Thursday, July 23, 2009

Canada's real estate bubble...poised for collapse

I can already hear the chatter, emanating from home owners and real estate agents far and wide.

"Bubble?!?! What bubble??? Canada's Real Estate market is doing fine, prices aren't rising out of control, they're up only modestly or holding steady. Pick up the paper and read what industry professionals are saying, our housing market is poised for bigger and better things in the years ahead"!!!

Uh huh, I know...every time I've discussed Canada's housing market in the past month or two, the reaction to my view is always the same. About a month ago I blogged on this topic, relating a conversation with a colleague who's going through a divorce. I had suggested to "Bob", that once the marital home is sold, that he'd do well to hold on tight to his cash and rent...with an eye to getting back into the market in another year, if not two.

Bobby didn't listen, I knew he wouldn't. The last words in that blog posting were as follows:

"Bob said he'll think about it...but I just know the media whores are going to get him".

In the final analysis, it wasn't really the "media whores", instead it was Bob's own prejudice towards owning versus renting....ah well.

Bob opted to buy a $220,000 detached little walk up in the same area as the marital home. He's plunking down a whopping $20,000, and amortizing the mortgage over 35 years. He better pray I'm wrong, and I could be....but I don't see how. There's always the chance a gold vein will be discovered on his 30'x90' plot of land, and that he won't soon slide into negative equity. There is always the unforeseen, and in the case of a home purchase...the unseeble offers the only chance of a bullish housing market, because everything we can see is scary.

$220,000 for a small home, barely 1,100 square feet, 3 bedrooms, no dining room, one and one half baths...basement unfinished. Am I the only person in Canada who thinks this is overpriced for a community about one hour north of Toronto? I feel like the guys who were bearish on tech stocks in and around the year 2000.

Look, I realize purchasing a home is about more than dollars and cents. It is quite likely the most emotional purchase an individual can make, with the possible exception of a middle aged man engaging the services of a 'professional' to revive his flagging libido. And that's the key word here, emotion.

When a young couple goes looking for their first home, thoughts about finances can fly quickly out the window. Money concerns are quickly replaced with visions of the family kitchen...of the child's room soon to be occupied by a little one, with a crib and a changing table. It doesn't take long for fear to set in. What if someone else buys "our home"??? Already in their imagination the couple has planned the garden, the furniture, the backyard BBQ parties.

For the sake of simplicity let's focus in on that little detached job north of Toronto that my friend closes on in about a month. While its a divorced father buying it, it could just as easily be a young couple purchasing their first home. Twenty thousand isn't chump change, although it is less than 10% of the purchase price, $220,000.

A mortgage with a 35 year am is going to carry for around $800 per month. Then there's property tax which I'll guesstimate at say $250...add in heat, hydro and insurance, and we'll say the cost of occupancy is $1,200 per month...being generous to the low side. Bob told me an acquaintance of his was looking to rent out a town home, slightly bigger in size...for $1,100 with heat and hydro included. I would wager that for $1,200 or so per month one could find decent rental accommodation an hour north of the big smoke, so there are other options.

Now obviously when someone buys a home, they're typically not looking to flip it in the short term...I'm not talking about RE speculators here. The idea is to live in it and build equity, and given that this is a small move up in the market in a few years. Okay...sounds reasonable. But is there legitimate reason for worry here?

You bet!

Bob is in a similar situation to a young couple buying their first home, depleting almost all his savings for a down payment. There are any number of situations which can cause a person to have a sudden need for cash. With the economy being what it is, job loss is certainly a possibility for many. Or what if the something happens to the car, or the roof. I don't mean to sound alarmist, but sound financial planning dictates the need for a rainy day fund that's accessible.

And when you take a close look, $20,000 worth of equity in a home valued at $220,000 is really no equity at all. If a sudden catastrophic need for cash arises there is always the possibility of selling. But with real estate and lawyer fees you're looking at 'at least' $15,000. All of a sudden that $20,000 in equity is whittled down to just $5,000.

And that $5,000 won't even be around when the air starts coming out of the real estate bubble.

Yeah, yeah, I hear ya....

"Again with the bubble
, there is no bubble!!! CANADA'S HOUSING MARKET IS NOT A BUBBLE"!!!

Yes it is.

Back in the fall of 2008, when Canadians were busy going to the polls to elect a new government (well some of us anyway) fear took hold of the Canadian economy. The bubble that was the energy market collapsed, with the world price for oil plummeting from a high of $140 a barrel all the way down to around the 40 dollar mark. Remember all those people who said that oil would still be cheap at $150? They're probably the same ones now telling us that the housing market has stabilized and that its geared for growth.

Back in the fall housing sales fell off the map, and prices did start to dip slightly. Amid fears of depression and bank failures Canada's government (in tandem with other nations) moved boldly to repair the hole in our housing market. The solution? Dirt cheap credit. Rates were dropped so low, the only way they could drop further would be if lenders paid people to borrow.

And it worked, the housing market recovered. I'm not talking about a market boom like the late 70's and very early 80's...housing was already grossly overpriced when prices started to dip. Just stabilization and even some bidding wars in hot spots like Vancouver.

So why am I predicting a market "collapse"? Well...firstly, collapse might be too strong a word, although it probably got your attention. Collapse though is a matter of perspective. I do think the broader Canadian real estate market will see prices falling by around 10% come next spring/summer, and dropping perhaps as much as 25% in the year following.

For the real "Bob" and the fictitious young couple buying that $220,000 walk-up, this could be seen as a catastrophe. A ten per cent drops wipes out all their equity, and a drop of 25 puts them deep into negative equity...owing more on a home than what it's worth.

Canada's economy is bleeding jobs, this is a fact. Interests rates are at their lowest levels EVER, and that means there is only one direction for them to move, UP. As rates climb affordability drops, and combined with rising unemployment we're looking at the perfect storm for housing prices to drop like they did in the 80's when interest rates started climbing.

On top of all this, these 35 year mortgages being handed out to buyers putting down very little, or nothing at all...they're being insured by our government through CMHC (Canada Mortgage and Housing). Thanks to the AIGs of the world, everyone now understands the dangers of toxic debt, the threat of 'asset backed commercial paper'. Our government can say all it wants about maintaining services without raising taxes, anyone with half a brain knows that's an impossibility.

Bob is like investors who borrowed money to buy into oil after it hit $100 a barrel and kept climbing. Will it get there again? Absolutely, and for those who were smart and waited for the collapse the rewards will be huge. Same as they will be for home buyers who keep their emotions in check and wait out the market over the next 12-24 months.

One last note. If you wish to question my predictions, that's fine. I'll just ask that you wait until January of 2010, bookmark this post if you wish. In the near term markets can be volatile, no matter how fundamentally flawed a particular commodity may be. Even a lousy hockey team can go on a 5 or 6 game winning streak. But that doesn't mean they're going to make the playoffs.

Talk to you in January and beyond, I'll be bragging.

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