Waiting for the Bubble to Burst

Making Sense of the Canadian Real Estate Market

The world’s leading bankers and analysts are closely watching the Canadian real estate market, chiefly hot markets in Toronto and Vancouver, trying to make sense of the perceived volatility that many speculate will result in a bubble and a subsequent crash.
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Recently, prices in Canada’s hottest housing markets have skyrocketed to record highs and though the government is taking action to cool these markets, there is still concern that these conditions will be unsustainable over the long term. While bubble conditions are certain, a crash is not guaranteed.

What is unique about the Canadian real estate market, especially in contrast to the United States is that, even if a bubble did exist in markets like Vancouver and Toronto, the reality is, while the market is certainly vulnerable, the impacts are more likely to be felt locally and perhaps regionally, as national averages would prevent the entire market from collapsing.

The Canadian real estate market is no stranger to booms, bubbles and recessions. In the 1980s and 1990s, lenders were relatively aggressive, which had a role in the failings of the market. As a result, lending behaviours were overhauled and legislation was enacted to prevent similar downturns in the future.

When the global financial crisis materialized in 2007 and 2008, the Canadian economy and markets like the Toronto real estate markets were just starting to regain strength from the struggles of the previous decades. These markets remained fairly insulated, partially due to an increase in foreign investment, and withstood the crash. Prices continued to rise and many speculated that these conditions would result in a bubble. The threat of a bursting bubble has long been a concern, especially in markets like Toronto and Vancouver where prices continued to climb for years.

In Vancouver, according to the Real Estate Board of Greater Vancouver, single detached homes have increased 33 percent in value in the last 15 years, going from $400 000 to $1.75 million since 2002. For many, these statistics are reminiscent of housing markets like Phoenix, Las Vegas and San Diego prior to the global financial crisis.

Between 2016 and 2017, construction permits in the province of Ontario increased almost 25 percent. During this time, a bubble was starting to form. Prices continued to rise and houses were selling higher than the asking price, leaving many people priced out of the market.

In October 2017, Swiss banking giant UBS ranked the Vancouver and Toronto markets in its international top five bad boy list, claiming that the risk of a bubble in these markets was more severe than in Hong Kong, Amsterdam and London. While there is no doubt that these markets are highly vulnerable, the severity of the fallout has yet to be determined.

According to John Mollenhauer, president and CEO of the Toronto Construction Association, the Toronto real estate market is likely to fall into a recession by early to mid-2020. “It used to be easier for economists to predict the cycles and there are a few reasons it’s been very difficult in recent years,” he said. These reasons include low interest rates, which have been intentionally maintained artificially by the government, initially used as stimulus but also in part to prevent the system from collapsing under significant Canadian debt.

Currently, Canada’s private sector debt to GDP is now 218 percent, which means a sudden change in interest rates could leave many Canadian homeowners unable to make their mortgage payments and could risk a catastrophe much like the one experienced by the United States in 2008. In the next year, almost half of Canadian mortgages are to reset, which could spell disaster for a number of individuals and families who are already stretched to the limit from a financial perspective. This will inevitably impact the strength of the Canadian economy and its various sectors including the housing market.

Despite the various factors influencing the Canadian housing market, Toronto remains an active market for new construction in the industrial, commercial, investment and residential sectors, specifically high-rises as they address the scarcity of land challenges that urban centres pose.

As Mollenhauer noted, “Toronto is one of the busiest construction markets in the world and arguably, for a time, it was the busiest construction market in the world,” with building permits continuing to be on the rise, especially for condominiums. Record numbers of condominiums are currently under construction and this is the segment expected to be hit with the most substantial price increases.

Vacancy in Canada’s hottest markets is still very low, though according to the 2016 census nearly 100 000 or 4.5 percent of all homes in the city remain unoccupied. After years of booming prices, prices are starting to correct themselves and as prices decrease, so too does the rate at which new listings are coming to the market.

One of the reasons for the price drop is the reduced demand for homes and this reduced demand is attributable to changes to mortgage restrictions or what is being called policy-based volatility. Tighter mortgage restrictions went into effect on January 1, 2018 and target the majority of potential homebuyers. The only people who are not impacted by the changes are those with enough money to make a cash purchase.

To buy a home, under the new stress test, homeowners are now required to qualify for mortgages based on either the Bank of Canada’s posted rate for a five-year fixed rate product or two percentage points higher than their contracted mortgage rate, whichever is higher. The rules have had a destabilizing impact on weaker housing markets that, unlike Toronto and Vancouver markets, were not in need of market cooling measures. Markets like Calgary, Regina, and Saint John were particularly hard hit, suffering collateral damage from these legislative changes.

These markets are likely to insulate the national market in the event that a bubble in the country’s hottest markets were to burst and if weakened, they stand to bear the brunt of a national housing market crash. This is likely to be exacerbated by the fact that interest rates are likely to increase, which will further impact housing affordability, meaning that buyers and sellers alike will have to re-evaluate their homeownership goals.

In Mississauga, Canada’s sixth largest real estate market, declines are becoming the norm. In a market that is inextricably linked to the Toronto market, home sales have declined 30 percent while average prices have dropped 9.5 percent. The greatest struggle seems to be in higher-end listings, and the condominium market is the only market segment without a pronounced decline.

Many people are starting to see the market soften and while buyers are on the hunt for improving prices, sellers are having a hard time accepting the lower value of their homes. Having seen what their house was worth only a year ago, some people are less inclined to list as they are attached to an anchor price that is no longer attainable. These trends are indicative that both buyers and sellers will have to readjust their expectations. According to the Canadian Real Estate Association (CREA), national home sales are down almost 14 percent year over year and had fallen to their lowest levels in more than five years as of April 2018.

The number of newly listed homes fell to a nine-year low, with listings down 4.8 percent and sales down 2.9 percent from March to April. In the Greater Toronto Area, home sales are down 33 percent. This year got off to a very slow start with CREA reporting that sales in all markets were down 60 percent, though 60 percent of these markets were considered balanced.

The confusion related to value stems from the fact that supply is constrained, interest rates are still relatively low, and there is still a compelling demand story, though the reality has shifted. Valuation depends on many factors, including services and amenities in the neighbourhood, transit access and market conditions of the time. In hot markets, unsatisfied demand persists.

The shift in the market not only has to do with natural economic cycles but also legislation that has been enacted to help the market incrementally correct itself from a bubble situation. Over the past year, as prices decreased, bubble conditions began to deflate, lessening the risk of the bubble bursting and mitigating the impacts of such an event.

Changes have been enacted incrementally to prevent the market from constricting. Recently, The Office of the Superintendent of Financial Institutions (OFSI) attempted to slow down the hot housing market by imposing a fifteen percent tax on foreign buyers who were believed to be driving down vacancy and driving up prices in markets like Toronto. In addition to the foreign buyer tax, in order to quell the boom that was taking place over the last couple of years, the Ontario Government instituted a number of changes, expanding rent controls, developing a plan to ensure property tax parity for new apartment buildings, and laying the ground work for municipalities to implement a vacant home tax.

While the actions of the various levels of government are having a positive impact on the market temporarily, there is still optimism that prices will return to strength once the new market conditions are adapted to, which means the market is not out of the woods yet regarding the return of bubble conditions.

Looking at the figures, there is no doubt that the Canadian real estate market is vulnerable and that bubble conditions exist; however, an exact timeline and the severity of the fallout has yet to be determined, especially as governments intervene, market conditions change, and as prices return to strength in Canada’s hottest markets. It’s certainly a market to watch.

Waiting for the Bubble to Burst

The world’s leading bankers and analysts are closely watching the Canadian real estate market, chiefly hot markets in Toronto and Vancouver, trying to make sense of the perceived volatility that many speculate will result in a bubble and a subsequent crash.

July 22, 2018, 10:36 AM EDT