Is Canadian Real Estate a Ticking Time Bomb?

An analyst has predicted Canada’s real estate market is headed 30% lower. What does this mean for investors?

| More on:
The Motley Fool

Last week, a report written by equity researcher Dan Werner of Morningstar warned that the Canadian real estate market is seriously overvalued. Because of a multitude of factors, Werner went as far as predicting that Canada could see a 30% nationwide decline in the price of houses.

Werner had several reasons for predicting such doom and gloom. Canadian law states that all mortgages (except in Alberta) are recourse loans. In theory, this would insulate lenders from large-scale defaults, since borrowers can be sued for any shortfall. But in reality, some of the hardest hit states in the U.S. housing meltdown were recourse states. When a borrower has most of their net worth tied up in housing, there’s little reason to sue for the scraps that remain.

Canadian debt-to-equity ratios look awfully similar to U.S. numbers at the top of its market, as 23% of Canadian homeowners have a debt-to-value ratio of greater than 80%. The number in the U.S. at its peak was 22%. Sure, the average homeowner owns about 55% of their home, but that’s weighed down considerably by the millions of Canadians who own their homes outright.

Werner also cites evidence that many Canadian borrowers can’t handle higher interest rates. More than 2.5 million of us have used our RRSP to help out with funding the down payment. This loan must be repaid over time, or else the recipient has to pay tax on the proceeds. In recent years, a full 25% of Canadians couldn’t afford to pay their RRSP loans back.

So if a crash happens, what does it mean for investors?

It’s obviously bad news for a company like Home Capital Group (TSX: HGC), which lends money to folks who don’t qualify at a traditional lender.

The company has been reporting some great results. Its most recent loan losses came in at less than 0.1% of its portfolio, and it continues to grow its business nicely. Management has done a terrific job leveraging mortgage brokers to help grow the business without the added cost of having to open up physical locations. The company has become Canada’s leading alternative lender.

This is all fine and dandy when the housing market continues to hit new highs. But what happens if it starts to decline in a significant way? The answer is pretty clear.

The share price will go down.

It doesn’t matter if the company has rock solid fundamentals. Investors will see the real estate market start to decline and flee for the exits. Investor sentiment is important for most companies, but it’s doubly important for Home Capital.

Canada’s largest lenders will also suffer in the event of a housing correction. The vast majority of earnings growth from Royal Bank (TSX: RY)(NYSE: RY) and TD Bank (TSX: TD)(NYSE: TD) has been from increases in mortgage and secured line of credit business. Both these banks are such big lenders that it will be difficult for either of them to make up for any lack of growth in mortgages.

Even if Canada’s real estate market has the proverbial ‘soft landing’ it’s hard to paint a bullish picture on the banks. If mortgage growth dries up, chances are economic growth will also be tepid, since many Canadians are borrowing against their house to consume. It’s one of the reasons why bank stocks are trading at a pretty significant P/E discount compared to the overall market.

For investors who are looking to buy Canadian bank stocks, the question is simple — do you think the value of Canadian homes is about to fall? If you believe Morningstar and think a 30% correction is imminent, you’ll want to stay away from the banks, and definitely stay away from Home Capital.

If you think the market will keep chugging higher, the banks probably represent pretty good value at today’s prices. That’s up to you to decide, but personally I’m staying away.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

More on Investing

Bank Stocks

Is it Too Late to Buy Bank of Nova Scotia Stock?

Bank of Nova Scotia should be higher than it is today, and you get paid well to wait for the…

Read more »

Airport and plane
Stocks for Beginners

If You’d Invested $1,000 in Air Canada Stock in 2014, This Is How Much You Would Have Today

Not everyone has seen their shares of Air Canada (TSX:AC) stock decline. But if you were to invest today, would…

Read more »

crypto, chart, stocks
Tech Stocks

2 Artificial Intelligence (AI) Stocks That Could Go Parabolic

Palantir Technologies stock and this tiny Canadian AI stock could rally as their new platforms bring new customers in 2024.

Read more »

Plane on runway, aircraft
Dividend Stocks

Down 40% From All-time Highs, Is Cargojet Stock a Good Buy Today?

Cargojet stock trades at a significant discount to consensus price target estimates in 2023.

Read more »

Money growing in soil , Business success concept.
Dividend Stocks

2 Companies With the Firepower to Raise Their Dividends

Here are three top Canadian dividend stocks long-term investors may want to consider, based on their potential for dividend growth…

Read more »

financial freedom sign

3 Stocks That Could Help You Retire a Millionaire

Are you looking for stocks that could help you retire a millionaire? Here are three top picks!

Read more »

A bull outlined against a field

1 Top Bargain Stock That’s Ready for a Bull Run!

Restaurant Brands International (TSX:QSR) stock could be off to the races, as it aims to run with the bull market.

Read more »

tsx today

TSX Today: What to Watch for in Stocks on Thursday, February 29

TSX investors will closely watch the U.S. personal consumption expenditure and Canada’s GDP growth numbers today.

Read more »