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Thursday, February 18, 2010

Canada not immune to downward pressure on housing prices

David Rosenberg
Published on Thursday, Feb. 18, 2010 12:00AM EST
Last updated on Thursday, Feb. 18, 2010 11:17AM EST

Canada not immune to downward pressure on housing prices
The landscape bears an eerie resemblance to the U.S. real estate market in 2005-06

The hot Canadian housing market is now likely to burn even brighter in coming months.

Expect a rush of sales activity as buyers look to get in ahead of new CMHC guidelines that kick in on April 19, just in time for the seasonal spring selling period.

Then we have the harmonized federal and provincial sales taxes in British Columbia and Ontario kicking in on July 1, adding more distortion.

And of course, the speculation is that the Bank of Canada will begin to raise interest rates some time in the third quarter.

So if there are any Canadian homeowner wannabes still sitting on the fence, look for them to hop in during the next few months - then expect a swan-dive in the second half of the year, right when the central bank is widely expected to start tightening.

While there may be a healthy debate as to whether there is a bubble or not in the Canadian housing market, suffice it to say that residential mortgage balances relative to disposable income just hit 92 per cent, which is exactly where this ratio was in the U.S. in 2005 when the mania was about to morph into a full-fledged bubble. It was barely a year later that the process of mean reversion began its course.

The Vanier Group just conducted a study showing that the price of an average home is now five times the size of average household after-tax income, which is 35-per-cent higher than the long-term norm. Remember - the word "norm" is not the guy sitting at the bar at Cheers but is short for "normal."

As prices inevitably normalize, it is hard to see the Bank of Canada tightening the policy screws as the primary asset on the consumer balance sheet deflates.

Meanwhile, that process of normalization is much further along south of the border - it seems prudent to not lose sight of the lessons being learned there.

A mere 3 per cent of respondents to the most recent University of Michigan consumer sentiment survey see housing as a solid investment. This is well below the 24 per cent who thought so back during the bubble days when the homeownership rate hit record highs of nearly 70 per cent as the boomers increasingly viewed real estate as a retirement asset instead of what it really is - a place to live and raise your family.

The aspect of housing supply that no one understands yet is that everyone wishes they still lived in the house that they sold to buy the one they now own. This is especially the case for U.S. baby boomers.

They bought their oversized home during the bubble years because they believed that the price would always go up; there would always be liquidity and they really wouldn't need to pay off the loan out of earned income. The mortgage would be retired at the closing table and they would walk away with a big cheque.

That was why they bought a house that was much larger and more opulent than they really envisioned themselves living in during retirement. It was half dwelling and half investment.

At the margin, the boomer population may not be as attached to the status quo as some think - now it wants to rid itself of a depreciating asset, and even more critically, get rid of the debt and the maintenance expenses. This is why the selling pressure has been so intense in the homeownership market in the U.S., and don't think for a minute that Canada won't see a similar development as the demand boom here subsides as government support wanes in the intermediate term.

As we have already witnessed in the U.S., selling pressure in real estate is far worse than the selling pressure on consumer durables because this housing asset tends to have a voracious appetite - it is both highly leveraged and yet highly illiquid. Since sales are still so difficult to transact, U.S. lenders are entering into deals that keep families in their homes. This is a new reality.

If it's not loan modifications, then it's foreclosure short sales and deeds-in-lieu. Three years into the housing crisis, and we have only recently begun the process of principal reduction to fully reflect the plunge in home prices from their bubble highs. Those deals will have to reflect a big enough writedown and rate concession to keep people in houses they don't want.

As society tries to get small, the marginal transaction is driven by sellers who are liquidating debt. I am pretty sure that the bottom line is that all of the buyers are going to be operating against a backdrop of a much bigger supply of sellers than anyone is currently thinking about. That is why supply and demand will take many years, not quarters, to come into true balance.

In other words, the deflation cycle in U.S. residential real estate is far from over. And while Canadians feel fortunate to have escaped the awful experience of a bubble burst in housing, considering that the degree of leverage, homeownership rates and home price overvaluation is not altogether that far off what the U.S. landscape looked like back at the bubble peak in 2005-06, I wonder what the future holds?

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