Canada – Standing on Thick Ice

Over the past several years, prices for Canadian real estate have appreciated dramatically; generating concerns of a bubble that was giving an unsustainable lift to an economy that should properly be considered to be in the mire. These concerns have naturally been articulated with frequent comparisons to the recent catastrophic real estate bust in the US.

The performance of the Canadian economy in the second quarter, however, shows that fear of an exploding bubble is not well-founded. Canada’s economy accelerated at a 4.5 percent pace, the best of all the Group of Seven countries. The performance was strong enough that the Bank of Canada raised its benchmark interest rate on September 6th for the second time this summer.

Skeptics can point to the fact that the economy was paced by a high level of household spending, some of this no doubt due to the monetization of increased real estate values.

However, some of this spending was also fueled by gains in the stock market – the same appreciation of equities that is helping support the US economy and other developed economies around the world.

In addition, some of Canada’s recent prosperity is being fueled by organic growth in the global economy and the fact that the Canadian dollar has been off about 20%, not only against the US dollar, but by similar amounts against most other hard currencies in the world. As a major exporter of natural resources with a depreciated currency, Canada is having a good run.

Canada’s rich mineral sector is benefiting from high prices. The Canadian lumber industry has not been crippled by the large tariff imposed by the US on Canadian softwood. China, not the US, has been the biggest market for softwood from British Columbia since 2011 and international prices for Canadian softwood have remained stable.

Even before Hurricane Harvey struck the Houston area, Alberta was emerging from the latest slump in oil and gas. While Houston mends from its disaster, Alberta should have a bit more wind at its back.

Better yet, the growth in the second quarter came in spite of, and not because of, the real estate market. As discussed further below, residential real estate resales fell significantly. Notwithstanding that slump, the household savings rate increased to 4.6 percent in the second quarter from 4.3 percent, indicating healthy and broad-based wages.

Furthermore, any comparison of the current Canadian real estate market to the pre-crash US market is bound to be misplaced because the crisis in the US was caused not simply by bad asset quality, but by financial institutions aggressively leveraging these bad assets many times over.

In the US, a bad home loan became part of a bad mortgage-backed security, which became part of a bad CDO, which became the basis for a bad synthetic CDO. Eventually, when the loan was not repaid, it took down all of the financial structures built on top of it. Eventually, this resulted in ruinous capital charges to the institutions sponsoring these financial structures, to the bewilderment of senior managements who understood little of the details of these products they were selling, except that they seemed to generate big profits. This type of hyper-leveraging is simply not present in the Canadian markets.

In addition, the headiest appreciation in Canada can be attributed to its already highest-priced, most cosmopolitan markets, Vancouver and Toronto. Prices in these markets had been buoyed by ‘hot’ money coming in from abroad: primarily Chinese investors anxious to see this money find a home in a free market economy, followed by American and other investors eager to play the momentum trade and to take advantage of the fall of the Canadian dollar.

This had become such an obvious trend that both markets famously imposed a 15% tax on purchases by foreign buyers. However, many outside commentators neglect to observe that the ‘foreigner taxes’ were part of a nationwide, comprehensive tightening up of standards in the real estate market due to concerns that home ownership and rents were becoming unreasonably burdensome for many Canadians.

The new regulations address the usual suspects of mortgage eligibility and mortgage insurance, but also include more vigilant tax collection especially regarding flippers, expanded rent control in some markets, and more consumer protection in real estate contracts.

These regulations have certainly helped blow the froth off the markets. The Toronto Real Estate Board’s sales numbers for August 2017 show that the number of homes sold in the Greater Toronto Area decreased by 34.8 per cent compared to August 2016. That decrease is only slightly less than July’s numbers, which were down 40 per cent year-over-year.

About Chris Donnelly

Christopher J. Donnelly, is an experienced attorney, bond analyst and fixed income strategist, with years of experience in structured finance, distressed bonds and bond related litigation in a variety of industries and the emerging markets. He is a graduate of Rutgers University (BA), The University of Pennsylvania (JD) and New York University, (LLM in Taxation). Chris is a Managing Director of Straacom, LLC and can be contacted at Straacom provides strategic research, analysis and communications for publication and on assignment for private clients.

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