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Real estate bears on the prowl
Some Bay Street observers emphasize the downside risks

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Friday, April 20, 2018 – Page H2

The Toronto-area real estate market is showing signs that it's in the midst of a spring rebound after a year of gyrating sales and prices. Under that scenario, new mortgage rules and government policies aimed at cooling the market have done their job nicely and the recent strength in prices marks the start of a new upward trend.

But some Bay Street mavens are warning of the risks of a darker scenario: They're on guard against a downward spiral that would hurt not only the country's housing markets but the entire Canadian economy.

As a portfolio manager at Richardson GMP Ltd., Chris Kerlow is always scanning the horizon for economic tailwinds and headwinds that might propel or hamstring the stocks in his team's funds.

"We have long felt that our housing sector, and thus banks, could be in real trouble during the next recession," he says in a research report titled Cracks in the Foundation are Widening.

In a phone interview he adds: "Now our thesis has pivoted to, housing possibly causes the next recession."

The risk in cities such as Toronto and Vancouver is heightened because foreign money poured in and values rose to dizzying heights after real estate values in this country emerged nearly unscathed from the 2009 global financial crisis.

"Almost every asset in the world rebased except for Canadian housing," Mr. Kerlow says.

His focus is on the big banks that provide the mortgages to so many Canadian homebuyers.

Right now, his team's flagship Redwood Core Income Equity Fund is underweight in Canadian bank stocks. He's on high alert for signs that it's time to further reduce the fund's exposure to Canada's Big Five banks.

For the Big Five, roughly half of their loans outstanding are mortgages, Mr. Kerlow says. And of those mortgages, approximately 70 per cent are concentrated in the Toronto and Vancouver regions, he cautions.

Last week, the Canadian Real Estate Association reported that national home sales edged up 1.3 per cent in March from February.

Sales in March plunged 22.7 per cent from record a year earlier. The national average price for a home dropped 10.4 per cent last month from March, 2017.

"Recent changes to mortgage regulations are fuelling demand for lower-priced homes while shrinking the pool of qualified buyers for higher-priced homes," explains Gregory Klump, CREA's chief economist.

At Capital Economics, chief North America economist Paul Ashworth says people who are bullish on Canadian housing would argue that the current market is undergoing a shortterm disruption caused by tighter mortgage rules and that prices will bounce back with the spring.

"Anecdotal information suggests there is some validity in that view," he says. "Housing slumps have a nasty habit of becoming self-perpetuating, however, as would-be buyers are scared off by the risk of overpaying and incurring losses. Why take the risk when you can wait a few months until prices have bottomed out, which means, of course, that prices will fall further."

Mr. Ashworth adds that the relatively lean number of new listings in Toronto will limit any downward pressure.

Still, even without a decline in prices, he warns that a benign end to the decade-long housing boom would become a modest drag on economic growth instead of one of the biggest drivers.

Mr. Kerlow at Richardson GMP says the CREA numbers were not as grim as he feared. "The news wasn't eye-poppingly bad on a national level."

But, in addition to shifting dynamics brought about by the new mortgage rules, Mr. Kerlow worries about future interest rate increases. The rates for fixed-term mortgages move with bond market yields. He already sees "green shoots of inflation" in North America.

If growth in the heavyweight U.S. economy remains robust, that could push rates higher - even if housing weakens further in Canada.

The recent yield of 2.17 per cent on a Bank of Canada five-year bond is roughly double what it was last year at this time, Mr. Kerlow points out. "We certainly position our portfolio for rising rates."

If interest rates rise much further, he is concerned that Canadian homeowners with huge mortgages and other loans won't be able to service their debt.

While the greatest risk to prices is in the markets that have climbed the most, Mr. Kerlow says the spectre of rising rates and falling prices would pretty quickly undo the "wealth effect" that encourages people to spend more when the value of their property is swelling.

No matter where you live in Canada, "it's not a good thing if you see mortgage rates rising and house prices falling," he says.

A prolonged slump in housing would have repercussions for the country's economy if developers are no longer enticed to build more homes, he says, adding that construction jobs currently make up for 7.8 per cent of the Canadian labour force.

In a downturn, real estate agent commissions would drop and so would government revenues from land transfer taxes. If fewer people buy new houses, the flipping and renovation businesses could also go into decline.

Despite the large number of new Toronto condo towers recently built and under construction, Mr. Kerlow is not too concerned about that segment of the market because many people want to live downtown. "There will always be someone to fill that condo."

He sees a larger threat to prices around the Greater Golden Horseshoe in southern Ontario because many people would move closer to jobs in Toronto if they could afford to do so.

Mr. Kerlow says he hasn't seen signs that short sellers - who bet against an asset rising in price - are circling the lenders entrenched in the Canadian housing market. But they could move quickly if they sense trouble.

In the United States, he points out, hedge fund managers exacerbated the problems when they bet against U.S. housing.

"If things go badly, it could get ugly," he says. "They'll probably jump on that trade and make it that much harder for us as a nation to stop the bleeding."

Despite that grisly picture, Mr. Kerlow is waiting to see how the Toronto market fares in the late spring and early summer, when sales and prices are no longer being compared on a year-over-year basis to the high-octane opening months of 2017.

Associated Graphic

Even without a decline in prices, one real estate observer says that a benign end to the decade-long housing boom would become a modest drag on economic growth.


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