How to Prepare for a Canadian Housing Bubble  

Rising interest rates are cooling Canada’s housing markets. Should you be worried about a housing bubble?

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Canada has been in a housing bubble for six years without a correction, according to Better Dwelling, citing the U.S. Federal Reserve’s “Exuberance Index.” Over two decades of rising prices have detached Canada’s house prices from their intrinsic value, making them unaffordable. Investors and speculators have entered the housing market, looking to make money from a price increase. 

Canadian average home price peaked at around $816,000 in February, according to the Canadian Real Estate Association. Toronto and Vancouver were the frontrunners in the list of “the world’s least affordable housing markets,” according to a study in February. The Globe reported that 10.5% of house renters in Vancouver were evicted from their previous homes. All these figures ring warning bells of a housing bubble. 

What is a housing bubble?   

A bubble forms when investors increase the prices of the underlying asset in hopes prices will continue to grow. This distorts the price from the value. But at some point, a trigger creates panic, and investors rush to sell, leading to a sharp drop in prices.

The problem with bubbles is they are hard to predict. When they burst, those who bought at the peak face huge losses. Many tech stocks have not yet reached the peak price of the bubble of 2000. That is the effect of a bubble. 

A housing bubble is way more devastating than a stock price bubble. The U.S. housing crisis in 2008 left several people homeless, as they defaulted on mortgages. 

Could a looming recession lead to a housing bubble burst in Canada? 

Canada saw a significant surge in house prices in the last two years, as record-low interest rates made mortgages affordable. House sales climbed, and so did Canadians’ mortgage debt. According to Statistics Canada, the average consumer debt is now $1.70 for every dollar of household disposable income. This makes Canadians vulnerable to economic shocks. 

The Bank of Canada is increasing interest rates aggressively to control inflation. That spells trouble for Canadians with high-value debts. Housing activity slowed, with home prices declining since March. The decline is gradual, and house prices could fall further, as rising interest rates reduce the number of home buyers while inventory levels increase. 

The housing market works differently than stock markets. A housing market correction takes several months to reflect in house prices. Canada’s housing market is normalizing from the pandemic growth. While fears of a recession and a housing bubble burst loom, they may or may not materialize if the price decline is well managed. Government regulations have proved successful in easing housing activity. The Justin Trudeau government is looking to control house prices by imposing a tax on house flippers and banning foreign buyers. 

It all boils down to how fast the prices fall and interest rates rise. A bubble is more psychological than economic, and human behaviour is difficult to predict. While Canada’s housing bubble is vulnerable to a recession, it might not burst in 2022. But it is better to be prepared. 

Time to rebalance your REIT portfolio 

The stock price of most Canadian residential REITs dipped 15-30% since November 2021. They might look like a value pick, but I would stay away from them. The macro-economic environment is not conducive to the housing market. Moreover, residential REITs offer a lower distribution yield as the government caps housing rent. 

If you own too many residential REITs, it is time to reduce your exposure in residential and increase exposure in commercial REITs with high credit tenants. SmartCentres REIT (TSX:SRU.UN) and True North Commercial REIT (TSX:TNT.UN) are some good commercial options. 

SmartCentres has Walmart, and True North has government as their biggest tenants. These REITs’ stock prices might fall in a recession or a housing bubble burst, but their fundamentals would remain strong. This will help them recover faster during an economic recovery, giving you double-digit capital appreciation. Moreover, you can lock in a 6.5-9.5% distribution yield, which can help you recover a 30% loss from residential REIT in the next few years. 

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 Puja Tayal has no position in any of the stocks mentioned. The Motley Fool recommends Smart REIT.

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