The future of Canadian real estate

September 1, 2008

What does the future hold for the Canadian real estate?

Year 2007 was very successful for Canadian real estate market – the numbers are clear. Sales activity climbed over 520 000 units, up 7.6 percent from 2006 levels (the largest growth since 2002) and transactions via the MLS systems have reached more than 500,000 units sold. The average real estate sale price was up by 14.1% to $317,825 in December 2007 when compared to December 2006 (again the largest growth in recent years).

Despite the optimism of last year’s banner real estate year year, 2008 has opened many questions. First the popping of the US real estate market bubble – front page financial news since the meltdown at Bear Stearns in March – makes the casual investor wonder if such a mortgage and price collapse could repeat itself in Canada. World oil and food price problems continue to make many people believe that world recession is knocking at the back door.

Is there any reason for concern in the Canadian real estate market? Let’s review the overall economic situation in more depth.

Growth and decay in Toronto – Photo by Susanne Jesperson

Canada

After a few years of healthy 3% real growth of GDP, Canadian economy had a small slowdown at the end of 2007 and GDP growth for Q1 2008 has not been impressive: -0.1%. In response, the Bank of Canada lowered GDP growth estimations for the year 2008 from previous 2.3% down below 2%. These numbers may seem scary, but let’s take a multiplying glass.

• The major factor is export level. Due to problems of USA (our biggest partner) and weak US dollar, exports have gone down. The good news is that domestic demand remains strong as does domestic consumer confidence.
• Rising commodity prices are actually not bad for Canada. On top of metals and forestry, we do have significant oil reserves of our own. Although Alberta oil is more expensive to extract, in such a pricy market its value is unlocked in such a pricy market. Due to rising fossil fuel costs, new nuclear power plants are being built all over the world? We are the world uranium leader, providing 25% of the world’s supply.
• Inflation rate remains below 2% and there is no sign of worsening in the next quarter.

However, some issues remain, especially in manufacturing regions, dependent on US markets. The Bank of Canada’s interest rate cuts have stopped at 3% and next step is questionable. The traditional way to boost economic growth a bit is rate lowering, and there isn’t much lowering left to do.

Torontos Financial District by ‘Shiny’

USA – spreading the disease?

USA are the biggest world economy and our nearest and the most important neighbour. So the question of falling into the same real estate problems is more than natural.

Thousands of pages were covered by studies, trying to figure out, who made the mistake. We have to go back to situation after Dot-com bubble and 9/11 events. FED interest rates fell down to 1% and real estate started booming. Easy to obtain subprime mortgages, sometimes at over 100% financing, left the American system fatally vulnerable to the slightest slip in housing prices. When the overpriced properties in an overheated market started to slip in price, panic ensued as owners abandoned their house payments and houses. The fallout carries on. Is Canada in the same situation. Let’s take the elements of the crisis one by one.

Interest rates:
The Bank of Canada, despite generally following the steps of the American Federal Reserve Bank, was not as aggressive during this period as the FED. FED interest rates fell from 6.5% in year 2000 to 1.0% in 2003, in an attempt to kickstart a flagging American economy. In the following years, interest rate climbed back up to 5.25% in June 2006, before renewed growth collapse sent the rates scurrying back down to 2.0% in April 2008. On the other hand, the Bank of Canada never lowered rates beyond to 2.0% and remained around 2.5% for most of the period. In 2007 rates rose to 4.5% for some months. Despite the comparatively high Canadian mortgage rates, 2007 was one of the best years ever for Canadian real estate. Our interest rates now stand at a reasonable 3.0%.

Federal Reserve Bank of New York Building by Michael Daddino

Mortgage on sale by ‘woodley wonderworks’

Subprime mortgages

The biggest difference between the Canadian and American markets are in subprime mortgages. Subprime mortgages can generally be defined as mortgages offered when home purchasers do not fit the banks’ prime mortgage customer profile. To put it even more bluntly, mortgages issues when there is doubt about the borrower’s ability to repay the loan. While such loans make up about 20% of the Americam mortgage market, Canadian financing is much more conservative – similar mortgages create about 5% of the market.

Loan policies in USA are not so strict, as in Canada. Many subprime loans are simply not available in Canada at any price – as loans at 100% financing without mortgage insurance are prohibited by Canadian banking practice. The most dangerous subprimee loans are "teaser" mortgages that offer low initial rates, only to reset at a higher level, a year or two later. Mortgages made to individuals with minimal income and without payment insurance contributed to the crisis substantially. These products are not common in Canada. Alas, new subprime financiers have joined the Canadian market recently and subprime segment is expected to double in next five years. Despite the stricter rules dealing with mortgage insurance and minimal downpayment in Canada, average household spending on monthly mortgage payments in 2007 reached 37 of after-tax income, compared to 32 in 2006.

Stabilizing, or falling?

In the past weeks, there have been lower sales numbers and larger numbers of listings available on the markets of Canadian big cities. Is this just a just simple trend correction, or a bubble losing air faster and faster?

Experts remain optimistic. Resales are expected to drop, but still supposed to remain above 465000 in every of next two years. Decline in new starts is expected as well, but with numbers still above past years average.

Average sale price, as the most important indicator, is expected to grow by about 5% in 2008. That’s much below almost 15% last year, but still strongly above inflation and turning seller’s market to more balanced one. In the light of the rising mortgage payments share on households expenses a slowdown in the rise of housing prices actually comes as good news.

The most influenced area so far is Alberta, where sales drop in Calgary and Edmonton are most noticeable, however, even in this area with sales going more than -30%, price rose by about 5%. Canadian real estate is far from being overpriced, as seen in the USA.

So that is where we are today in the Canadian real estate market. Steady, with slow growth. But what might the future hold for Canadian real estate?

• Interest rates: no prediction for substantial change at present. Cut from 3.0% was expected in June and may be still possible in the near future. On the other hand, commodity price turmoil may raise inflation. Against inflation, the Bank of Canada would raise interest rates as necessary, making mortgages more expensive.
• Net migration: believed to remain on high level of about 200000 people. People who will search for homes on the market! On the other hand, Canada’s birth rate is decreasing, potentially lowering future demand for housing.
• Overseas investments: after the meltdown of the American market, global capital is looking for new vaults and Canada seems as a good place to invest. During years 2003-2007 direct foreign investments rose by about 60%. And there are many other Saudis or Chinese looking for some real estate property.
• Baby boomers: First baby boomers from 1947-1966 period are going to retire. The question is whether they will look up for recreational property in Canada, or sell their house and move to Costa Rica? Only time will tell.
• Energy prices: probably will influence the structure of demand in the future. Energy consuming huge houses in distant suburbs will be less attractive to commuters than inner city condos or smaller houses downtown close to the place of work. On the other hand, rising energy prices may encourage many potential Snowbirds not to relocate out of the country far away from family, as the cost of returning to Canada regularly rises.

Conclusion?

Finally, everybody will draw his or her own conclusion based on the facts. Empirically, the Canadian real estate is slowing down now and the market is turning from strictly seller driven to a balanced one, with more affordable housing. But buying real estate in Canada remains a certain and good investment, with price growth beating the inflation rate. The factors driving the market are more decentralized and healthy – economic and population growth – with no hidden landmines like an out of control subprime mortgage sector.

The Canadian real estate market is healthy and advancing. With more properties available now is a splendid time to step in and get the house of your dreams on your own terms.

Toronto skyline by Susanne Jesperson

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