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Executive Summary

Canada's housing market is currently undergoing a rapid boom and its government is taking aggressive measures to curb its pace in an attempt to avoid the formation and consequent eruption of yet another housing bubble. In addition, high momentum of construction activity and an inability on the part of the government to increase borrowing costs is further adding to the problems. Meanwhile, after five years of a severe economic recession, the U.S. housing sector is demonstrating signs of recovery amidst low mortgage rates and high new home and pending home sales. Furthermore, the good operating results shown by homebuilders like KB Homes (NYSE:KBH), Lennar Corp. (NYSE:LEN), and Hovnanian Enterprises Inc. (NYSE:HOV) in their recent earnings' releases, have streamlined the recovery phase of this sector. Given these two distinct market outlooks, a possible trading strategy might be long U.S. homebuilders and short Canadian Residential REITS or mortgage lenders.

Canadian Housing Sector

Escalating house prices and low interest rates have contributed to a real estate boom in Canada from the past few years. The Canadian government is trying to take concrete steps to cool the country's housing market, even at the expense of slower economic growth, to avoid the development of a housing bubble. However, while doing so, the government is trying to avoid interest rates' increase amidst global financial malaise. In addition, if borrowing costs rise, the borrowers who have taken high debt at the ongoing low interest rates won't be able to payback.

According to the Bank of Canada, the biggest domestic risk to the Canadian economy is the high amounts of household debt, as the debt-to-income ratio surged to a record-high level of 152%. This level is similar to what was seen in the U.S. before the end to the housing boom. It is also worth consideration that the fraction of Canadian homes that would be exposed to an adverse economic shock is at a nine-year high level.

Recently, Canada's Finance Minister Jim Flaherty announced the following adjustments to the rules for government-backed insured mortgages so as to avoid the housing bubble:

  • Reduction in maximum amortization period from 30-to-25 years.
  • Decrease in maximum borrowing amount from 85%-to-80% of the value of borrowers' homes.
  • Government-backed mortgage insurance is limited to homes worth less than C$1 million.
  • Debt payments to be capped at 39% of income.

Previously, mortgage insurance rules have been tightened three times since 2008. According to the Canadian Real Estate Association, national average resale housing prices reduced after every move, but then rebounded and continued their incline.

The tightening of mortgage rules is also expected to reduce the pace of construction activity in Toronto where there are more skyscrapers under construction than any city in North America. Next year, the number of completed condominium units in Toronto is expected to be double the five-year average, which shows the current outlook of the housing sector in the city, and the possible need of reforms to prevent the development of a bubble.

U.S. Housing Sector

In the U.S., the facts that new-home sales have recently touched their two-year high levels, along with record-low mortgage rates, have raised expectations of a possible housing sector recovery after a long period of downturn following the subprime mortgage crisis. Bloomberg reported that: "the Washington-based National Association of Home Builders/Wells Fargo sentiment index rose by 1 point" last month, which is "the highest level since May 2007." In addition, the May pending home sales index have also increase by about 6%, a two-year high level. All these are positive signs of improvement in this sector.

Recently, latest quarter's earnings' releases by some homebuilders like KB Homes , Lennar Corp. and Hovnanian Enterprises Inc. are leading us to the same conclusion. Even KB Homes, which was earlier one of the poor performers in the industry, illustrated an increase in net orders, deliveries, and quarterly backlogs, along with a reduction in the order cancellation rate, which are all good signs for a homebuilder company. LEN and HOV also exhibited similar trends in their recent earnings' releases.

Trading Ideas

To play with the potential Canadian housing bubble, our advice is to long one or more of the following U.S. homebuilders' stocks: Lennar Corp., Toll Brothers (NYSE:TOL), DR Horton (NYSE:DHI), and KB Homes in decreasing order of preference.

We have various potential shorting stock ideas as part of the portfolio completion:

Residential REITS

Canadian REITS have recently rallied to five-year high levels. In the booming Canadian housing market, those residential REITS, whose cash flow yield trails the dividend yield, can be good potential shorts:

BOWFF.PK

NPR-U:CN

Dividend yield

3.26%

4.65%

Operating Cash flow (C$ million)

25.55

-7.3

Market Cap (C$ million)

3064.58

1126.73

Cash Flow Yield

0.83%

-0.65%

Its dividend yield of 3.3% trails the cash flow yield of 0.8%.

  • Northern Property Real Estate Investment Trust (NPR-U: CN)

Its operating cash flow is negative and so its cash flow yield is also negative (-0.7%). Dividend yield is way above that (4.7%).

Mortgage Lenders

Mortgage Lenders are good shorting options because in case of a default, they are going to lose money even if they are insured. Some of the potential shorts in this sector could be Home Capital Group Inc. (HCG - CN), HOMEQ Corporation (HEQ - CN), and Equitable Group Inc. (OTC:EQGPF) etc. In the short-term, these non-bank lenders are expected to benefit from increased product and higher quality customers as new stringent lending standards may drive clients away from commercial banks. However, we recommend them as potentials shorts from a longer-term perspective, considering the housing bubble will burst after its ongoing development.

Other Options - Brookfield Asset Management (NYSE:BAM)

Another potential short, which is also listed in the U.S., is Brookfield Asset Management , whose one business includes investment in property. It owns and manages office properties, develops residential communities, and offers financial and advisory services. It is currently trading at a price-to-earnings ratio of 21x, while the industry average is 15x.

Conclusion

To reiterate, the Canadian government is currently trying to curtail the boom in the housing sector so as to prevent another major crisis. In addition, the rebounding of the U.S. housing market has given traders an option to take positions and bet for the housing bubble to burst in Canada.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: The Way To Play Canadian Housing Market Bust