Will a Real Estate Crash Kill Canadian Banks?

Our economy is in rough shape. Central bank action saved markets and rescued real estate, but will the effect last? If real estate crashes, will the Canadian banks like Royal Bank of Canada (TSX:RY)(NYSE:RY) survive?

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edit Back view of hugging couple standing with real estate agent in front of house for sale

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For years I believed that there would be a housing crash at some point. I always reckoned that high global debt loads, extended valuations on a price-to-rent basis, and tepid economic growth would eventually result in a real estate pull-back, if not a full out collapse. But this is the age of extreme government involvement in markets, so the collapse never occurred.

What I find interesting at the moment is that no governmental agency seems to believe in asset longevity. The Federal Reserve warned that stocks could go down. The International Monetary Fund and OECD are warning about poor economic conditions. Canada Mortgage and Housing Corporation is warning about a potential collapse in housing prices.

Owning banks with a potential debt crisis on the horizon

I own a fair number of Canadian bank stocks. I wrote about how Canadian banks are solid dividend payers with a long-term history of growth over the past couple of years. During the market crash earlier in 2020, I suggested buying more of these stocks.

Over the long term, these companies will do well. However, I am prepared for potential volatility in the banking sector should the economy sputter harder and for longer than expected.

Choose a large, diversified bank

I am cautious about the future of asset prices, so I decided to stick with larger diversified banks like the Royal Bank of Canada (TSX:RY)(NYSE:RY). It will not be immune to a downturn in real estate, of course. The company should be able to weather the storm more effectively than a smaller bank.

Royal Bank, for example, significantly diversified operations spread throughout the United States and Canada. The pandemic lockdown hit both the entire United States and Canada so the diversification is slightly less effective.

However, it still provides a buffer. After all, earnings from the higher U.S. dollar are translated into Canadian dollars for reporting purposes, which provides a boost in income.

Its results were down in the Q2 2020 report. Net income decreased by 54% year over year. A large part of the decrease in net income comes from its provisions for loan losses, which increased to $3.8 billion in the quarter.

These provisions mean that earnings are affected in the near term. It also means that the bank is prepared to absorb the impact of defaults if they occur.

Dividends

I am pleased that the bank raised its dividend in February before the market crashed. The $0.03 a quarter dividend hike will likely remain in place. Canadian banks will do about anything to keep the dividend in place. The bank has a year to ascertain the economic landscape before deciding whether to hike its dividend next year. 

The bottom line

The government stepped in immediately, effectively eliminating an imminent March debt crisis for individuals and businesses. Of course, the credit crunch might yet occur. Personally, I think it speaks to the sad state of the Canadian economy that it had to be rescued only days after a lockdown began. 

A real estate crash is certainly possible. But rest assured that Royal Bank is preparing for a potential collapse. Increasing loan loss provisions is a good thing. If real estate crashes, they are prepared. If it doesn’t and the economy recovers, earnings will improve as provisions are reduced.

Royal Bank will survive a housing collapse, so keep holding.

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 Kris Knutson owns shares of ROYAL BANK OF CANADA.

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