents (most likely, in my opinion.)

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PK October 16, 2012 at 11:00

You’ve played this game, right?

There isn’t much to add to this great analysis, but on the Vancouver front… I believe the ‘needle’ is a slowing Chinese economy. Considering the number of rich Chinese expats purchasing property in Vancouver (a similar dynamic is in effect in the Bay Area, it’s just not as prominent), or even people still living in the mainland buying houses abroad, China is definitely helping the bubble along.

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JT McGee October 19, 2012 at 12:33

Best game on the internet!

I don’t know how to place Vancouver’s relationship to Canada exactly. I mean, a lot of the money flooding in there is Chinese, so it has some relationship to Chinese economic growth. Given how many “new rich” Chinese are rich because of some ill-gotten economic power from Chinese government contracts, etc. I don’t know if that gravy train into Canada will stop with a Chinese slowdown.

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Echo October 19, 2012 at 21:18

I’m not really sure what will happen. All signs certainly point to a big correction. According to the CBC, the average house price in Canada is $355k (http://www.cbc.ca/news/interactives/housing-canada/), but Vancouver is at $736k and Toronto is at $509k. Those are the two markets that are really overheated. The question is, can these two huge markets crash without sending the whole country into a tailspin? Probably not.

The gov’t already made some moves to tighten lending standards for mortgages and HELOC’s. That seems to have cooled things off a bit. The only catalyst I can see tipping this into major trouble is an interest rate hike…which isn’t likely to happen while U.S. rates remain near zero.

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JT McGee October 20, 2012 at 14:27

Yeah an interest rate hike is most definitely the kicker – no ifs, ands, or buts about it. Like you, I also find it relatively improbable that Canada will raise rates any time soon.

I just wonder what happens when industries fueled by real estate no longer have those tailwinds. People work in construction because they know construction – where do those people go when construction work is unavailable? Generally speaking, what happens when home-equity fueled consumption no longer exists because Canadians tap their home equity to the full extent that banks are willing to let them.

I think there are more triggers than interest rate hikes, though an interest rate hike would absolutely send real estate valuations lower by necessity.

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qmanrei October 20, 2012 at 11:06

Hi JT,

Saw this from TFB blog. This is a good start with regards to a comparison of different us vs can markets. Just a few more things to consider.

Price to rent ratios aren’t a good measure to use as a way to show a market is overvalued. I remember a similar report a year ago out of UBC. Think about rents in rent controlled environments like Ontario. At least rents can change on tenants turnover but rents are artificially kept down. Even more so now that the prOvincial governments have capped rent increases.

Loans in Canada ( – Alberta) are all recourse loans while in the USA they are mostly non-recourse. Hence the jingle mail phenome.

Also mortgage defaults have and continue to be extremely low below 3 %. Even when the media yells and screams that the default rate has increased 1/3 rd. compare this to the us.

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JT McGee October 20, 2012 at 14:20

Hi qmanrei,

Capping rent increases should only serve to cap the value of property. Intrinsically, a piece of real estate is equal to the NPV of future cash flows. Apparently rent caps are not capping appreciation.

Help me understand how much nonrecourse lending really matters. Does it? Student loans are nonrecourse in the US but there are still millions upon millions of borrowers in default. I don’t see how the fact that loans are nonrecourse would have any impact on justifying property values.

Defaults and delinquency rates were quite low in the United States during the bubble years because people who were in trouble could just sell their home and repay their mortgage. Defaults and delinquencies do not rise until you have a serious change in the price of real estate. Given that home prices are going up in Canada, I would not expect defaults or delinquencies of any magnitude. If the market reverses, and the rate of home sales (liquidity) falls, I would expect far more defaults and delinquencies – especially from people working in the housing sector.

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qmanrei October 20, 2012 at 23:07

Hi JT,

Well I don’t see the US and the Canadian market the same in the big picture. Real estate cycles are local and not national, but have influencers that are caused by big changes or problems. Yes condos in downtown Toronto are out of wack and if supply isn’t curtailed then there will be drops in prices. But for single family homes the supply does not meet the demand or is barely meeting the demand in many markets around and in Toronto.

Yes there is higher debt in Canada with access to cheaper credit but there are more assets being purchased, hence the increased net worth correlation you are making about Canadians over that period of time. Also Canadians exposure to variable rates as compared to our American friends, and the length of time that these loans are locked in are different. Right down to the amount of equity that Canadians hold in their homes as opposed to American homeowners is different. The average Canadian with a mortgage has 49% equity in their home.

If you don’t pay your mortgage in Canada your car, your boat, your wages can be used as part of collections. Foreclosure doesn’t excuse you from the debt.

I was wrong about the mortgage arears rate in canada. The highest it has been is 1.02 percent in 1983, not 3 percent. I won’t go into the mainstream media, the world is ending headlines when that increase by 33% in 2009. (0.8 percent or approx) Also 70% of mortgages in Canada are insured, as compared to 15 % in the US.

The government has stepped in way too many times to cool down the condo markets in Vancouver and Toronto by applying rules for the rest of the country. The latest was changing Amortization rates to 25 years essentially for first time home buyers. And now reducing the amount of HELOC you can access from banks to 65% LTV down from 85%.

I’m a proud Canadian and am tired of being compared to the US market. It’s like comparing Apples to Back Bacon -eh.

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qmanrei October 20, 2012 at 23:17

Now if I could only convince more Canadians to stop buying American property assets. For the last 3 years there has been an onslaught of Florida, Texas, Arizonan and every other state buy property because its cheap. I wonder what percentage of the Canadian Networth is being put into American housing assets? Then maybe we are in some real trouble.

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JT McGee October 20, 2012 at 23:36

I don’t think your banks are going down. I don’t think you’ll have a financial crisis to the extent that we had in the United States.

However, consumption powered by home equity and employment amped by construction doesn’t last forever – and these two variables affect virtually everything in an economy driven by consumption.

I’ve heard time and time again that “this time/place is different” and it never works out that way. As a real estate investor, I’m sure you’re heavily invested in keeping up confidence in the property markets. Best of luck, but I’d bet my last dollar any investment in American housing proves to be a much better investment than Canadian housing going forward.

qmanrei October 21, 2012 at 08:46

Hi JT,

All real estate goes through cycles some influenced by governments or financing practices or both, or other external influencers. Having gone through enough cycles in my life to see them has been key. US or Canadian real estate is not a good investment, you need to look at the opportunity locally. Even through the housing bust there were cities that were still appreciating in the US. Know the economic fundamentals of the local area.

I could care less whether people buy or sell real estate. I’m just tired of reporters and pundits in the mainstream media scream that the sky is falling. When they having been saying the same thing since 2009. And eventually they might be right. If you say the same thing long enough.

In 2009 our ultra-conservative financial banking system looked great compared to the rest of the worlds system. Ask any Canadian if it is easier or harder to get a mortgage today. If anything or system has become even more conservative.

I’m going to do something very un-Canadian. I’m proud of our financing, economy, and housing sector. Yes “God’s Gift to the World”

Have a great day!

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SavingMentor October 21, 2012 at 18:52

Great article JT. I love all the research you did for it to back it up. Fortunately, I live in a smaller market where house prices are typically more stable. They have been rising just the same and could definitely fall during a correction, but hopefully not plummet like it sounds like will happen in Vancouver and Toronto if things go bad.

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