Stagnation in the Canadian Housing Market

A LESSON IN TIMING, INCENTIVES, AND PSYCHOLOGY

The Aug 8^th 2012 edition of Canada’s Globe & Mail newspaper boldly stated that the country’s economists had reached a consensus: the bloated housing market will first slip 10-15%, and then “stagnate for years.”

The Frost Report has been warning prospective buyers about the coming decline of Canadian (and world) home prices since the first peak of February and March 2010 (see Spin City).  So, why are economists lagging so far behind?

First, the news is coming out now because it can.  The economists in the article -- who are employed by financial institutions -- have nothing left to lose since the market is “effectively exhausted” (their words).  People who have already bought homes have given the banks and brokerages their business, and can no longer benefit from the advice.  Those who don’t have homes after years of low interest rates either can’t afford them or don’t want them.

Secondly, economists have virtually no natural incentive to accurately predict slowdowns and price declines.  Nasty predictions about the most popular investment in the country (real estate) are unpopular, unwanted, and of no benefit to the companies who employ economists.

And then there are the clients…

It’s dangerous to advise a client not to buy real estate.  Contrary to what is taught in most investment psychology manuals, clients take declines in prices (“who could have known?”) far better than missed opportunities (“you said not to buy and prices went up 50%!”).  Furthermore, a client who has already decided to buy (which is typically why they are speaking with a banker or real estate agent in the first place) will never, ever listen to advice anyway.  If a client, who has already decided to buy, asks a banker if it’s a good time to do so and the banker replies, “I don’t believe it is,” that client will usually spend the next 15-20 minutes explaining to the banker why he is wrong.

The Cinderella party in Canadian housing is officially over.  I sincerely hope that the moderate 10-15% decline predicted by the nation’s top economists is accurate – but I doubt it.

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See also:

Canadian house prices to slip, then likely stagnate for years

Summer chill cools Toronto, Vancouver property markets

 
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The World has Changed

There was an unprecedented delay since the last post in The Frost Report, as you may have noticed.

I could write volumes about the reasons for this, but simple explanations are always best: a new position at a global financial institution, followed by several high intensity 60-hour workweeks. For the moment, life is back to normal.

So, what has changed since the last post?

For one, the subject of the last post - the lawsuits expected against Baja Mining - have now begun. 

On July 27th, a large shareholder initiated a class action lawsuit for over $250 million, claiming "misrepresentation" by Baja.  Although the shares are now sure to be worth almost nothing (creating a loss for me) I am nevertheless satisfied by this development.  As a speculative buy, I own just enough BAJ shares to be annoyed at their drop in value, but not enough to affect me in any material way whatsoever.  In this case, justice is more interesting than profits.

In anticipation of the inevitable slowdown of the Chinese economy (something The Frost Report has been writing about since early 2011), the XME Metals and Mining Index has dropped more than 50%, exactly as expected.  Interestingly, established mining companies were hit just as much as companies that own nothing more than a piece of land.  And, those that produce gold were hit just as much as those that produce iron.  One of these days I will remember that when a sector drops, even the best companies drop right along with it.

With many commodity-producing companies running at P/E Ratios of around 2.0, opportunities certainly abound.  Long-term investors would be wise to consider making regular purchases of commodity index funds, such as XME.  I say "regular purchases" because December of this year may mark the low point.  In December, many investors will be doing year-end tax loss selling of the most battered stocks.

The global housing market slowdown (also something that The Frost Report has been anticipating since 2011) is now well underway.

In Israel prices have notably softened and they are preparing for a hard landing (i.e. a drop that they will not be able to control).  In Canada, regional bank branches that were doing 6-10 mortgages a week in the spring of 2011 are now lucky if they do 2.  And in China, home prices are officially stable and robust, signifying that the government is lying its pants off.

And finally, the thing that hasn't changed at all since the last post...

Retail Investors remain deathly afraid of stocks.

A Financial Planner a few days ago mentioned that in 2006 their company's best-selling mutual fund was composed of 80% stocks.  Now, their best-selling mutual fund is composed of 80% bonds.

It seems that stocks are still, and for some time will continue to be, shunned by regular investors as a dangerous game.  And so it is, if you don't know what you are doing.

If you are a long-term investor with a eye for value, the 2008-2012 (+) period will likely be the single greatest stock purchasing opportunity of your lifetime.

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"The day I went to work in 1932, steel mills were running at eight percent of capacity.  I remember days when the trading was so slow people played ball on the floor of the exchange."

David Babson, as told to Adam Smith in Supermoney

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Assess This

 

In yet the latest reminder of the inevitable Canadian real estate apocalypse, B.C. Assessment announced this week that home prices in Vancouver rose between 10-25% during 2011.   In the family-oriented West Side of Vancouver, prices “skyrocketed” (their words) as much as 20-40%.

In order to lessen the blow to existing homeowners, B.C. Assessment sent what it calls “extreme letters” to approx. 1500 households, letting them know in advance (as a matter of courtesy) that their property taxes will be increasing dramatically.

Since 2002, Vancouver real estate fairy tales have become so commonplace that many people now actually believe that their run-down house on an average size lot is worth $1.3 million dollars (1.26 million USD).

In the East Side of Vancouver (the city’s equivalent to New Jersey), an average single family home is now worth more than $800,000.

In a brilliant understatement earlier this week, the deputy assessor for the Vancouver Sea to Sky region stated: “It’s been a really strong market for Vancouver, a good one –a robust one."

Apparently, BC Assessment sees no downside risk to real estate prices rising at rates up to 37% faster than wages.

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"In our view, the housing market is one of the most vulnerable sectors to this weakening economic environment, showing classic signs of overvaluation, speculation and oversupply.  We are not calling for an all-out rout in the market, but caution is now decidedly warranted."

Bank of America Merrill Lynch, regarding Canadian real estate, December 2011.

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The Fortune Teller

Everyone seems to be wondering what bombshell will hit world markets next. Will the economy continue to recover? Will it slip back into recession? What can we expect and why?

The uncertainty of today's market is perhaps unlike any before it. In response, on this page are The Frost Report's official predictions for the next two years.

Note that as my name is not, nor has ever been “Nostradamus,” so take this for what it is – a murky prediction based on current events and statistics. I encourage the reader to think about the reasoning behind these statements, rather than getting caught up on specifics.

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The world's economies will remain stable - though not rapidly growing - until the cataclysmic event: the collapse of the massive Chinese asset bubble.

Within the next two years, the Chinese bubble in real estate, shell-companies and factories will burst. Faced with huge declines in asset values, China's citizens will go into self-preservation mode and stop buying overpriced real estate and unproven stocks. As corrupt and wealthy Chinese flee with their remaining assets, the poor will be left to wallow. A revolution is a very real possibility.

Due to the collapse of the Chinese bubble, other economies currently dependent upon Chinese overspending will also burst. Canada and Australia will be most affected, as they will be hit with the double-whammy of home price declines of between 20%-40% (depending upon the area), and a fall in commodity prices due to reduced demand. Since both Canada and Australia have commodity-based currencies, these currencies will dive. Large-cap usable commodities producers will also be hard hit.

Similar asset-plunging disruptions will be felt throughout the world, from Israel to Lebanon to South Africa. The list of countries experiencing low-interest rate asset bubbles is long. As citizens around the world shut their wallets in response to their shrinking net worth, world markets will decline.

During this entire period, gold and silver prices will roller-coaster from one extreme to another, from both high demand and the actual need to cash in gold and silver for money. Due to fear in the stock market, gold and silver producers will be in the strange position of having record profits and marginal stock prices at the same time. It will be possible to buy these stocks and receive excellent dividends.

The big winners of all this strife will be the US and Japan. US markets will drop when China’s drops; but, because US markets are already valued so minimally, the US market will rebound quickly. US housing, already fairly priced in some regions and underpriced in others, will remain a coiled spring, waiting to jump.

Any substantial drop in values in US markets will be a long-term buying opportunity. If one is smart and buys actual stock (not options), and uses no margin (borrowed money), this period will be extremely lucrative, though time and patience will be required to reap the rewards. In fact, buyers of US stock and real estate who have the conviction to buy as prices drop - and hold without selling - will be the big winners of this century.

Japanese manufacturing will have a tough time at first, since Chinese companies fighting for business will go cutthroat with regard to pricing. As more and more Chinese companies fail, however, Japanese businesses will pick up the pieces. Both Japan and the US will benefit from the low cost of Chinese goods and materials available for purchase. Due to the influx of low-priced Chinese goods, inflation will be kept in check.

Canada, Australia, New Zealand, Germany, Norway, England and other Germanic-speaking countries (excluding the US) will recover but remain sickly for years to come, since a quarter of their populations will be bound by high levels of personal debt. All talk of China becoming the “next superpower” will disappear.

The events of the past three years have resulted in the strange worldwide coexistence of vastly overpriced assets (ex. Chinese real estate and BRIC stocks) and vastly under priced assets (ex. US regional financial stocks and real estate). "Regression to the mean" will haunt unwary investors.

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Time will tell if these predictions prove correct, or not. But, for great investors it really doesn't matter.

I have been buying undervalued stocks of great companies, and will continue to do so regardless of whether or not the world's economies are rocked; and that, my friends, is perhaps the greatest lesson of all.

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"Nearly everyone interested in common stocks wants to be told by someone else what he thinks the market is going to do. The demand being there, it must be supplied."

Benjamin Graham

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Canadian Debt Levels Hit Record

In a speech this week that was as straightforward as possible, Bank of Canada governor Mark Carney told the crowd at the Economic Club in Toronto that "low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce; the greater the complacency, the more brutal the reckoning."

Mr. Carney was, of course, referring to Statistic's Canada's announcement that household debt ratios have hit a record high, and that people could get stung badly if rates increase. Statistics Canada's announcement was surely a frustrating development for Mr. Carney, who has been warning Canadians about their debts for over a year.

The debt-to-income ratio for Canadians is now higher than that of Americans - a fact which many Canadians likely refuse to believe, since their self-image is that of financial prudence compared with their Southern neighbors.

Dangerously, these record debt levels coincide with unusually high home prices and unusually low interest rates: a situation that could easily lead to the double-whammy of rising payments on falling equity values - a sure formula for financial disaster.

Meanwhile, deaf ears continue to buy new condos and pull out the plastic for Christmas shopping. It is likely that most indebted Canadians will never read this article, or, for that matter, give it a second thought even if they do.

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"It’s a matter of concern but it’s not a matter with respect to which we’re going to act immediately."

Jim Flaherty, Canadian Finance Minister, December 2010, when asked if Canadian personal debt levels are a concern.

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See also:

Canadian Debt Levels now Higher than Americans

World Housing Bubble - All Aboard!

For months, I was clearly the minority in saying that real estate prices in places like China, Australia, Canada, Hong Kong etc are experiencing a bubble. I was also the minority in saying that US home prices are, in fact, undervalued. In recent weeks though, such ideas have become accepted, even mainstream.

By now, I have to admit that I am actually sick of writing about housing bubbles. However, I know from emails I have received that as a result of these articles, at least some people have been dissuaded from purchasing high-priced condos at the edge of personal affordability, and for this I feel that repeating the same message ad nauseum is worth it.

Paradoxically, money tends to flow to assets and areas that are considered "safest," without regard to whether or not they are "reasonably priced." For investors, immediate safety of capital (or immediate gain) is paramount, and everything else is secondary. It is precisely this desire for immediate reward that results in horrible long-term investment choices.

In some countries, such as China, investment dollars are still incoming. In the US, real estate is stagnant water, despite low prices and excellent investment opportunities. In Canada, the flow is now a trickle, and ready to backflow.

The educated media is coming on board. For the masses, the onset of reality will still take several months.

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Video: Bubble Trouble - MSN Money
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See also the previous Frost Report articles:

The World Housing Bubble – Part II

The World Housing Bubble

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Loose Wallets Sink Ships

How bad is it? Bad.

In many previous articles, I explained the obvious: that the Canadian housing market is grossly overpriced - driven by low interest rates and personal debt - and ripe for a crash.

Many disagreed. Those who disagreed most strongly were, unsurprisingly, those who had bought rental properties or first homes within the last 3 years (for the reason why, see Cognitive Dissonance). Yet, what was obvious to some is slowly becoming obvious to all: the Canadian housing market is sinking.

A recent press release by the Bank of Canada was brutally straightforward: “The slowing since the spring in resale, renovation, and new home construction activity has been driven by a number of factors, including the passing of pent-up and pulled-forward demand; the expiration of the federal Home Renovation Tax Credit in January; the tightening of standards for government-backed insured mortgages that came into effect in April; the introduction of the HST in Ontario and British Columbia in July; declining affordability; and subdued income growth.” This painful laundry list is the reality of the Canadian housing market today.

The demise of the housing market has received surprisingly little coverage in Canadian news. In fact, a recent headline in the Financial Post (Ottawa ponders further tightening of mortgage rules) suggests that the housing market is still hot and may require cooling.

Canadian personal debt levels, which have risen along with the housing market, have been a cause of great concern for the Bank of Canada for some time. Again, the Bank of Canada has been blunt, noting that “Canadian households have now collectively run a net financial deficit for 37 consecutive quarters. That is, their investment in housing has outstripped their total savings for over nine straight years.” The Bank of Canada concludes in a single line, “This cannot continue.”

Debt levels have reached the point where any further increase in interest rates – which may be necessary to combat inflation – will strain Canadian families. If inflation rises, the BOC may be forced to raise interest rates and push those citizens who are now “just hanging on” into bankruptcy.

The Canadian housing market’s decline is just beginning. How long this process will take is anyone’s guess, but it will likely be measured in years, not months. A decline in value of an asset class this large ensures no quick recovery.

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To review the progression...

The Canadian Housing Market
Canadian Debt II
Spin City
The Canadian Housing Bubble - CREA to the Rescue
The Canadian Real Estate Market: Trouble in the Pipeline
Canadian Real Estate: Stick a Fork in It

The Bank of Canada - Employment in a Modest Recovery
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"Results - Fall 2010

The Canadian Real Estate Association says first-time home buying activity is slowing. What’s happening in your region?

I’m seeing more first-time homebuyers this year - 24%
I’m seeing fewer first-time homebuyers this year - 66%
I haven’t noticed a change - 10%

Genworth Financial Canada - The Homeownership CompanyPrime Source"

A recent poll by Genworth Financial Corp, given to mortgage brokers and bankers across Canada
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Canadian Real Estate: Stick a Fork in It

IT'S DONE.



The Canadian housing boom is officially over.

In addition to the myriad of anecdotal stories from real estate agents and mortgage specialists who tell me that the market “has shifted in favor of buyers,” banks are finally experiencing the inevitable decline.

Back in July, I mentioned that the mortgage pipeline was drying up, and that the results should soon hit the banks. Well, they have. According to my contacts at three of Canada’s major banks, new mortgage and refinance business has fallen off a cliff. Pre-approved mortgage applications – an indication of sales beyond 30 days - are virtually non-existent. Any of this may be confirmed by a casual visit to a local bank or credit union, which reveals empty reception areas and bored lenders.

In an effort to kick some life back into the markets, major Canadian banks reduced their mortgage rates twice in the past two weeks, but it had no impact whatsoever. In light of these circumstances, I suspect the Bank of Canada will rethink its intention to slowly raise interest rates.

At the same time as the Canadian media was announcing that home prices have dropped, sales have slipped, and housing starts fallen, the Canadian Real Estate Association was busy announcing that home prices will continue to rise. I love the CREA. When sales and demand increase, they announce that real estate prices will rise. When sales and demand drop, they announce that real estate prices will rise. You can say a lot about the CREA, but you can’t fault them for inconsistency.

I suspect that several months will pass before the severity of the downturn becomes fully apparent. By then, it should be so obvious that not even the CREA will be able to ignore it.
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Further reading:

The CREA's Use of Spin (The Frost Report)
The Canadian Real Estate Market - Trouble in the Pipeline (The Frost Report)
Housing Starts Slip in July
Shaky Days in the Housing Market
Homeowners Sell, Start Renting Instead
CREA's Resale Housing Forecast

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The Canadian Real Estate Market: Trouble in the Pipeline

The Canadian Housing market is going well, with big volume and qualified customers. At least, that’s the current perspective at the end of the line. The further one goes up the pipeline, however, the worse the big picture looks.

A mortgage department employee from a major bank recently told me that application volumes are down 25% or more since June 15th. Though employees are not being laid off, those who leave or retire are not being replaced. At the same time, the quality of mortgage applications is deteriorating rapidly (“scraping the bottom of the barrel” was the exact expression).

Further up the pipeline, Real Estate agents tell me they are worried. Sales have dropped noticeably since May. In an attempt to make up the difference, agents are cold-calling and self-marketing like they have not done for a very long time.

Of course, all this is anecdotal evidence. At the bank level, sales numbers still look great. Yet, I suspect that the drying mortgage pipeline will reach Canadian banks soon. When it does, you will read about it here.

For further information, see:

Spin City
Canadian Debt II
World Housing Bubble II
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"Phew. With yesterday's report that home resales are cooling and price increases shrinking, we can finally put behind us the horror of Canada's great imaginary housing bubble. ...What Canada had was modest overvaluation with very little sign of speculation."

Jay Bryan, The Montreal Gazette, June 17 2010.

Abouuuuut….Face!

The CREA Gets Real




Just seven days ago, I wrote an article stating that the Canadian Real Estate Association should be ashamed of themselves for their cheery and completely unrealistic assessment of the Canadian housing market (see: CREA to the Rescue).

Today, in a stunning about-face, the CREA "updated" its forecast, admitting that by 2011 a "demand-driven downturn" will push Canadian home prices lower. They even added that the threat of rising interest rates and new taxes caused buyers to jump into the market sooner than they may have otherwise (something I wrote about in April, in Spending 'til it Hurts).

It’s unclear what prompted the CREA to come clean. I’d like to think it was my blog, but more likely they simply realized that a small dose of reality now prevents egg-on-your-face later.

Of course, the CREA is still being idealistic (read "deceptive"). Amongst other nonsense, they insist that Canada’s "conservative lending practices" and mythical "prudent borrowing" will prevent a large price correction; that the two most overpriced markets (Ontario and B.C.) will inexplicably plateau next year after a small drop; and, of course that the current market shows a good balance between supply and demand. But, at least they aren’t encouraging a new wave of oblivious buyers. The CREA has, with its latest press release, gained back a shred of dignity.

I have to give credit where credit is due: the CREA did the right thing. More of the same would be nice.

For the CREA's full press release, see Housing Forecast Revised.
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"Home sales are coming down from the mountain peak, but they will level out at a high plateau -- a plateau that is higher than previous peaks in the housing cycle.”

David Lereah, Chief Economist, National Association of Realtors, USA 2006

The Canadian Housing Bubble: CREA to the Rescue

In response to a series of headlines suggesting that real estate is overpriced, visibly annoyed members of the Canadian Real Estate Association issued a statement today denying any possibility of a housing bubble, with scores of statistics and beautiful charts to support their claim.

In this article, The Frost Report reviews the CREA's rebuttal (and why they should be ashamed of themselves).

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CREA: “Canada’s solid mortgage market trends, conservative lending practices, and prudent borrowing by home buyers means that Canada will avoid a U.S.-style housing price correction.”

The Frost Report: Canada's conservative lending practices are a myth. In the heat of 2006 Canadian banks were, just like their American counterparts, doing loans without even confirming the borrower’s income. As long as the client’s credit bureau reported the name of the company they claimed to work for, this was considered enough evidence. In addition, although the Canadian Mortgage and Housing Corporation has strict guidelines regarding credit scores and income levels required for approval, a CMHC representative recently told me that they had been making exceptions to the rules "left right and center."
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CREA: The “vast majority” of Canadians have mortgages they can afford.

The Frost Report: Canadians can afford them today because of record low interest rates, which is exactly what caused the bubble to re-expand. For several months now the Bank of Canada has been warning consumers that interest rates will be increasing, and expressing concern about their personal debt levels. From June until Nov 2009, many if not most new mortgages were variable rate; this worried the Bank of Canada as well as the Big 5 banks. As a result, laws were passed stating that all buyers must qualify for a fixed rate even if they intend to take a lower (for the moment) variable rate mortgage.
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CREA: “Over the past 12 months, most new mortgages (64 per cent) have amortization periods of 25 years or less. This is an increase compared to 54 per cent one year ago.”

The Frost Report: The insinuation here is that since people are choosing 25-year mortgages (with higher payments) instead of longer-amortization mortgages, they must have money to spare. In fact, the opposite is true. In the past year home prices have become so high that the majority of home purchases have been from existing homeowners - either selling and repurchasing, or doing equity take-outs to purchase second properties. First time homebuyers are seldom able to afford 25-year amortizations. The decline in longer mortgages means that first time homebuyers are abandoning the market.
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CREA: Twenty five per cent of mortgage holders recently increased their home equity via lump sum payments against the principal and/or by increasing their mortgage payments above their scheduled payment.

The Frost Report: It is not these homeowners, but the 75% of homeowners that do not or cannot make extra payments that is concerning. The CREA's comment ignores that fact that if even a small percentage of homeowners fall behind on their payments it will bring down the entire market. In the United States in Q3 2007, subprime adjustable rate mortgages made up only 6.8% of the market, yet accounted for 43% of foreclosures.
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CREA: Most mortgage holders (77 per cent) have a home equity position of at least 25 per cent.

The Frost Report: This is because until 2006, 25% was the minimum requirement to purchase a home in Canada. At that point, the minimum down payment was changed to 0% in order to boost the housing market. Presumably because of the risks, CHMC pulled the plug on zero down payment mortgages in 2008. The minimum is now 5%.
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CREA: Housing prices will not drop. Instead, personal incomes will rise to match home prices.

The Frost Report: I feel vomit in my mouth right now.
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It's hard to imagine a more biased source of information about real estate than an organization whose purpose is to represent “more than 96,000 real estate Brokers/agents and salespeople working through more than 100 real estate Boards and Associations.” Still, the CREA could do the morally upright thing and at least present the potential downside risks. Due to the CREA's press release, hundreds of dreamy-eyed homebuyers will once again enter the market, oblivious of the dangers.

For more examples of CREA spin-doctoring, see Spin City.

For the full text of the CREA statement from which this article was based, see: Relax: It's Just Another Housing Market Cycle.

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“There is no evidence of a housing ‘bubble’ in the United States and housing demand should stay strong for years to come.”

James F. Smith, Society of Industrial and Office Realtors, 2005
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