Canadian Residential Market: Quick Health Check
By Hai Nguyen
It has been 10 months since RAMA’s last blog talked about Canada’s residential housing market. I believe that it is an opportune time to do a little health check on the market sustainability.
Overall, the housing market continues to show little sign of slowing down, reflected via faster year-over-year inventory turnover and high absorption rates (~57%) on high level of new listings. In addition, total monthly successful transactions have been growing at a CAGR of 6.3% over the last 3 years. Regardless, sluggish oil and commodity prices continue to cause job loss and affect negatively in some markets such as Alberta. My question is again: “Is that too good to be true?”
Before addressing the underlying market circumstances, I think it is good to understand how a common housing bubble often reacts before it bursts. There are three steps:
1) Elevated profit-taking activities from investors (defined as people who purchased properties for the purpose of flipping the assets to realize returns) as seen by high levels of resale transactions occurring at increasingly higher prices, up to the point that become unaffordable to most of the citizens.
2) Next, weak demand dries up market liquidity, causing inventory abundance (financed heavily by debts) and home prices start falling dramatically.
3) Finally, the mortgage installments obligation on unsold inventory pushes a large amount of investors into the verge of insolvency, bursting the market bubble.
As a result, in this topic, I would like to suggest looking at resale activities in the secondary market and affordability factor. I believe these factors have certain predicting power toward market sustainability.
1) Elevating resale activities concentrate in Toronto and Vancouver market
At the end of 3Q15, number of successful transactions in secondary market reached its 4-year high record of ~510,000 units/quarter, attributed mainly to Ontario and BC. Toronto and Vancouver, who exhibit average home prices of $614K and $889K, respectively, compared to the national average of $436K, led the market with total secondary transactions surging by 7% and 18% YoY. This represents my serious concern, as most Canadian citizens cannot afford these high levels of housing prices (which we will address in more details below in affordability analysis). Moreover, is this similar to the phase 1 of the market bubble that we just mentioned? (Increasing number of resale transactions and unaffordable price).
2) Affordability Issue – Housing is unaffordable for young Canadian families
My diagnostic on the affordability factor neither helps improve my confidence in the market health. According to StatsCan (2014), roughly 63% of the Canadian population is in their working age, and 69.5% population has annual income under $50,000 (average income of the Canadian is $49,000).
Additionally, while the price-to-income ratio on average in most of the cities in Canada is around 4.0-5.0x, Vancouver and Toronto housing markets appear to be more expensive than average by 103.5% and 22.8% respectively. Based on my rough estimation, a young working couple on average will only be able to make the initial down payment of 20% of home value after 4 years (in Toronto), or 6 years (Vancouver) given annual savings of 30% of total income and no support from parents.
This even does not take into account the later mortgage payments, which usually eats up 30%-50% of their annual income. From my perspective, this ratio is too risky for young families financial positions since it exposes them into financial uncertainty when interest rates start rising. In addition, it is worth mentioning that the household debt to disposable income did not change significantly over last 10 months, still hovering at record 15-year highs.
As a result, we have to conclude that housing markets in Toronto and Vancouver are not for a large proportion of Canadian residence. Then, the next question should be “Where is the demand that facilitating the secondary market?”
We believe the strong influx of foreigners and immigrants may help to explain this issue. Looking at migration trends among provinces, it is not too difficult to realize Toronto and Vancouver are two favorable destinations of immigrants, given the government’s open immigration policy to attract skilled workers. This phenomenon happens not only in Canada, but also in our neighbor US, with a good comparison between Vancouver and Los Angeles, as well as between Toronto and New York. Surveys by brokers in Vancouver show that around 50-70% of homebuyers are Asian. Our hypothesis is that these immigrants consist of high net-worth individuals who would love to migrate their wealth to Canada to enjoy a higher standard of living (better education for children, social benefits, etc.).
Furthermore, their weakened currencies incentivize them to buy houses in Canada and US to preserve their wealth. If so, it is less concerning since they do not have incentive to flip assets to realize short-term returns. As a result, the increasing transactions in secondary markets can come from the fact that Canadian homeowners sold their houses to foreigners. On the other hand, it will hang over home prices and rent rates at this record high level for a long time, until Canadian income catches up with prices (i.e. drag the price-to-income ratio down).
Will an interest rate hike trigger the market crash?
In my opinion, we believe that the possible 25 bps increase in mortgage rate has certain impacts, but will not burst the bubble. My rationale is as follows: (1) given the example above, the additional annual interest rate that homeowner have to make is only around $2,000, which should not significantly affect homeowners’ ability to repay mortgage, and (2) as being rational people, we believe the market has priced in the expectation of a interest rate hike since the last quarter. As a result, I only expect a small correction in prices and a slight decrease in market liquidity. I see this event in a positive way since it will help to rebalance residential markets by reducing incentives of speculators, who will be affected more severely with their high debt leverage position.
The Canadian residential housing market fails my test of affordability but the strong housing demand from the influx of foreign immigrants absorbs the increasing supply. As a result, we would say there is a reason to be concerned that market is not in good shape. However, since we are not sure about how long this demand can be sustained (depending on government immigration policy, other economy’s performance, etc.), it is insufficient to conclude that the market is going to crash. My personal view is that while there will be a moderate correction in prices at some specific markets such as ON and BC in short-term, government’s expertise to tackle housing problems and continuing open immigration policy under the Liberal’s term will minimize the likelihood of a market crash in the long-term. My key takeaway is to keep an eye on the secondary market performance and the affordability of homebuyers. Buckle up your seat belt, since the future will be rough.