House prices in Toronto might seem overvalued, “but the fact is that fundamentals have all changed” (such as jobs and population growth), said Stephen Poloz, Governor of the Bank of Canada, in April.  Does that sound familiar?  It should.  Back in 2006 we heard Ben Bernanke, Former Federal Reserve Chair, state pretty much the same thing; rising house prices in the US “largely reflect strong economic fundamentals such as jobs and population growth”.  Canada could be different, but we doubt it.  

The Economist’s house-price indicator shows that Canada’s home prices are the second most overvalued when compared to rents, and the fourth most overvalued when compared to incomes.  This does not only confirm that house prices are overvalued, but shows that renting is the better option.   Of the fifteen countries they track, only half of the markets favour buying, based on incomes.  The indicators show that only four markets (Italy, Germany, Switzerland, and Japan) offer the potential for a decent investment going forward.  

Prem Watsa, the founder and CEO of Fairfax Financial, recently insinuated that Toronto’s market could face a substantial drop in prices when he stated that our financial institutions could not withstand a 50% correction in Toronto’s house prices.  He has raised subtle hints that Canada’s prices are out of whack for years.  Only this year did he raise the alarm bells. 

Either Statistics Canada’s data is 100% wrong or the banks and mortgage lenders are giving out loans with nothing down or very little.  Obviously, risky mortgages are a problem given Home Capital’s, Canada’s largest alternative lender, most recent meltdown.  Either way, house prices in Canada bear no relationship to family income and will correct. 

In Canada, the average house price ($460,000) is roughly 5 times family income.  This does not include lawyer fees, transfer taxes (up to $27,000 in Toronto), moving costs, and so on.  We are baffled trying to figure out where the money is coming from to buy the average mom and pop home.  The rule of thumb is, with or without a down payment, to never pay more than 3 times income for brick and mortar.  In big cities like Toronto and Vancouver families are paying up to 10 times income.  Even if these people put down 50% they are still heading for a financial nightmare.

The household debt-to-income ratio now stands at 169.4, up 23 per cent from a decade ago, and on par with the U.S. at the peak of its housing bubble.  Wage increases are around 1% annually.  This is before taxes which continue to creep up.  Cash pays anywhere from .05 of 1% to 1.25%, before tax.  In order to stick to the 3-times income rule, a family trying to purchase an average house, while maintaining a healthy balance sheet, must save at least $10,000 a year for 18 years to get a down payment in todays low interest rate environment.  In Toronto and Vancouver it will take up to roughly 35 years.  Given Canada’s low savings rate, how many Canadian families are actually saving $10,000 a year? 

A TD branch had an ad that the customer could pick the type of mortgage they wanted.  One choice was interest only.  In other words these people will be hoping house prices will continue the price appreciation of the past decade, which is literally impossible.  What the borrower does not think about is if they cannot make the full interest payment for one month, the difference is added to the principal.  This means future monthly payments will be even higher.  This is also a road to a financial nightmare.

Canada has a home ownership rate of 70%, the highest on record.  Like household debt, this is on par with the US in 2006.  Today, US home ownership is at a 50 year low.  Part of the reason US home prices started to decline was because too many people owned, equating to fewer potential buyers to hold up prices.  This resulted in a large price decline that tried to attract the few potential buyers.  It was a perfect house of cards.  Stocks cannot increase in price with few buyers.  Brick and mortar is no different.

Contrary to popular belief, we believe there is no shortage of housing.  If there is, it will only be temporary.  In fact, we are willing to bet that homes are being overbuilt.  Everywhere one travels they will see numerous cranes across the skyline.  So many people are becoming amateur landlords and buying second homes speculating that prices will continue to rise.  This is confirmed by a CBC report which found that 50% of condo units in Toronto and Vancouver are bought by investors.  Basic finance dictates that anyone who bought a rental property at current prices is losing cash because rents cannot cover costs unless one puts a significant down payment on the property. 

The most recent data released by CMHC also confirms our surplus belief.  The report highlights an epic proportion of new construction underway. As of February 2017 new homes under construction across Metro Vancouver are up 30% year over year.   Home sales are down over 20% from last year.  Falling sales and increased inventory does not make a healthy market.  The markets that are representing the bulk of Canadians are most likely similar.

Because the debt levels are so high and people having little to no savings, the collapse in real-estate will last for many years. Maybe even a generation given the amount of debt we are responsible for.  Lenders are not obligated to renew mortgages.  If prices fall many new owners may not be able to renew their mortgage without putting money down.  If they do not, they will be facing bankruptcy because their outstanding debt will easily exceed the value of their property.  This was also an issue in the US collapse. 

If politicians were serious about correcting the housing market they would make it law that there must be a minimum 20% down payment and the loan cannot exceed three times household income.  It should also be law that an audit should be conducted to ensure that the borrower actually saved the downpayment.   

When the correction comes house prices will fall back to their long term norm.  Just like they did in the late nineties, during the late seventies, and every other bubble in the past.   There will be few buyers around and lenders will quickly tighten lending.  It sounds unreal in today’s world, but every boom is followed by a bust.  This is just history repeating itself. 

We hope it does not take place but we can see no way to stop the coming correction.  History has shown prices always revert to yhr norm.  Tomorrow will be no different.  Cash is the number one asset to own.  Debt in any form is your number one enemy in this phase of the cycle.