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Housing Bubble  – When Will It Burst ?

By: Sloan Levett
September 2011

Are we in a housing bubble? We all know the old saying – “what goes up must come down.” Housing prices have consistently increased for well over a decade now. Cities such as Toronto, ON, have seen prices more than double since 1996. The average house price in Toronto now stands at $458,000.

Canada’s housing market is being compared to the U.S. housing market and what inevitably happened to it a few years ago. A few differences should be noted, suggesting that it may not be appropriate to make the comparison. In Canada, we don’t have sub-prime lending with interest rate resets. Mortgages in Canada are recourse loans and our default rate has been historically much lower than the rate in the U.S.

Government Measures

Over the last year 18 months, the government has introduced a few measures to try and ensure a housing bubble doesn’t materialize:

  • Reduction in the maximum amortization period to 30 years from 35 years for government backed insured mortgages with loan-to-value ratios of more than 80 per cent
  • Reduction in the maximum amount one can borrow to finance their mortgage to 85 per cent from 90 per cent of the value of their homes
  • Require borrowers to meet the standards for a five year fixed-rate mortgage even if they choose a variable mortgage with a lower rate or shorter term

There are some people who believe that we won’t see a housing correction. They contend that the housing market will be supported by a continued low interest rate environment and a growing Canadian economy. Unlike the United States which saw housing prices increased by speculators who were buying multiple properties as investments, in Canada housing prices are predominantly being supported by homeowners.

But there’s another side to the debate. I believe that Canada’s high house prices in relation to incomes, combined with record household debt levels and overinvestment in residential construction, will cause a severe correction in the real estate market. Signs of stress are becoming evident. The increase in housing prices is being funded through increased household debt. In 2010, the average Canadian family’s debt level stood at $100,000.

Perfect Storm

All signs point that we are. We have the perfect storm brewing ‒ consistent rising housing prices for over a decade, historically low interest rates, and people borrowing money than ever before. Not to mention that bidding wars are commonplace these days with many homeowners accepting 10 or more offers on their property. The margin for error is becoming increasingly small. It’s a story I see and hear often. People look to determine how much they can borrow, base it on prevailing interest rates today and focusing on variable rates which today stand at well under three per cent. Is this rate not going to go rise someday?

As well, I find most people don’t consider what their expenses might look like five years from now. If we presume many of these people have young children now, the cost to provide for them later for private schools and university will drive their expenses that much higher and put increasing pressure on their cash flow. If you’re carrying a $700,000 mortgage and rates increase by two per cent, which would still make interest rates very low, all of a sudden carrying costs have increased to the tune of $14,000 per year, after tax dollars
Canada has so far escaped any semblance of a housing bubble, but, as University of Western Ontario finance professor George Athanassakos recently pointed out, the fundamentals suggest that we are headed in that direction. “Home prices are simply way out of line, especially when viewed in relation to household income. The ratio of house prices to income has historically averaged about 3.5 in Canada. It now stands at about 5.5. It is difficult to see how income growth in the future can bring this ratio close to the historical average within any reasonable period, so it follows that house prices will have to decline.”

Housing Correction

An even more powerful indicator also points to a severe housing correction in Canada. Residential housing investment as a percentage of GDP was 6.48 per cent in 2009, down slightly from 6.76 per cent in 2008, after peaking at 7.13 per cent in 2007. The previous peaks were at 7.26 per cent in 1976 and 7.18 per cent in 1989, and we all know what happened to the housing market in the late ’80s and early ’90 s. After residential housing investment as a percentage of GDP peaked in the previous two cycles, the housing market crashed within a few years. In addition, house prices have risen to almost 5.5 times disposable income per worker, well above the long-term historical average of 3.5 times.

I believe it is inevitable that our housing will burst. It may not occur tomorrow, but once interest rates rise a few percentage points – and they will, watch out!!

SLSloan Levett, CA, CFP, is director of Fuller Landau Family Offices Services Inc., responsible for its wealth management initiatives including investment portfolio advisory services, insurance advisory, estate planning, and related tax strategies (slevett@fullerlandau.com).

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