Canadian Housing Market: Party's Over

Summary

• Low interest rates and government stimulus have driven Canadian housing prices to record highs, stretching the marginal buyer to its absolute limit.
• Affordability is at 30-year lows and exposure to short-term interest rates at record highs, just as the Bank of Canada enters a tightening phase.
• I predict Canadian house prices will be up to 20% lower in two years time, and certainly no higher than they are today.

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The Never Ending Party

The Canadian Housing Market. The Never Ending Party. Where the drinks are free, the music is always on, and the neighbors never complain about the noise.

In the past 25 years, Canadian housing prices have more than quadrupled, doubling the pace in the US. But is the party finally coming to an end?

Sources: Teranet House Price Index, US Federal Reserve, Bank of Canada

What makes for a fun time in your mind? Food? Music? Friends?

How about a decades-long march towards 0% interest rates? How about record foreign investment flows? How about a $325B government deficit and the 3rd highest deficit-to-GDP in the OECD? The stimulus was so generous people earned more off of the Canadian Emergency Response Benefit (CERB) than they did "working".

All this leading to record-high savings, historically-low mortgage delinquency, and a 25% spike in home prices, making home owners filthy rich on paper and developers filthy rich in real life ... during a pandemic.

Now that's what I call a party.

Too Much Of A Good Thing

Unfortunately, like any great party, too many people have shown up. Now, the host is worried she won't be able to clean up all the damage before her parents get home ... or at least she should be.

In 2021, residential investment reached a record 10.3% of GDP (nearly twice the US peak) and housing affordability reached its worst level in 30 years. In Toronto, a high-income earner now needs 26 years to save for a downpayment, which at this party makes Millennials the annoying younger brother that was told to go to his room.

Notice the last time these metrics peaked was 1988 - 1991, just before housing entered a 10-year bear market.

Sources: Stat Can via Better Dwelling and RBC Housing Affordability Measures

And so with buyers teetering on the edge of their financial wherewithal, we might be seeing the first hint of distress: the popularity of variable rate debt.

Historically, Canadians have preferred to fix their interest rate over a 1- to 5-year period with the vast majority of those fixing for 5 years. Well, not anymore: more than half of all new advances have been variable rate the past two months, far more than any month on record.

Source: Stat Can

This is at least in part due to a decoupling of the variable mortgage rate from government yields. The Bank of Canada chopped the benchmark rate to 0.25% and has been holding there since March 2020. The corresponding mortgage rate also fell dramatically in March 2020 ... but has fallen by almost a full percentage point more since.

Source: Stat Can

We can see the spread in the long-term rate has been relatively range bound, while the spread in the short-term rate has narrowed 1.5%. This likely results from the record surplus of deposits at Canadian banks. When you have more variable liabilities, you need more variable assets.

Ghosts Of Rate Hikes Past

We don't need to look too far back to get a sense for what the current environment might portend. Below we compare the Teranet House Price Index with interest rates and proportion of term for the period 2015 thru 2019.

Timeline:

• 2015 to mid-2017: record low rates correspond with 31% increase in prices
• mid-2017 to 2019: increasing rates correspond with stagnated prices
• early 2018: a short-lived dip in the variable rate correspond with a spike in variable advances and these cheaper borrowing costs correlated perfectly with a short-lived rally in prices.
• late 2018: variable borrowing costs bounce back, leading to a peak in the RBC Affordability Index in October 2018 and flat prices.

*I included the implementation of the new qualifying rate above, but it doesn't seem to have had much impact. Like any government regulation, I have a strong suspicion that borrowers found ways around it.

Let's see how this compares to the current state.

Timeline:

• Mar2020 to Mar2021: record low rates corresponding with surge in prices
• Apr2021 to Aug2021: long-term rates jump higher while the short-term variable rate continues to fall. This leads to surge in variable preference and prices continue to climb.
• Sep2021 to now: prices have remained relatively flat, though for a short period. The increased qualifying rate may have had a small impact, offsetting further declines in the variable rate.

The story continues through to the date of writing, with most 5-year offer rates well above October and many variables well below.

Party's Over

To summarize, Canada finds itself with:

• the most economic exposure to residential real estate ever
• historically poor affordability
• record exposure to short-term rate changes

These are conditions more typical of the late business cycle, as interest rate increases put pressure on the economy. Instead, these conditions exist before the rate hikes have even begun.

To temper the negativity somewhat, the Canadian market has a number of supports in place that are likely to prevent a proper crisis:

• Many borrowers are comfortably locked-in at low rates. Even most variable mortgages are "closed", meaning they have a fixed payment. Only the marginal new buyer will be impacted by rising rates in the near term.
• Regulation of the Canadian banking industry is strong and should, in aggregate, protect against the "AAA"-rated Liar loans, NINJA loans, and Alt-A bombs that precipitated the US housing crisis.
• the Big 5 Canadian banks are generally well-capitalized and geographically diversified, including the largest international acquisition ever announced by Bank of Montreal (BMO) just last week. Interesting timing.
• "The Great Recession" probably became "Great" on the day Congress voted down the bank bailout. The hand-wringing about Too Big to Fail was absolutely justified, but in the moment only served to exacerbate the problem. Thankfully, Canadian taxpayers have already agreed to bail out the banks to the tune of ~$500B.

Still, housing prices are determined by the marginal buyer. If fewer buyers exist, fewer homes will sell at lower prices. In the next two years, the variable rate could easily increase 2% as a combination of:

• a 1% increase in the Bank of Canada benchmark rate
• a 1% reversion in the consumer mortgage spread.

That translates to a 30% increase in mortgage payments for the marginal buyer. This will absolutely impact housing demand, regardless of the qualifying rate.

One might argue that incomes could simply increase along with costs, but even a slight decrease in demand could have devastating consequences for housing-related incomes. And other parts of the economy are unlikely to pick up the slack ... because so few other parts of the economy exist.

And so begins the end. In two years time, I wager the Teranet House Price Index will be 0% - 20% lower than today ... certainly no higher and perhaps even lower that.

Investors should consider puts or shorts on the many Canadian businesses exposed to residential real estate, particularly non-prime mortgage lenders like Home Capital Group Inc. (OTCPK:HMCBF) and Equitable Group Inc. (OTCPK:EQGPF). Note they are both already down ~20% from all-time highs in the past two months. I will likely be assessing each in further detail in the future.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.