Jul 2013 19

Slowing Housing Market Shouldn’t Put Canadian Banks at Risk

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Financial District by Francisco Diez Financial District by Francisco Diez

The Canadian real estate market has been cooling down since the government tightened mortgage lending rules, particularly in the number of home sales, which went down 2.6 per cent this May on a year-over-year basis. According to a report by the Canadian Imperial Bank of Commerce (CIBC), the slowing housing market will significantly affect the value of loan growth. However, there will also be some positives, including more stable prices and a stronger position for first-time buyers.

Recently, there have been many predictions about a hard landing of the Canadian housing market due to a decreasing volume of home sales. However, home sales levelled in April and May, indicating that the market remains stable.

Figures of the Canadian Real Estate Association (CREA) indicated an increase in national home sales activity at the end of the first quarter, which accelerated even more in the second quarter. On a month-to-month basis, March recorded a 2.4 per cent increase in the number of transactions, April was up by 0.6 per cent, and May experienced the largest month-to-month growth in more than two years, with an increase of 3.6 per cent. Furthermore, year-over-year resale activity declines are slowing down, with a 3 per cent drop on an annual basis in April and 2.6 per cent in May. Douglas Porter, chief economist with BMO Capital Markets, pointed out,

The overall message is that there is still some strength in the economy. This has gone hand in hand with better job news and some more encouraging reports generally. I wouldn’t say the economy is booming by any stretch of the imagination but I think the main point is that it’s holding up better than many had expected as recently as a couple of months ago.

Furthermore, resale prices remain stable, increasing 1.3 per cent year-over-year in April and 3.7 per cent in May compared to May 2012. The national sales-to-new listing ratio was still firmly in balanced territory, rising to 50.4 per cent in April and to 51.4 per cent in May. The sales-to-new-listings ratio in May showed that two-thirds of all local markets were in balanced market territory in May.

Financial District in Toronto by Chris Tyler Financial District in Toronto by Chris Tyler

CIBC reported that it has the greatest sensitivity to domestic retail loan growth pressure, followed by Toronto-Dominion Bank (TD) and National Bank. On the other hand, the Bank of Nova Scotia (Scotiabank), Bank of Montreal (BMO), and Royal Bank of Canada (RBC) are at the other end of the spectrum. John Aiken, Barclays Capital analyst, suggested,

This coincides with the relative contributions of domestic mortgages to the banks‘ overall loan portfolio as well as the contribution of earnings from their domestic retail bank segments.

The housing market outlook for the second half of 2013 and 2014 released by the Canada Mortgage and Housing Corporation (CMHC) indicates that home sales should stay stable in 2013 and rise in 2014 along with employment, economic growth, and net migration. Apparently, increases in mortgage rates that are expected shouldn’t have a significant impact on economic conditions. Prices are expected to increase in line with inflation. Mario Mendonca, analyst at Canaccord Genuity, sees signs of stabilization in Canadian housing prices too. He pointed out,

Importantly, we believe the Canadian banks would be able to weather a more than modest decline in housing prices due to the relatively high level of insured mortgages (approximately 60 per cent of all mortgages), the relatively low loan-to-value ratios (55–60 per cent) and the relatively low debt-service ratio of around 30–40 per cent. That said, there is some tail risk with lower-income homeowners with a higher debt service ratio, particularly if we see a rise in unemployment.

Risk Areas

The Bank of Canada warned that Canada’s economy may be at risk due to certain overheated segments of the real estate market, particularly Toronto’s condo market. The main national risk factors are imbalances in the housing market and high household debt. Furthermore, the Bank of Canada still believes that the euro-zone crisis represents the biggest international risk.

The overbuilt and overpriced Toronto condo market could face a steep correction in prices and construction activity, which would affect other segments, resulting in a negative feedback loop. This would encompass a drop in net household worth, disturbing confidence and consumer spending as well as affecting income and job creation. The Bank of Canada informed,

These adverse effects would weaken the credit quality of banks' loan portfolios and could lead to tighter lending conditions for households and businesses. This chain of events could then feed back to the housing market, causing the drop in house prices to overshoot.

Moreover, the central bank pointed out that the housing market is overvalued and housing affordability could become a serious issue when interest rates increase and reach normal levels. According to the OECD, Canada has the third most overvalued real estate market of the advanced economies, pointing out that the prices are still increasing. The Canadian housing market is overvalued by 60 per cent based on rents and by 30 per cent compared to prices. The OECD warned that the Canadian real estate market is vulnerable to the risk of a price correction.

Bank of Canada by Brent Eades Bank of Canada by Brent Eades

However, the income per person in Canada is growing, and there aren’t forecasts of interest rate hikes until 2014. Furthermore, Angel Gurria, secretary-general of the OECD, noted that the Canadian economy is in decent shape. He added,

An overvalued housing market and a bubble are not the same thing. The housing market has been building very steadily over a period based on growth, jobs, good income, and a Canadian economy that’s been in good shape. Frankly, it’s not a bubble in the sense of great big speculation in the property. I think there will be a cull in some investment in the sector, which will see prices stabilize over time.

Even though prices went up in May, the increase wasn’t exceptionally large — below the average of 1.2 per cent in the last 12 years. According to Marc Pinsonneaut, senior economist at National Bank, there shouldn’t be a significant acceleration in annual prices in the near future. Overall, we can say that Canada’s real estate market is not at risk of a significant correction, even though the market might be declining slightly and the prices are going up.

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