Is Your House 63% Overvalued?

Falling home prices will have a huge effect on Canada’s economy. Why Royal Bank of Canada (TSX:RY)(NYSE:RY) and Home Capital Group Inc. (TSX:HCG) will really take it on the chin.

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According to a recent report by Deutsche Bank, you’re sitting on an absolute gold mine with a pretty limited window of opportunity.

Economists Torsten Slok, Matthew Luzzetti, and Peter Hooper used a pretty simple methodology. The trio looked at the median income to house price ratio around the world and compared it to where each country was in the past. A few areas of the world were pretty noticeable.

For instance, when looked at as a multiple of the average income, Wollongong, in the Australian state of New South Wales, is more expensive than Manhattan. The nation’s commodity boom has raised the value of real estate across the Land Down Under, leading the trio of economists to declare the Australian market 50% overvalued.

Australia still looks cheap compared to the worst offender on the list, Canada. The report declared Canada had the most overvalued housing market in the world, coming in at a whopping 63% higher than what it should be.

That’s a huge number, but it isn’t anything we haven’t heard before. The Bank of Canada recently came out with its own report, which said housing was 30% overvalued. The International Monetary Fund says our housing market is 87% higher than what it should be, but also predicts a soft landing.

Those have to be alarming numbers, especially for Canadians with a large percentage of their net worth tied up in their principal residence. Here are some steps you can take to lessen the pain of a housing correction.

Sell and invest the equity

This may be a drastic step, but for a lot of Canadians it makes sense.

I know folks who are sitting on nearly $1 million in home equity while their other investments are in pretty poor shape. Considering Canada’s great housing market and the average investor’s tendency to buy high and sell low, it’s little wonder why most Canadians would list their house as one of their best investments.

But that puts the average Canadian at risk. If the market falls 30% like the Bank of Canada thinks it might, that’s the equivalent to a stock market meltdown for folks with most of their net worth tied up in their house. And as we’ve seen with previous housing busts, the market takes a long time to come back.

By selling their home and investing the equity, Canadians accomplish two things. First, they lock in their gains, which is important. Secondly, they can use the equity to create a portfolio of dividend paying stocks that can add financial flexibility going forward. That can really help with future rent payments or pay for the fixed costs of owning a cheaper house.

Avoid the banks

While I’m not about to predict anything catastrophic, it’s obvious that investors who believe a housing correction is imminent should avoid Canada’s largest banks.

Particularly, I’d avoid Royal Bank of Canada (TSX:RY)(NYSE:RY). It’s Canada’s largest retail bank, which by default makes it the most likely choice to be attacked by short sellers and bearish hedge funds. It also is Canada’s largest lender, and even though the vast majority of the mortgages on its books are insured by CMHC mortgage insurance, it still carries billions in uninsured loans, some in the form of home equity lines of credit. Like Citigroup in the U.S., Royal Bank will become the poster child of Canada’s housing excess if the market declines in a serious way.

The other financial institution I’d avoid is Home Capital Group Inc. (TSX:HCG), Canada’s largest alternative lender. Because the company’s niche is lending to people who can’t qualify at the big banks, it has actively moved away from mortgages that are insured against default. This could prove unwise in a declining house price environment.

Home Capital has approximately $15.6 billion worth of mortgages outstanding, some 90% of which are concentrated in the Toronto area. If the market there declines and the company is forced to write-off some of its assets, it doesn’t take long for it to completely wipe out its $1.3 billion worth of equity.

Because of housing, it’s easy to be bearish on Canada. Maybe Canadian investors would be better served to check out these U.S. stocks instead.

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.

Fool contributor Nelson Smith has no position in any stocks mentioned.

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