Will 2017 Finally Be the Year Toronto’s Real Estate Bubble Bursts?

This year will likely be remembered as the year Canada finally got serious about its real estate problem.

After two decades of non-stop growth, there were two major changes made by various levels of governments. The first was in British Columbia; the province instituted a 15% real estate tax targeting foreign buyers in Vancouver.

Even though all of the statistics indicated foreigners only bought a small percentage of homes in Vancouver, citizens of Canada’s third-largest metropolis have had to deal with unaffordable housing for years now. These folks have been clamouring for the government to do something about it.

The new tax seems to be working. Prices in most parts of the city have slid noticeably since the new tax was implemented with the ultra-expensive Vancouver West area seeing the biggest drop.

The other big change made in the housing market will likely impact every major market in Canada. In October, the feds announced any mortgages insured by government-backed default insurance would be subject to stricter qualification rules.

According to Genworth MI Canada Inc (TSX:MIC), the privately held alternative to CMHC, the changes will see anywhere from 25% to 50% of potential first-time buyers shut out of the market, especially in expensive cities.

That is a lot of potential supply taken out of the market.

What’s next for Toronto’s real estate market in 2017? Will new mortgage rules finally burst the bubble, or are we in for another year of big gains?

Fundamentals still look good

I remember first stumbling upon the Toronto bubble argument back in 2012.

It was the same argument we’re all making today. The market was overvalued on every traditional metric. Insane bidding wars were happening, even with mediocre properties. The sky was littered with new condo developments. It was obvious the market was in a bubble.

And yet nothing has changed in four plus years. The market continues to chug steadily higher. Bidding wars are still common. New condos are still being built as fast as developers can churn them out. Insane valuations have become even more insane.

So what’s driving demand in Toronto? There are a huge number of investors, all clamouring to capture what they view as inevitable capital gains. Thousands more are first-time buyers–people who are worried if they don’t get in today, they’ll be shut out forever. And yes, there’s significant demand in Toronto from foreign buyers.

The point is this: Toronto’s supply-and-demand equation is so skewed towards demand that it’s hard to say if the new mortgage rules will have any impact. Sure, they’ll take people out of the market. I’m just not sure it’ll be enough to really matter.

The party will end

Every bubble ends badly. It’s only a matter of time.

I don’t know if 2017 will be that year. Nobody does. The market could continue rising for years. Or it could crash spectacularly. Anything could happen.

All I know is this: eventually, real estate will get out of favour. The froth will leave the market, and we will see values decline.

The time to sell is before this happens. Don’t worry about capturing the last 10% or 20%. Just focus on the 100% run-up.

This also bodes poorly for Home Capital Group Inc. (TSX:HCG), Canada’s largest subprime lender with a real focus on the Greater Toronto Area.

Home Capital has consistently reported microscopic loan-loss reserves, primarily because values in Toronto keep going up. If somebody falls behind on their mortgage, all they’ve needed to do is sell and end up ahead. It’s not quite that easy in a falling market.

And remember, Home Capital admitted in 2015 that it has upwards of $2 billion of loans on its balance sheet that may have been obtained fraudulently.

The bottom line

It could very well be that 2017 will be the year Toronto’s real estate bubble bursts. But we could have said the same thing in 2014, 2015, or 2016. At this point, it’s just a waiting game.

One thing is certain: a massive decline in Toronto is very bad news for Home Capital Group and wouldn’t be very pleasant for Genworth MI Canada either. If I held either of those companies in my portfolio, I’d be inclined to sell today before a crisis occurs.

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

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