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Will the Oil Rout Trigger a Housing Crash?

There has been considerable concern about Canada’s frothy housing market for some time, with some analysts fearing a full-scale crash. It now appears that the oil rout may just be the catalyst required to trigger a correction.

Now what?

Canadian housing prices have roughly doubled in the last decade, but there are already a range of indicators that prices have peaked and a correction, or even a crash, is looming.

First, the oil rout is having a significant impact on Canada’s economy. With the advent of the oil rout, Canada’s economy is only expected to grow by 1.9% in 2015, well below the 2.5% reported for 2014. Slower economic growth will create higher unemployment and lower wage growth, increasing the financial pressure on Canadian households.

The oil rout has already forced energy companies to slash costs, with many cutting employee numbers and ending outsourced services. This will continue for as long as oil prices remain significantly low.

Another impact will be a slump in consumer confidence that will see many households delay major purchases, such as real estate, until the economy improves.

Each of these factors will drive lower demand for housing and cause rental vacancy rates to rise, putting pressure on housing prices.

Second, the housing market appears to be significantly overvalued in comparison to historical averages.

The price-to-rent index indicates that housing prices are 91% overvalued and the price-to-income index indicates they are 35% overvalued when compared to their historical averages. Such high valuations are making housing unaffordable at time of economic stress, thereby reducing the pool of potential buyers. As a result, I would expect to see housing prices fall, as they adjust back to historical averages.

Finally, household indebtedness is at record levels, leaving them highly vulnerable to economic shocks.

Household debt has risen to an historical high of 163% of disposable income and is one of the highest levels among OECD countries. Such a high degree of leverage leaves little room for households to cope with any unexpected events, such as unemployment, stagnating wages, or an interest rate rise, increasing the likelihood of defaults.

Even though an interest rate rise is off the table in the current economic environment, it could certainly occur once the rate of economic growth improves. This creates the potential for a protracted housing slump, even when economic conditions start to improve.

So what?

It will take some time for the full impact of the oil rout to be felt, but I expect to see housing prices cool across the market. The lightest impact will be in Canada’s east, while markets, like Alberta, with the greatest exposure to the energy patch will experience a sharp correction.

This makes it imperative that investors avoid stocks that are exposed to regional housing markets in the patch. One such stock is Canadian Western Bank (TSX:CWB) which has the majority of its mortgages located in the region. Another is the Boardwalk REIT (TSX:BEI.UN) which has over half of its portfolio of rental properties located in Alberta. As layoffs in the patch continue and rental vacancies rise, its earnings, along with its asset value, will be hit hard.

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

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