Canada's Brewing Real Estate Storm
Perhaps it's best to start with the good news. The sudden slowdown in Canada's housing market in recent months could simply turn out to be a hiccup. The carnage racking REAL ESTATE markets around the world might yet spare this country similar pain. And tighter lending standards affecting first-time homebuyers might not knock the foundation out from beneath Canadian house prices. Or maybe, after living through one of the wildest housing booms this country has ever seen, the whole bonanza could be about to completely unravel. For nervous homeowners sitting on a lot of pricey real estate, it's increasingly difficult to tell if the glass is half full, or completely empty.
Until very recently, Canada's real estate sector looked like it would weather the current economic storm and emerge more or less intact. The boom certainly rewarded homeowners, at least on paper. Double-digit annual growth in the value of the average home over the last six years meant that, at their peak in the spring, residential properties in Central Canada were worth 74 per cent more than at the start of the decade, while in the West home prices jumped by more than 130 per cent. There was plenty of talk about a slowdown. But thanks to our relatively strong economy, most economists predicted house prices would hold up.
Few were quite prepared for what happened next. In June, the average price of existing homes in Canada's major markets dipped 0.4 per cent from the year before - a tiny slip, but the first decline in nine years, and quite possibly the first major crack in the edifice of Canada's real estate market. Then, like a series of bad sequels to a horror movie, the market continued to fall in July, and then August. As of last week, when the Canadian Real Estate Association reported the average price of homes in major markets was $316,052, prices were already down 7.3 per cent from where they were in June. At the same time sales volume has tumbled, leaving many city streets cluttered with "For Sale" signs for the first time in years. In western markets such as North Vancouver, the inventory of homes for sale on the Multiple Listing Service website has doubled in the last six months. And in Edmonton, where prices in July fell 5.3 per cent from a year ago, the city's real estate board felt compelled to urge calm. "Edmonton's resale housing market is not 'plunging,' " the board said in a terse statement. "There is no cause for concern." Of course, when you issue a press release insisting there's no reason to panic, that's often a reason to panic.
Those who share the realtors' optimistic outlook are a shrinking bunch. Merrill Lynch economist David Wolf recently published a biting analysis of the housing market that predicted not just a slowdown, but significant price declines in many cities, particularly in the West. On a national basis, Wolf says houses are 9.2 per cent overvalued, while markets in Vancouver and Victoria are inflated by as much as 35 per cent. As for Regina and Saskatoon, a doubling in house prices over the last two years has put those cities into the "extreme zone," says Wolf. His findings were echoed late last month in a report by researchers at the University of British Columbia's Sauder School of Business, which found housing markets in many Canadian cities are seriously out of balance when compared to rental rates. While housing markets in Toronto and Edmonton appear sound when compared to rents, in cities such as Halifax, Montreal, Ottawa, Regina and Winnipeg prices must drop at least 25 per cent in order to be in balance. "Nobody likes to see their property values go down, but those values are inevitably tethered to economic reality," Wolf told Maclean's. "The reality is that after a wonderful few years, we've finally reached the end."
For now, Wolf and others like him are in the minority. The warnings stand in stark contrast to the repeated assurances of realtors and bullish economists, and the ubiquitous armchair experts you tend to meet at dinner parties. The two most common and reassuring explanations for this have been echoed a lot lately. First of all, the argument goes, Canada will not experience a U.S.-style housing crisis because our mortgage industry was more conservative and restrained. Secondly, even if the current slump continues, it won't be as severe as downturns that happened in the late 1980s, because interest rates are expected to remain low. Both statements have been repeated so often they're regarded as absolute fact. But a closer look at the realities of Canada's recent housing boom, say experts, shows holes in both arguments. It's becoming painfully clear that the party has ended. The question is how bad will the housing hangover get, and how long could it last?
In the future, when the U.S. housing crisis has long since passed and people try to convey how bad it was, they can tell stories about the little house in Detroit that sold for $1. The three-storey home, a few blocks from the city's downtown airport, was sold for $65,000 in 2006, before the housing market began to collapse. Then, last year, the bank foreclosed and the family living there was evicted. Vandals soon stripped the home of its siding, copper tubing and furnace. The bank, faced with back taxes and outstanding utility bills, dropped the price to $1 in July. Even then, it took 19 days to find a buyer.
Such stories have come to epitomize the carnage under way in the U.S. housing sector. The subprime mortgage debacle is well into its second year, and the fallout is showing few signs of letting up. Millions of individuals with poor credit took out subprime mortgages to buy homes. Many of those mortgages came with extremely low rates that reset after two years, by which time mortgage rates had climbed. Unable to keep up with their payments, millions faced foreclosure. The flood of foreclosed homes onto the market drove down the property values for everyone, including those who were making their payments. Since July 2006, U.S. house prices have fallen nearly 19 per cent, as measured by the S&P/Case-Shiller index of 20 urban markets. In some places, whole suburbs have taken on the look of modern ghost towns, with dozens and even hundreds of empty, foreclosed homes.
There's no question there are significant differences between the U.S. bloodbath and the situation facing Canada. It's just that the gap isn't as wide as some might believe. The good news is Canada never had a huge subprime market. In the U.S., more than 30 per cent of all mortgages issued between 2004 and 2006 fell into that category. Up here, subprime loans never accounted for more than five per cent of the market. That does not mean, however, that Canada's mortgage sector has been a bastion of responsible conservatism. Canada found other ways to make it easy for homebuyers to take out huge loans that they might not necessarily be able to afford.
For Larry Smith, professor emeritus of economics at the University of Toronto and a long-time real estate watcher, the moves by the Canada Mortgage and Housing Corporation in recent years to loosen lending standards have created a ticking time bomb in the housing market. In 2004, for instance, the federally owned mortgage insurer allowed homebuyers to take out loans with no cash down payment whatsoever. Two years later CMHC extended the maximum amortization period for mortgages from 25 years to four decades. At the time, former Bank of Canada governor David Dodge warned the lax terms could spark inflation. In July the government backtracked, limiting mortgage terms to 35 years and requiring down payments of at least five per cent in an effort "to reduce the risk of a U.S.-style housing bubble." But according to Smith, the damage may have been done. By some estimates, three-quarters of all mortgages over the last two years were at 35- to 40-year terms. That's a sign, Smith says, that homebuyers are stretched to the limit. What's more, when it comes time to refinance their mortgages, there's no guarantee even the 35-year amortizations will still be there, meaning borrowers could face higher rates. "It sounds elitist, but it's not appropriate to entice people into thinking they can afford home ownership by giving them enticements that may not last," he says. "The circumstances here are a foggy mirror of the U.S. Not as bad but nevertheless in the same direction."
Homebuyers who opted for the longer-term mortgages could also face problems if house prices continue to fall even modestly. It can take years to put a significant dent in the principle of a 40-year mortgage, experts say. That means some owners have next to no equity in their homes. Should the value of their homes fall by another five per cent, they could find themselves underwater. If that happens, they'll feel handcuffed and unable to sell. It doesn't take many people feeling trapped to weigh heavily on the market.
Add it all up, says Garth Turner, the Liberal MP and Canada's resident real estate doomsdayer, and the outlook for housing is grim. "If you want to look at where we're going to be in two years, look south," says Turner, whose latest book, Greater Fool, predicts a severe downturn in the Canadian market. "Right now there's a hate-on for real estate in the U.S. because it's a prison people can't get out of. We're still in the love phase, but we've seen lipstick on the collar and we're a little suspicious of what the hell is going on."
The great unspoken fear lurking in the backs of everyone's mind is the kind of collapse of house prices that followed the bubble of the late 1980s. It was certainly a zanier market than today, with national prices climbing at 25 per cent a year, compared to 10 per cent this time around. Also, when adjusted for inflation, prices haven't soared as high this time. The average single family home in Toronto peaked at $420,000 in 1989 whereas in July the city's average stood at $371,000. When the Bank of Canada jacked interest rates as high as 14 per cent to fight inflation back then, the party ended with a squeal of rubber and the sound of shattering glass. In a matter of months many homes lost more than half of their value.
Today interest rates are relatively low, at three per cent, and are not expected to rise significantly. But while this would seem to be positive for the housing market, that's not necessarily so, according to Merrill Lynch's Wolf. To realize why, it helps to understand the concept of housing affordability. In simple terms, it measures how easily a family earning an average income and paying current mortgage rates could afford a typical house on the market. When that hypothetical family can afford today's average home, the market is considered fairly valued. But housing affordability has deteriorated to levels not seen since the early 1990s. When house prices get out of whack, there are only four ways to turn it around again: falling interest rates; rising incomes; massive inflation; or outright house price declines. In the early 1980s inflation brought the market back into balance by effectively chipping away at house prices until they returned back to earth. In the early 1990s it was falling interest rates. The problem now, says Wolf, is interest rates are already near rock bottom, inflation has been kept in check, and a deteriorating economy means growth in incomes will be limited. That leaves only one option: falling house prices. "Even though the market isn't hugely overvalued, it may be that prices have to fall, on a nominal basis, more than after those bigger booms of the past," says Wolf. This downturn may not be exactly like those in the past, but that doesn't mean it will be any less painful.
Four years ago, Steve Throndson was a truck driver working in the oil sands and living in a $190,000 trailer home in Fort McMurray, Alta. Today, after catching the Alberta real estate bug, Throndson, 32, owns apartments and houses in Edmonton, Calgary and Fort Mac, including his original trailer home, now worth half a million dollars. "I think I'm up to 23," he says after a pause to sum up his burgeoning empire. "A little while ago I tallied everything up and I was worth about 10 years the annual wage of oil sands employees."
How has he accumulated so much, so fast? Leverage. By borrowing heavily against one property, he's been able to buy the next. Throndson wouldn't say how much he actually owes, but said he typically borrows between 75 per cent and 100 per cent of a property's value and always has enough rental income coming in to cover mortgage payments. It's a strategy that works well in up markets. But as even the most sophisticated real estate barons - think Montreal's Reichmann clan and their failed Olympia & York empire - have found, any significant downturn can cause such elaborate structures to go down like a house of cards. Even so, Throndson is now branching into a new market: pre-foreclosures, in which he teams up with partners to buy homes from owners who are at risk of defaulting on their mortgages. Every month he sees about 180 new cases. Just don't suggest to him that he's a real estate speculator. "I'm not a speculator at all," he says. "I call myself an investor. I study the fundamentals and I know that over the long term, real estate prices are going to go up because of Alberta's economic fundamentals."
If there's one thing that many experts have found reassuring about this latest run-up, it's that there didn't seem to be the excesses of past bubbles. For instance, Vancouver is said to have banished its condo-flippers thanks to a hefty land transfer tax, while real estate professionals have said the flurry of condo towers going up in Toronto is merely to meet renewed demand for urban living. But did the speculation really go away? Or has it just changed form? Hard and fast numbers are difficult to come by but experts say even a decade ago it was common for people to hold onto their homes for eight to 10 years. Today, young, first-time homebuyers think nothing of snapping up a condo and then reselling it two years later to upgrade to a larger space.
As any serious financial adviser would point out, buying a home with a two-year horizon is pure speculation that prices will keep rising, and that implies an important shift in mindset. "When you own a home, it's different than owning stocks," says Tom Vanderwell, who writes on the U.S. housing market at Straighttalkaboutmortgages.com. "There's the investment factor, but it's where you go every night, where family memories are created. You have all these emotional factors." Homeowners evaluate their needs, desires and finances, and make long-term decisions about where they want to live and how much they can afford. Investors make projections about asset values, interest rates and resale prices, all of which are inherently risky. But when the market is red-hot, the distinction blurs, and it doesn't take much for even a small slump to feed on itself and quickly spiral out of control as speculators dump properties to which they have no emotional attachment.
The grim reality south of the border continues to hang over Canada like a black cloud. And no wonder. Real estate is arguably more important to Canadian family finances than ever before. For one thing, more people own property now than at any time in decades. According to a recent report by STATISTICS CANADA, 68 per cent of Canadian households owned their own home as of 2006, the highest level since 1971. With more than a year of stunning home sales since then, that figure will have risen even higher. Real estate makes up more than $2.2 trillion, or 37 per cent of total household assets in Canada, up from 30 per cent a decade ago.
Canadians also rely heavily on their houses to finance their lifestyles. As of 2007 Canadians had an estimated $153 billion in outstanding debt they'd borrowed against the equity in their homes, according to the BANK OF CANADA, up from just $47 billion in 2001. That money paid for home renovations, flat screen TVs, family vacations and second properties. Without doing anything, Canadians felt wealthier because of the rising value of their homes. The problem is, that so-called "wealth effect" can work in reverse too. And it can have a devastating impact on the economy as a whole, dragging down even those who never even signed a mortgage.
One potential weakness is Canada's strong job market, often cited as a reason house prices won't fall. According to Wolf at Merrill Lynch, roughly 7.2 per cent of Canada's workforce is now in the construction sector, the highest it's ever been. This is a worry because many construction jobs are tied to the housing sector itself. For several years home construction has been plowing ahead far beyond demand and leading to oversupply, according to Dale Orr, an economist at Global Insight. Housing starts have hovered around 220,000 to 230,000 a year. Yet based on Canada's demographics, says Orr, housing starts should be in the 170,000 range to be sustainable. If construction slows to that level, the result could be layoffs on a large scale. A weak housing market will leave homeowners feeling poorer, but it also threatens to bleed into the broader economy, and vice versa, creating a vicious cycle.
Canadians need look no further than the carnage on Wall Street to see how fast a severe drop in house prices can spread, and how devastating the results can be. What started as some U.S. homeowners struggling to make payments on their subprime mortgages has mushroomed into a crisis that's forced venerable names like Merrill Lynch and Bear Stearns into takeovers, and Lehman Bros. into bankruptcy. True, our banks look solid compared to their U.S. counterparts. But with the global credit crunch, bankers are expected to tighten their purse strings, and that could strangle Canada's housing market and pummel the wider economy.
With Washington spending hundreds of billions to rescue the financial industry, that only heightens the anxiety here at home. Housing starts in Regina were cut in half last month; proposed condo projects in Toronto and Calgary have been shelved; and in Vancouver, one condo developer is offering to subsidize buyers' mortgage payments for two years as a way to fill unsold units. Even those closest to the action are losing faith that prices can stay afloat. "Realtors are a pretty optimistic bunch, but when there's a sales drop of this magnitude, there's no way people aren't feeling it," says Paul Boenisch, a real estate agent and blogger in North Vancouver who tracks Greater Vancouver's housing market. "Is there going to be a crash? I don't know. Are prices going to keep going down? I don't know. But if the trend of higher inventory and weaker sales stays the same, there's nowhere else that prices can go."
If the housing market is a barometer of where the economy is headed, the signs would suggest it's time to take shelter from the coming storm. That is, if the price is right.
Maclean's October 6, 2008