CIO Insights: Canadian Residential Real Estate ? The Next Bubble ...

Mark Kopinski, Chief Investment Officer, Global and Non-U.S. Equity

In our increasingly interconnected world, weakness in one market can quickly reverberate throughout the global economy. As events of the past five years have clearly demonstrated, investors must be vigilant for new stresses. Canada has been a relative isle of stability in recent years, and its real estate market has remained robust even after others have collapsed. But therein may lay a problem.

A Bull Market for Canadian Real Estate

In the past decade, low interest rates combined with high demand for housing and investment properties have caused Canadian residential real estate prices to almost double, far outstripping household income. As property values have grown, Canadians have further increased their debt through home equity loans. Canadian household debt relative to disposable income rose to a record this year, exceeding 150%. Recent estimates are that the big six Canadian banks have over CAD$700 billion in Canadian mortgage exposure and another CAD$180 billion in home-equity loan exposure. The Canadian Mortgage and Housing Corporation (CMHC) has insured about CAD$560 billion of the mortgage market which amounts to about a third of Canadian gross domestic product (GDP).¹

Is a Correction Coming?

Many fear that Canadian residential real estate prices are due for a correction. Estimates range from a fall of 10-30%. Overbuilding in some cities, slowing income growth, and higher interest rates are triggers that could cause real estate prices to fall. Due to the high level of household debt in Canada, a fall in property values could have a reverse wealth effect in the world?s 10th largest economy. The Bank of Canada has repeatedly warned that interest rates will increase, which will increase costs to highly leveraged borrowers and potentially lead to defaults and foreclosures. If the CMHC lacks sufficient assets to cover these losses, the Canadian taxpayer will have to take up the slack, adding further pressure on the economy.

Fundamental Differences

While this situation is potentially serious, there are fundamental differences between Canada?s real estate market and those that collapsed in the United States, Ireland, and Spain. First, national statistics for Canadian home ownership affordability are skewed by extreme market conditions in the city of Vancouver, British Columbia, which continues to be the least affordable city in Canada. Reports indicate that many new buyers in Vancouver are not highly levered Canadians but Chinese with plenty of cash looking for second homes and investment properties. As high as Vancouver prices have become, they are still very attractive relative to similar properties in Asia. And while affordability has deteriorated in other areas of Canada, nationally it is still below the peaks reached during the Canadian housing bubble of the late 1980s.

Second, starting in 2008, the Canadian government has implemented a series of reforms to cool the housing market, including higher down payments, more stringent loan-to-value requirements, shorter payment periods, and tougher underwriting standards. Recent data shows that these measures are having the desired effect. In addition, because a greater share of mortgages in Canada have variable interest rates and not the long-term fixed rates favored in the United States, the Canadian market is more sensitive to interest rate changes and hence to Central Bank policy. Finally, unlike in many states within the United States, Canadian homeowners cannot simply walk away from their mortgages, making default a far less attractive option.

In summary, the structure of the Canadian real estate market and timely government policies that have already been implemented make a U.S.-style real estate collapse and the attendant stress on financial markets unlikely, though not impossible.

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¹ MarketWatch, May 24, 2012

International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.

The opinions expressed are those of Mark Kopinski and are no guarantee of the future performance of any American Century Investments portfolio.

For educational use only. This information is not intended to serve as investment advice.

Source: http://americancenturyblog.com/2012/10/cio-insights-canadian-residential-real-estate-the-next-bubble/

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