Canada’s weak economic performance during this past year elevated concerns about a severe housing market correction, with most concern centered on Toronto and Vancouver. Despite the concerns, and susceptibility to a myriad of factors, the housing markets in both cities have remained quite resilient throughout 2015, and are anticipated to maintain a sound level of stability into the short to medium term.
The following article identifies and evaluates the severity of major threats to the Canadian housing market, with a specific focus on the Toronto area.
Canada’s household debt levels are some of the highest in the world. In fact, they are very close to the debt levels the US reached at the peak of their housing crash in 2008.
The striking difference between US and Canadian debt is who holds that debt. Much less debt in Canada is held by homeowners who are at risk of defaulting. Canadian households possess $5 worth of assets for every $1 worth of debt. Also, approximately one-third of all Canadian households are debt free, and only about a quarter owe more than $100,000.
Some of the wealthiest countries with very high quality of life factors like Denmark, Netherlands, Switzerland, Sweden, Australia and Norway all have higher debt levels than Canada, as shown in Figure 1.
This should come as no surprise, given that the cost of living (e.g., shelter, food, taxes, etc.) in these countries is high. Also, high debt levels are not necessarily undesirable, as debt can be used to acquire and/or create wealth, particularly in countries with prominent financial institutions and high financial literacy. Based on the 2015 ratings of the 50 safest banks in the world by the Global Finance Magazine, 35 banks belong to the countries shown in Figure 1, of which 6 Canadian banks made the list (i.e., TD, RBC, Scotiabank, Desjardins, BMO and CIBC).
It is however important to be cognizant of Canada’s growing debt levels, particularly among first time home buyers under the age of 35.
Credit Scores, Mortgage Delinquencies and Subprime Lending
At their November 2015 Housing Outlook Conference, CMHC reported that almost 90% of new Canadian and 87% of new Toronto mortgage consumers have good to excellent credit scores (660+). Moreover, as shown in Figure 2, between 2010 and 2013, the share of consumer credit growth has risen fastest for borrowers with credit scores of over 807, which means that highest income Canadians have undertaken the bulk of household borrowing in recent years.
Between 2012 and 2015, mortgage delinquency rates have improved for Canada overall, and across all large urban centres, as illustrated in Figure 3.
As it currently stands, the Canadian Bankers Association noted that about 0.27% of Canadian mortgages are in arrears, while only about 0.15% are in arrears in Ontario. Relatively speaking, the US mortgage delinquency rate peaked at about 4.5% during their most recent housing bubble.
Also, subprime lending is a cause of concern for many given its rapid growth in recent years in Canada. However, subprime lending accounts for a very small portion of total mortgages, and has never risen above 5% in Canada. In comparison, subprime lending in the US accounted for almost a quarter (23.5%) of total mortgages at its peak in 2006.
Canada’s central bank recently made a claim that Canadian housing was overvalued by 10% to 30%. Although homes are very expensive, especially in Toronto and Vancouver, they may not necessarily be overvalued. Many of the claims about overvalued house prices in Canada rely on basic calculations like home price-to-income and home price-to-rent ratios, which omit important supply side factors and valuation elements such as interest rates, taxes, land constraints, quality of life, population growth, density, etc.
Figure 4 shows the different measures used to determine how affordability of homes in Canada has changed since the 1980s. The two latter measures (i.e., carrying cost) are more accurate, as they include the drop in interest rates since the 1980s in their analysis. When interest rates are accounted for and an average monthly mortgage payment is determined, the ratio to the average monthly income is interestingly enough generally in line with historical averages.
Also, Canadian homes are generally bigger, relative to homes in other countries, as shown in Figure 5, which makes them pricier.
Furthermore, as I’ve previously written, quality does not come cheap. Canada is consistently ranked as one of the most liveable countries in the world. Toronto alone this year has been ranked by the Economist, Metropolis Magazine and Citi Foundation as the most livable city in the world, and best city for youth. Living in one of the best cities in the world is not going to be a bargain.
In May of 2015 CMHC set off alarm bells in the country and internationally, reporting a huge spike in the number of completed and unabsorbed condo units in the Toronto area. In particular, CMHC noted that the number of unabsorbed condo units increased from fewer than 1,000 in December of 2014, to almost 3,000 in May of 2015 – a level not seen since the crash of the early 1990s. The following month, CMHC reported a drop of 800 unsold units, with a total of 1,956 unsold units as of June 2015, as seen in Figure 6.
The volatility in the CMHC findings enticed Urbanation, Benjamin Tal of CIBC and Ben Myers of Fortress to review the data. Urbanation looked closely at where CMHC reported the jump in unabsorbed units, and concluded that the completions were overstated for May, and absorptions were in fact not reported. In light of this new evidence, CMHC publicly admitted their initial findings were inaccurate due to a “paperwork problem”. Furthermore, Benjamin Tal and Ben Myers both stressed the importance of considering the context with respect to unabsorbed units. Ben Myers noted that the 1,956 unsold units in June 2015 represented only 6.3% of the completed supply in 2015, and Benjamin Tal emphasized that the number of total condo completions in the first half of 2015 was about three times higher than the level of completions in previous years, as shown in Figure 7.
Foreign and Speculative Buying
Many residents in Toronto and Vancouver believe that prices of homes are being driven up in part by wealthy foreign investors who indirectly exacerbate affordability for locals. Of particular concern is the anticipated mass sell-off of homes and exodus of foreign residents if a housing crash materializes.
CMHC recently released their first report on foreign ownership of condos in Canadian housing markets. Although the number of condos owned by foreign residents increased in the Toronto area by 40% since 2014, the total rate of foreign ownership currently is about 3.2%. The highest rate of foreign ownership is not surprisingly in Toronto’s downtown core, at 5.8%.
However, the CMHC findings must be taken with caution as only condos are evaluated, there is no information on the intents with the purchased units, and it is difficult to define a foreign resident, especially in a city like Toronto where half the population wasn’t born in Canada.
Price of Oil
The drop in oil prices over the last year had a detrimental impact on the Canadian economy, and particularly Alberta. In contrast, Ontario and the Toronto area are expected to benefit from lower oil prices (and the lower Canadian dollar), with anticipated growth in consumer savings, and increase in manufacturing output and export activity. As a result, Ontario and the Toronto area will experience some of the highest GDP and job growth rates in the country during the short to medium term. Furthermore, robust population growth in Ontario and Toronto is to be further bolstered by interprovincial migration from Alberta.
Rising Interest Rates
Interest rates are currently at their lowest levels. Strong economic performance in the US over the last year is persuading the Federal Reserve to hike interest rates in December 2015. Alternatively, major banks in Canada have not forecasted an increase in interest rates until at least the second quarter of 2016. Maintaining low interest rates might stimulate the currently sluggish Canadian economy, but must be done with extreme caution. Benjamin Tal reiterated that the housing crash of the early 1990s could repeat itself if inflation subsists and is left unchecked, causing the Bank of Canada to “act aggressively” and raise interest rates.
A hike in interest rates could increase monthly mortgage payments for homeowners, further growing debt and deteriorating affordability. This can also translate into severe effects on the broader economy, as incomes will be allocated to servicing debt, leaving less for consumer spending.
However, the idea of an interest rate hike is nothing new. Many Canadian homeowners are cognizant that interest rates are currently at their lowest levels, and have been bracing for an increase for years. As well, the Bank of Canada and the US Federal Reserve are well aware that a sudden sharp increase in interest rates might shock the economy. Therefore, it is predicted that interest rates will be increased at a reasonable pace to give homeowners time to absorb the added costs of their monthly mortgage payments.
At a recent conference hosted jointly by the Urban Land Institute and PwC, Richard Florida delivered the keynote speech in which he revealed a new and impending crisis facing cities. Richard emphasized that the rise of the creative class and resulting high home prices are intensifying inequality, and turning some major cities into “sheltered enclaves for the super-rich”. In order for cities to maintain their appeal, Richard proposed 5 major initiatives, of which one was to push the bottom up. This is incredibly important as it signifies the growing importance and need for cities to become more tolerant, equitable and inclusive in the future.
Context is also a vital component in understanding affordability, as Ben Myers explains – “Affordability by buyer is related to what compromises that buyer is willing to make. A couple with a household income of $750,000/year can find that they cannot afford to purchase a home in Toronto’s Rosedale neighbourhood.”
The middle class and millennials are able to make compromises with respect to their shelter and location. Furthermore, the burgeoning rental market in the Toronto area will fill the gap for those who are priced out of the ownership market and for those who don’t want to own a home.
But the real issue of affordability will be for the 165,000 Ontarians on the wait list for affordable housing, and the homeless population.
Great cities rely on great infrastructure. It is absolutely imperative to a city’s longevity and success. Furthermore, the right type of infrastructure is required in the most appropriate areas so that its use is optimized, and costs are minimized for governments, residents and businesses.
In 2013, the US received a D+ grade on its state of infrastructure, according to the Report Card for America’s Infrastructure. Canada and specifically the Toronto area are not far from the infrastructure deficit evident in the US.
For instance, commute times in the Toronto area are still some of the longest in all of North America. This can have debilitating effects on business and residents, as it is in no one’s interest to spend hours commuting. If Canada and its major cities do not begin investing in infrastructure, and soon, residents and businesses are very likely to vote with their feet.
It is evident from the threats identified in this article that a housing market crash is still unlikely to materialize in the Toronto area. However, that does not mean that the Toronto area is invincible, as a “cool-down” period for home values in the future is not inconceivable.
Barring an unforeseen external shock, (e.g., a recession, no population growth, etc.) the most pressing threats at the moment include rising interest rates (and their impact on debt levels), deteriorating affordability and the infrastructure deficit. These threats extend beyond Toronto and Canada, and if left unregulated, will have tremendous consequences not just on the housing market, but the broader economy and livelihood of cities.
However, the election of Prime Minister Justin Trudeau has restored some optimism in Canada, as there is unprecedented interest from the Federal Government in providing more affordable housing and investing in urban infrastructure. These initiatives are further supported by the Province of Ontario, which has also made significant strides in commitments to fund and build transport infrastructure, among many other things.
Rapid price appreciation of homes can send the wrong message to prospective buyers. Homes can be great investments, but most importantly and above all else, a home is a home, and everyone needs a place to live. If you’re buying a home as an investment, you’re essentially starting a business. And with business, there is a lot of risk associated. If you’re buying a home for the long-term, minor short-term price corrections shouldn’t be too much of a concern.