REAL TALK

Canada’s real es­tate mar­ket isn’t just boom­ing — it’s be­com­ing too big to fail

Sharp - - CONTENTS - By Kevin Carmichael

Canada’s hous­ing mar­ket isn’t in the midst of a boomand-bust story — in fact, it’s be­come too big to fail.

It was all about to come crash­ing down. That’s the con­clu­sion one would draw from read­ing the Cana­dian busi­ness press in the spring of 2017, which, af­ter gid­dily cheer­ing the hous­ing boom, now her­alded an in­evitable bust.

A favourite theme: Cana­di­ans ap­peared to have lost their minds over houses the same way their Amer­i­can cousins had ahead of the fi­nan­cial cri­sis of 2008. Non­de­script de­tached homes in hard-luck Hamil­ton, On­tario, were sell­ing for $1 mil­lion. In Van­cou­ver, prices had climbed 50 per cent in only three years head­ing into 2016 — great if you hap­pened to own prop­erty, not so great if you didn’t. In­sti­tu­tions such as the Bank of Canada had started talk­ing in more de­tail about the per­ils of debt. To keep up with those surg­ing house prices, Cana­di­ans had mort­gaged their fu­tures like never be­fore, prompt­ing the cen­tral bank to worry about fi­nan­cial sta­bil­ity.

There was an­other par­tic­u­larly bad omen. Home Cap­i­tal, a small­ish mort­gage lender, had cast a dark shadow over the real es­tate mar­ket. A cou­ple of years ear­lier, the firm re­al­ized that a few dozen bro­kers it worked with had been fil­ing false mort­gage ap­pli­ca­tions. Home Cap­i­tal in­sisted the is­sue was mi­nor, but its ex­ec­u­tives couldn’t make the prob­lem go away. If you saw The Big Short, you know that ram­pant fraud was at the heart of the U.S. hous­ing col­lapse in 2006 and 2007, and alarm bells were sound­ing.

All the talk was of bub­bles and crashes. Van­cou­ver prices cratered af­ter the provin­cial gov­ern­ment be­gan tax­ing in­ter­na­tional buy­ers. Real es­tate in the Greater Toronto Area was still on fire, but that no longer felt like a good thing. Prices in the GTA jumped al­most 30 per cent in Fe­bru­ary. (Fe­bru­ary!) Panic set in, and the new class of pa­per mil­lion­aires rushed to cash in while they still could. In May, new list­ings in Toronto in­creased 40 per cent from a year ear­lier, then jumped 60 per cent in June.

“The hous­ing mar­ket is on the verge of a po­ten­tially se­vere down­turn,” David Madani, an econ­o­mist at a re­search out­fit called Cap­i­tal Eco­nom­ics, ad­vised his clients around this time.

Madani, who has a knack for get­ting his name in the pa­pers, had been pre­dict­ing doom for years. But in early 2017, it felt like he might fi­nally be proven right. And then War­ren Buf­fett showed up.

Let’s get some­thing out of the way: this may be an­other story about Canada’s hous­ing ma­nia, but this isn’t a story about bub­bles and crashes. Bad things could hap­pen; of course they could. It would prob­a­bly take a re­ces­sion to do the dam­age, and Canada’s econ­omy hasn’t looked this good in years. Yes, higher in­ter­est rates could cause in­debted house­holds some pain. The Bank of Canada knows that, which is why it has been clear in say­ing that it in­tends to raise in­ter­est rates slowly. It doesn’t want to trig­ger a wave of per­sonal bank­rupt­cies.

From here, the most likely sce­nario for Cana­dian real es­tate is that prices level off. Var­i­ous gov­ern­ments have in­tro­duced mea­sures to cool de­mand, but the politi­cians have been ten­ta­tive, leav­ing most of their vot­ers’ cher­ished hous­ing sub­si­dies in­tact. So don’t get too hung up on all the talk that gov­ern­ment pol­icy has killed de­mand. The po­lit­i­cal class has a vested in­ter­est in keep­ing home prices buoy­ant: real es­tate has be­come a big part of the econ­omy and, as such, an im­por­tant source of rev­enue. You might even say that real es­tate is too big to fail, a po­lit­i­cal re­al­ity that will dis­ap­point the eco­nom­ics academy but re­as­sure a na­tion in which nearly 70 per cent of the pop­u­la­tion now owns a home.

Bot­tom line: don’t be­lieve ev­ery­thing you read about Canada’s hous­ing mar­ket. The best of times are over, but the worst of times re­mains a low-prob­a­bil­ity event.

Now let’s get back to Buf­fett, the world’s third-rich­est per­son and a bringer of fi­nan­cial sta­bil­ity. In June, Buf­fett, who works through his hold­ing com­pany, Berk­shire Hath­away, re­ceived an email from a con­tact in Canada about an in­vest­ment op­por­tu­nity: be­nighted Home Cap­i­tal, which by this time was be­ing por­trayed as Canada’s ver­sion of Lehman

Broth­ers, the in­vest­ment bank whose bank­ruptcy is syn­ony­mous with the Great Re­ces­sion.

Marc Co­hodes, an in­fa­mous short seller who bets against com­pa­nies from his chicken farm in Cal­i­for­nia, was trash­ing Home Cap­i­tal on Twit­ter and in the me­dia. The On­tario Se­cu­ri­ties Com­mis­sion had ac­cused the firm of mis­lead­ing share­hold­ers over the fake mort­gage ap­pli­ca­tions. De­pos­i­tors were flee­ing, and the stock price had plunged 70 per cent. In May, The Globe and Mail re­ported that reg­u­la­tors were hours away from forc­ing Home Cap­i­tal to shut down.

All this had made the over­all hous­ing gloom worse. Gold­man Sachs, the in­flu­en­tial New York–based in­vest­ment bank, doesn’t pay a lot of at­ten­tion to Canada, but that didn’t stop if from putting the odds of a True North fi­nan­cial cri­sis at 30 per cent. The value of the Cana­dian dol­lar dropped, and in­vestors sold their shares in Canada’s six big­gest banks, even though each one had just posted mas­sive quar­terly prof­its. Buf­fett ab­sorbed all of this in­for­ma­tion from his sta­tion in Omaha, Ne­braska. But in­stead of an im­mi­nent col­lapse, he saw op­por­tu­nity. “I’m bullish on Canada,” Buf­fett would tell The Globe a few weeks later.

The com­par­isons be­tween Home Cap­i­tal and Lehman were non­sense; one was a tiny pur­veyor of home loans that rep­re­sented about one per cent of the Cana­dian mar­ket, the other was a leg­endary Wall Street firm that had deal­ings with vir­tu­ally ev­ery ma­jor bank in the world. If Home Cap­i­tal went down, Bay Street wasn’t go­ing down with it.

Buf­fett saw through the sen­sa­tion­al­ism. He preys on panic: when mor­tals lose their heads, he comes down from the heav­ens and buys at a dis­count. Buf­fett would have known that even if Home Cap­i­tal did run out of money, the Of­fice of the Su­per­in­ten­dent of Fi­nan­cial In­sti­tu­tions in Ot­tawa would take over the firm and dis­trib­ute its as­sets. Af­ter 10 days of as­sess­ing the sit­u­a­tion, Berk­shire an­nounced that it would pur­chase $400 mil­lion worth of Home Cap­i­tal stock and ex­tend the firm a $2-bil­lion line of credit.

“Es­sen­tially,” said Buf­fett, “I feel Berk­shire’s par­tic­i­pa­tion is very likely to im­prove an al­ready rea­son­ably sta­bi­lized po­si­tion.”

You don’t have to be a bil­lion­aire to take ad­van­tage of fear. Quentin D’souza has been hon­ing his in­vest­ing strat­egy for 15 years. He started out trad­ing stocks, bonds, and mu­tual funds. But when he learned that his wealth man­ager was driv­ing a Jaguar — while he was driv­ing a Pon­tiac Sun­fire — he fig­ured there must be a bet­ter way.

The guy driv­ing the Jag had al­ways steered D’souza away from prop­erty. D’souza, who is based in Whitby, On­tario, de­cided to go his own way. Since the 1970s, home prices in the Toronto re­gion have trended con­sis­tently higher. Also, de­mand was grow­ing faster than sup­ply. D’souza de­cided to be­come a land­lord, buy­ing prop­er­ties, fix­ing them up, then rent­ing them out. “Peo­ple al­ways need a place to live,” D’souza says. “But they can stop eat­ing at Mcdon­ald’s. They can stop shop­ping at Wal­mart.” His point: a stock in­vestor has lit­tle con­trol over his or her in­vest­ments. As a prop­erty owner, he says, “I have di­rect con­trol over the as­set.” D’souza now owns a cou­ple of dozen build­ings through his com­pany, Ap­p­leridge Homes, and has writ­ten three books about the rental busi­ness. Re­cently, he bought him­self a new truck.

For some, D’souza is an em­blem of Canada’s prob­lem: an­other blind fool who be­lieves house prices will never fall. But he isn’t a pure evan­ge­list. For ex­am­ple, he’s wary of the Toronto condo mar­ket and says thou­sands of al­ready stretched buy­ers could be in for a shock if they ever have to pitch in on a ma­jor re­pair of the glass tower for which they are now par­tially li­able. His spread­sheets of his­tor­i­cal prices in the Greater Toronto Area show that booms some­times lead to busts: it hap­pened in the 1970s and again in the 1980s.

The lat­est data has con­vinced some that a third col­lapse is in­evitable. Home sales dropped more than 30 per cent in Au­gust from July, and new list­ings were the low­est since the sum­mer of 2010, ac­cord­ing to the Toronto Real Es­tate Board. Prices are hold­ing up, though. The av­er­age cost of a home in the GTA in Au­gust — $732,292 — was still three per cent higher than it was a year ear­lier.

That fits with D’souza’s out­look. The era of dou­ble-digit price in­creases is over, he says. But if you are will­ing to buy and hold, he doesn’t see how any­one can lose money on Toronto hous­ing. D’souza has been tak­ing ad­van­tage of the softer prices, adding a few more prop­er­ties to his col­lec­tion over the sum­mer. He says he will be look­ing out for more.

“Peo­ple are scared,” he says. “When peo­ple are scared, it’s an op­por­tu­nity.”

There is still a lot of smart money that sees po­ten­tial in hous­ing. That will keep up­ward pres­sure on prices; maybe not enough to drive big re­turns but likely

enough to fore­stall a fi­nan­cial cri­sis.

And if it doesn’t? Canada’s banks are flush with cash and it would take a lot to top­ple them. Chris Catliff, chief ex­ec­u­tive of Blueshore Fi­nan­cial, a credit union in Van­cou­ver, said hous­ing prices could plunge 30 per cent and his firm would still be fine.

There’s an­other back­stop: you, the tax­payer.

David Dodge, the for­mer Bank of Canada gover­nor, told me ear­lier this year that no gov­ern­ment would let the real es­tate mar­ket col­lapse. Later, I heard Fi­nance Min­is­ter Bill Morneau de­scribe for an au­di­ence in Mon­treal what vot­ers ex­pected of him. Among other things, “they are count­ing on you to en­sure their home keeps its value,” he said. That’s not the kind of thing you say if you are in­dif­fer­ent to the hous­ing mar­ket.

Ot­tawa has grown wary of su­per­charged price in­creases, which is why Morneau made it more dif­fi­cult to qual­ify for a mort­gage. But that’s aimed at dis­cour­ag­ing peo­ple from tak­ing on loans they can’t af­ford. No one in Ot­tawa is talk­ing about or­ches­trat­ing a cor­rec­tion.

Some wish he would — Van­cou­ver and Toronto rank among the most un­af­ford­able cities in the world, and things aren’t much bet­ter in Mon­treal, Calgary, and Ed­mon­ton, ac­cord­ing to De­mographia, a St. Louis–based con­sul­tancy that stud­ies ur­ban plan­ning. Prices rose dra­mat­i­cally faster than in­comes over the past decade, and home own­er­ship in too many places is now the pre­serve of the wealthy. It’s a prob­lem that gov­ern­ments will feel pres­sure to ad­dress.

That doesn’t mean prices will fall. Ot­tawa and lo­cal au­thor­i­ties in Bri­tish Columbia and On­tario have been ten­ta­tive in their at­tacks on run­away prop­erty mar­kets. Here’s why: economists reckon hous­ing and as­so­ci­ated in­dus­tries, such as con­struc­tion, now ac­count for at least 20 per cent of Canada’s gross do­mes­tic prod­uct. An eco­nomic en­gine of that size must be ad­justed care­fully. Royal Bank of Canada es­ti­mates that a 10 per cent drop in na­tional house prices would erase a full per­cent­age point from GDP growth. That would kill what has be­come an im­por­tant rev­enue stream for gov­ern­ments across the coun­try. On­tario projects it will earn $3 bil­lion from land-trans­fer taxes this year, the dif­fer­ence be­tween a bud­get sur­plus and a bud­get deficit head­ing into an elec­tion year. In 2016, Bri­tish Columbia’s gov­ern­ment earned $2.2 bil­lion from var­i­ous real es­tate taxes, more than it nets from forestry and min­ing.

These are the numbers you don’t hear about in most real es­tate con­ver­sa­tions. And they’re pow­er­ful in­cen­tives to keep prices aloft.

In Septem­ber, the Bank of Canada raised in­ter­est rates for the sec­ond time in two months — a star­tling de­vel­op­ment, given that it hadn’t turned the dial in the di­rec­tion of higher bor­row­ing costs for seven years.

One of the rea­sons for the change was to curb our credit lust: the cen­tral bank sees all that debt as a vul­ner­a­bil­ity. The sec­ond in­crease was prompted by data that showed the Cana­dian econ­omy was grow­ing at an an­nual rate of 4.5 per cent — much faster than cen­tral bankers think is pos­si­ble with­out caus­ing in­fla­tion. That put the bench­mark rate at one per cent — still very low. And it might stay there for a while. The cen­tral bank said fu­ture in­creases would de­pend on a hand­ful of fac­tors, in­clud­ing the “sen­si­tiv­ity of the econ­omy to higher in­ter­est rates.” That’s code for: we in­tend to go slow.

A last bit of per­spec­tive. A year ago, the Van­cou­ver mar­ket looked wob­bly. Buy­ers were thrown by that tax on for­eign­ers, and the mar­ket re­treated. Now it’s com­ing back. The av­er­age price for a home in the Greater Van­cou­ver Area was $1.03 mil­lion in Au­gust, a 9.4 per cent in­crease from a year ear­lier, ac­cord­ing to the Real Es­tate Board of Greater Van­cou­ver.

It should sur­prise no one if some­thing sim­i­lar oc­curs in Toronto. Yes, prices are high, maybe even too high. But the con­vic­tion that real es­tate is the ul­ti­mate in­vest­ment runs strong with Cana­di­ans, so much so that D’souza, who would ben­e­fit per­son­ally if more of us would rent, can’t stop preach­ing the ben­e­fits of own­er­ship. “I even en­cour­age the peo­ple who rent from me to buy,” he says. War­ren Buf­fett would be proud.

“When peo­ple are scared, it’s an op­por­tu­nity.”

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