U.S. - Canada Housing Update
In our previous article, we suggested a strategy to play on the potential eruption of the housing market bubble in Canada. The country is undergoing a real estate boom for the past few years as a result of rising home prices and low interest rates, which the government has been unable to raise amidst a worldwide financial meltdown and fears of borrowers' default. As an alternative measure, the government has tightened mortgage rules to curtail the pace of housing activity. Meanwhile, the U.S. housing sector is showing signs of a potential rebound, and its homebuilders are posting good operating results lately. Consequently, we recommended a strategy of taking a long position in U.S. homebuilders and a short position in residential REITs or mortgage lenders in Canada.
After the tightening of mortgage rules by Canadian Finance Minister Jim Flaherty, which caused a reduction in loan-to-value ratio from 85% to 80%, along with a decrease in maximum amortization period to 25 years from 30 years, the condominium market in Toronto has experienced a severe dip of 18% in YoY sales in June. The overall home sales in Toronto decreased by 5.4% in June as compared to the last year, while prices of condo units have increased by 2% over the same period.
Even if the housing bubble doesn't burst, due to the government's belligerent efforts to reduce the rapid pace of the market, these stringent standards are expected to have a "dampening effect" on the economy and the residential real estate market. Whichever way the pendulum swings, we expect the Canadian housing market to moderate during the rest of 2012. So, we still recommend taking short positions in Canadian Residential REITs like Boardwalk Real Estate Investment Trust (BEI-U:CN) and Northern Property Real Estate Investment Trust (NPR-U:CN), whose cash flow yields are less than their dividend yields.
Mortgage lenders can also be good potential shorts, but only if an investor feels that despite the government's efforts to cool the housing market, the eruption of the housing bubble is inevitable. Otherwise, in the short-term, these mortgage lenders (like Equitable Group Inc. (ETC: CN) and HOMEQ Corporation (HEQ: CN)) are expected to perform well amidst new tight lending regulations.
In addition, the U.S. construction sector has exhibited YoY job growth for the tenth consecutive month, primarily due to a growing housing sector. Plus, with new-home and pending-home sales surging to two-year high levels, low mortgage rates, and construction spending mounting to more than two-year high levels (due to a rapid increase in residential construction spending primarily), we continue to remain optimistic about U.S. homebuilders. We reiterate our recommendation of taking a long position in U.S. homebuilders, preferably Lennar Corp. (LEN), Toll Brothers (TOL), DR Horton (DHI) and KB Homes (KBH), in a descending order.
In conclusion, we feel that the Canadian housing market is going to slow down, either due to the bubble's eruption, or due to the government's intervention. Plus, the U.S. housing sector is showing healthy signs of improvement after the disastrous aftermaths of the 2007-08 financial crisis. Hence, we recommend shorting Canadian Residential REITS (or mortgage lenders) and going long U.S. homebuilders.