Real Estate Selection in the Cheap Money Era

Latest Read on Canadian Housing

The first half of 2019 has passed, and most of the Canadian companies have reported their quarterly results.  There are renewed concerns regarding the level of debt in the Canadian economy and the risks surrounding it. In this report we want to have a closer look at the Canadian credit market with emphases on its real estate sector. But before going to the fundamental part, let’s have a quick look at the latest read on national real estate statistics for the month of May released by the Canadian Real Estate Association (CREA) :

  • Average real estate price increased 1.8% YoY in May. This is the second increase since Sept 2018. Canadian real estate prices were supported by higher unit sales while new listings declined which strengthened demand versus supply
  • National real estate dollar volume increased by 8.6% YoY. This the second month of positive change in dollar-volume in the past 15 months
  • New listing declined 4.1% vs. last year and 9.4% compared with May 2017. We think this is the main driver of improved dollar volume number. Less listing brings less supply to the equation. We are closely watching new listing number in the next 6 months as it usually picks up in summer.

Economic perspective of Household’s Debt

Canadian household accumulated debt at the compound annual growth rate (CAGR) of 6.7% between 1990 and 2018, while their disposable income grew at 3.9% annually. This resulted the household’s debt to disponible income ratio reached to 175% level at the end of 2018 from 80% in 1990(First chart).


So, the question is why we haven’t seen any serious problem while we are pilling debt? The Answer is: thanks to the declining interest rate, borrowers are not paying for their additional debt. (Look at our previous report about the secular low interest rate environment)

When we gauge the credit risk at the household level, we look at the cost of debt versus just using the absolute level of that. In other words, we watch closely how much more or less does it costs the average Canadian families to service their debt. Debt Service ratio (DSR) measures how much of your disposable income goes to pay principal and interest for your debt. From the absolute volume of debt, mortgages and HELOC (homes’ line of credit) have made ~65% of the households’ debt at the end of 2018 based on Statistics Canada. However, the monthly payment installment balance is not divided as the absolute debt value. Although mortgages made 65% of Canadian debt, they are only responsible for 45% of monthly debt payments (Second Chart). Auto loans, Line of credits and credit cards with higher effective interest rate, and different default profiles, are responsible for 55% of monthly payments. (non-mortgage payment was 40% in late 90s)

The next chart shows the DSR change over the last 30 years. Debt service ratio reached back again to its elevated level of 14.9% at end of March. This is the same level back in 2007-2008. Increasing interest rate started in 4Q17 lifted DSR ratio from 14% to 14.9% in the last twelve months. At Uptimo we think that DSR is a leading indicator of credit losses, so if the interest rate increases further, which is not our base case scenario, we expect to see defaults on some of the households’ debts. However, due to the Canadian debt portfolio’s structure, we believe discretionary purchases are the one which get the first hit, should the interest rate move higher. Discretionary goods are not on the top essential list of households, therefore they cut them first when rainy days come by. (We are watching auto loans and auto loan default carefully as the key proxy for).

Expensive non-mortgage credits have made Canadian more sensitive to change in interest rate. Effective interest rate increased during 2018 from 3.03% to 4% (following charts), derived DSR ratio to 14.9% level. The effective interest rate is a weighted-average of various mortgage and consumer credit interest rates that households are paying on all their borrowed money. The lower the number, the less cash out of pocket. We expect the effective interest rate will be adjusted lower in the coming weeks as the Canadian general yield declined from 2.01% at the end of 2018 to 1.39% level now.

Canadian Real Estate Market Economy

When we look at the regional perspective, Vancouver is showing slowing sales and Calgary has not really recovered from its 2015 – 2016 oil downturn. On the other hand, Toronto is seeing some stability and Montreal is experiencing hottest real estate in Canada as the capital follow targeting Montreal and the unemployment is at its historical low level.


Looking at the forty years historical data, there are only two major corrections for Canadian real estate prices,the first happen in 1990[1], the severed one with ~30% correction, and the second one was 2008 with 18% decline in prices. (Black line is the average price line and the colored bars are changes in activities measured by dollar volume change in the real estate.)
Here is an interesting question: Why we didn’t have a correction during 2000 dotcom bubble burst period? In other words, what is the other factor affecting Canadian real estate market and differentiate it cycles from those of stock market?


[1] Changes in BOC policy to tackle high inflation, defaults, restructurings, and downsizing in Canadian corporations, large budget deficit both in provincial and federal governments, and emerging market crises were the elements defined the economic environment in 1990s. Rental Market

If we look at “New listing/ Housing stock” (NLHS) ratio we can find new supply to the market at any given time. The average value for this ratio is 5.6% for the past forty years, meaning that ~5% of the all units changed in hand annually which makes sense assuming illiquidity of real estate asset. We think that NLHS is that puzzle part that you should watch to follow the housing cycle. In other words, NLHS encompasses supply and demand simultaneously and gives a clear view about the strength of the market. As you can see in both 1990 and 2008 NLHS ratio reached to their peak, yet in 2000 recession the ratio experienced one of its lowest level. The reason is that properties owners did not list their houses to the market because they did not need to do so. (compare the periods in the first chart of the report)

Having said that, if you look at the current NLHS ratio, we are at the lowest rate in the past 15 years which is telling us that supply is not a threat to the market. (The only region which shows a concern is Vancouver where new listing increases more than sales and put pressure on the prices. We believe this a direct result of B20 bill). Decreasing vacancy rate in most of cities, is a concrete example that supply is getting tight. (Look at our 2019 outlook report to find out about Sherbrooke surprising tight rental market)

Household Mortgage

Majority of consumers’ credit is from mortgage loans, and ~45% of these mortgages renews every year[1]. Therefore, the interest rate environment is the main catalyst for the household debt service delinquency. Expectation about interest rate path has been changed vividly in the last 6 months. That was mid-2018 when market participants anticipated at least two rate hikes for 2019 and yields on the Canadian bond started to increase. In December, Federal reserve, south of the border, predicted that it would raise the federal funds rate twice in 2019. In March it thought it would hold it steady instead, and now they are speaking about possibility of cut. European central bank also defended the tool that it has to even cut further interest rate and print out money if inflation does not reach its target.

As we explained in our 2019 outlook report, we do believe that the change in inflation has been evolved to secular movement from cyclical variation, and there is no clear driver of inflation in the foreseeable future. This gives all central banks room to continue their accommodative policies. Why do bother to risk the economy if inflation is at its lowest historical levels and debt level has lifted?  Moreover, on top of the muted inflation, we think that the level of uncertainly concurring with upcoming elections in some of the developed economies made central banks stay on hold if not dovish.

[2] 30% of outstanding mortgages are variable and 20% of the balance renews every year, assuming 5-year fixed rate term. Therefore ~45% of total mortgages book is exposed to interest rate annually


Although the risk of high interest rate environment is not in the Canadian macro landscape (i.e. 200 bps above the current level in ~5% environment) it worth asking how did indebted Canadian response to higher interest at the end of 2018 and what should we expect?


Higher interest rate in 4Q18 scared the investors as they had to adjust higher their expected return due to more expensive cost of their capital, Stock markets plunged during the last quarter of 2018 and closed the year in red (total return for TSX was negative 8.9% and -4.4% for S&P500 in 2018), although they returned to their high level in the first half 2019.

So, if higher interest rate makes money more expensive, and Canadian household are among the most indebted nations in developed countries, which asset class is most vulnerable? Discretionary assets funded by credit.

We are riding in the credit cycle together and our investment/expenditure behavior have formed the assets’ values. If you want to be positioned safe in the credit cycle, we think you should look at the household payment behavior. There are four categories of debt in retail market: Mortgages, Auto Loans, Credit cards and Personal lines of credit. We think car loan payment is the first payment which in-debt individual would declare delinquent for. On the other hand, by paying ~ 10$ minimum amount for your credit cards and Lines of credit you can secure yourself from default although it will take 100 years to pay them off. Mortgages, as the largest debt in any household, are being service either through landlord residents’ payments or rent which they collect from their tenants. So, the risk lays in the part of market which have been bought for pure speculation and are vacant.
It takes time for the mortgage market to show a sign of recession. Auto loans, as a discretionary expense on the other hand, are the kind of debt whose collateral can be easily substituted, by public transport or cheaper car for instances, and are not as important as residency in the mind of the owner. Therefore, Auto loans will be the first in the line of risk.

Having explained this concept, the latest financial reports released by Canadian banks also confirms the health of real east loan book. Mortgage delinquency rate is at its lowest cyclical level as it is shown in the following graph. Canadian banks are the main player in mortgage writing in Canada, so their mortgage delinquency ratio can be a good proxy.


Final Word

High level of debt in Canadian household balance sheet has made speculative investments more vulnerable than before. Stretches prices in big cities, reduces the cap ratio for the house purchases. Canadian real estate market is showing an heterogenous characteristics due to different fundamentals and as the title of this report suggests, investors should select the market carefully to invest.
We continue to suggest real estate to reduce volatility in the portfolio of investments and collecting yield. Nevertheless, investing in big cities while the nation is in its highest DSR level is like investing in a premium bond which we do not suggest, meaning more downside than upside potential. On the other hand, tier 2 cities, with less volatile economic fundamental can provide enough cash flow and accumulate wealth for the investors while enjoying leverage.

We believe in province of Quebec due to its diversified economy and low exposure to natural resources and foreign capital. The main factor we are watching is CAQ’s immigration policy which could alter the current robust housing demand.


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