A Major Risk for Canadian Banks: Real Estate

What impact could a real estate downturn have on Toronto-Dominion Bank (TSE:TD)(NYSE:TD), Royal Bank of Canada (TSX:RY)(NYSE:RY), The Bank of Nova Scotia (TSX:BNS)(NYSE:BNS), and Bank of Montreal (TSX:BMO)(NYSE:BMO)?

| More on:
The Motley Fool

The major Canadian banks all have considerable exposure to the Canadian real estate market, either through residential mortgage lending, housing equity loans, or various forms of commercial lending, including development and project finance.

When the real estate market crashes, banks hurt

The Canadian real estate market, at the broad overall level, is considered by many analysts to be overvalued. Given the traditional deep links of banks to the real estate market, there is really nowhere to hide for banks when the real estate market goes into a tailspin.

The real estate exposure of the major Canadian banks is considerable

The table below indicates that the two largest banks, Royal Bank of Canada (TSE: RY)(NYSE: RY) and Toronto-Dominion Bank (TSE: TD)(NYSE: TD), have the largest portfolios of Canadian real estate-backed loans — no surprise here. What is surprising is that RBC also has the largest exposure when Canadian real estate loans are measured as a proportion of the total loan portfolio, currently at 64%.

On the other hand, Bank of Montreal (TSE: BMO)(NYSE: BMO) has a much smaller portfolio of $109 billion, representing 45% of the total loan portfolio. Should things go wrong in the real estate market, BMO will be less vulnerable.

A further point to note here is RBC’s level of diversification. While a considerable portion of the loan book is exposed to Canadian real estate, RBC has the lowest proportion of total revenue coming from interest income. TD Bank has the highest reliance of interest income while The Bank of Nova Scotia (TSE: BNS)(NYSE:BNS) and BMO are in the middle of the group.

Canadian Real Estate Lending $ Billion 255 275 208 109
Canadian Real Estate Loans % Total Loans % 54% 64% 49% 45%
Net Interest Income/Total Revenue % 58% 43% 51% 51%

Risk-mitigating factors are in place

The banks employ various measures to mitigate the risks of their real estate lending activities. In the first instance, loans can be insured by the government-backed CMHC reducing the risk to the lenders. RBC has the lowest portion of their Canadian residential portfolio insured while TD Bank has almost two-thirds of the residential portfolio insured.

A second risk management technique is the loan-to-value ratios, which indicates the value of the loans compared to the value of the property lending book. Here is not much to choose between the banks, but the ratios below do indicate that property prices can drop a long way before the real estate backing the loans will become a concern to the banks.

Canadian Residential Real Estate Loans Insured % 63% 45% 47% 49%
LTV of Uninsured Residential Portfolio % 61% 55% 55% 58%

A substantial reduction in residential real estate prices would impact the banks mainly through an increase in provisions for credit losses as defaulting borrowers will increase during a market downturn. These provisions for the real estate portfolios are currently at extremely low levels supported by the real estate bull market. A further impact could be a decline in interest income from real estate lending should further growth in real estate lending activity dry up.

Banks are performing well but real estate remains a major risk

The Canadian banks are performing well at the moment with the core lending businesses growing steadily and wealth management and investment banking activities providing some impetus. The real estate risk is mitigated through insured mortgages and relatively low loan-to-value ratios for the uninsured components.

However, should the Canadian real estate market go through a deep and extended correction, there will be a negative impact on the banks, with RBC more exposed and BMO somewhat less exposed than the other major banks.

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 Bank Stocks

A stock price graph showing declines
Bank Stocks

Bank Stocks Under Pressure Again! Time to Buy the Dip?

Bank of Nova Scotia (TSX:BNS) is one cheap dividend stock that it may be time to buy!

Read more »

A bull outlined against a field
Bank Stocks

Forget TD Bank: This Growth Stock Is Poised for a Potential Bull Run

TD Bank stock may underperform, again. However, Propel Holdings (PRL) stock could sustain a multi-year bull run while satisfying income…

Read more »

money cash dividends
Bank Stocks

2 No-Brainer Canadian Bank Stocks to Buy Right Now for Less Than $500

Despite falling sharply of late, the long-term growth outlook for these large Canadian bank stocks is still solid.

Read more »

Bank sign on traditional europe building facade
Bank Stocks

Better Buy in February 2024: TD Bank Stock vs. Air Canada Stock

Only risky investors would consider putting their play money in Air Canada stock. Conservative investors would park their money in…

Read more »

Man holding magnifying glass over a document
Bank Stocks

The Best Warren Buffett Stocks to Buy With $300 Right Now

Here are two of the best stocks you can buy from Warren Buffett’s portfolio today with an initial investment of…

Read more »

sad concerned deep in thought
Bank Stocks

Where Will National Bank of Canada Stock Be in 5 Years?

These fundamental factors could help National Bank stock continue rallying in the next five years.

Read more »

Bank Stocks

3 Reasons to Buy TD Bank Stock Like There’s No Tomorrow

Looking for a great bank stock to add to your portfolio? Here are three reasons why TD (TSX:TD) may be…

Read more »

Stocks for Beginners

Value Investors: Are You Buying and Holding Forever? Think Again

Value stocks are great, but if you don't have a goal in mind that stock can quickly turn from value…

Read more »