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Monday, March 5, 2012

Toronto Condo Bubble might burst

CANADA - What happens when you have too much supply, ridiculously high prices and not enough people buying?

The answer is obvious. The bubble bursts.

Toronto keeps building more and more condos, so many in fact that it is above and beyond the demand to actually buy condos.

Lets take for example Ten York...

Ten York is a 75-story glass condo building which 4 years from now will be the 3rd tallest condo in all of Canada. Currently the site is a parking lot and a police impound, but the chunk of land beside the freeway will see a lot of construction in the next couple of years and it is not alone.

Toronto is building more skyscrapers and high-rises than any North American city... in fact Toronto is building almost 3 times as many as New York City is currently building. And we all know Canada's largest city is small potatoes compared to New York City.

So why are we building 3 times as many condos and skyscrapers? Do we need the extra homes close to downtown Toronto and the extra office space?

What is also silly is that Toronto's condo market is pretty soft. There isn't a huge demand, but investors in Toronto's construction industry seem to think this will change.

(But what those investors don't realize is the correlation between building skyscrapers and stock market crashes... see my older article Skyscrapers = Recession.)

Meanwhile average home prices in Toronto is just under $500,000, prices are at record highs and household borrowing is also at a record high. Torontonians are piling on so much debt that if anything happens there will be a huge collapse. Canadian lenders are worried too: The Toronto-Dominion Bank last week raised mortgage rates in an effort to cool off the housing market.

TD Bank isn't alone in its thinking that Toronto is heading towards a condo market burst.

“Condo construction has always been rather prone to boom and bust cycles, and this one seems particularly strong,” says Sheryl King, an economist with Bank of America Merrill Lynch in Toronto. “Builders seem to overestimate how much demand is going to be out there, and that’s when you tend to see some abrupt pull-back.”

According to King, Canada’s housing market is already about 10% overvalued, with inflated prices primarily in Vancouver, Montreal and Toronto. “We would call it a bubble,” she said.

Rising home prices have led to a 53% increase in residential mortgage credit in the past five years, or an average rate increase of 8.9% per year. The volume of outstanding mortgages rose to $1.08 trillion CDN as of August 2011, according to the Canadian Association of Accredited Mortgage Professionals. Defaults currently remain low, at 0.42%, according to government-run housing agency Canada Mortgage & Housing Corp., but if something happens that causes sales to drop off, prices to fall... then defaults could skyrocket.

Too much supply 4 years from now could do just that. Toronto's housing market prices could collapse up to 50% and end up with prices comparable to those in the USA.

Canada’s financial authorities have become increasingly worried and vocal about the possibility of a housing market collapse. The Bank of Montreal and Royal Bank of Canada, Canada’s banking regulator, and Bank of Canada Governor Mark Carney have all expressed worries about the condo markets in 2012 as cranes and construction crews swamp Toronto. They're all fearing a construction led bust which would lead to a recession in Ontario and then effect the rest of Canada.

Toronto currently has 148 high-rises and skyscrapers being built, compared with 59 tall buildings being built in New York City, and 22 going up in Chicago.

Most of the buildings in Toronto is 105 new condo buildings, but there are many more scheduled for the next 4 years. 14 buildings will be finished in 2012, including two hotel-condos: Trump International Hotel & Tower Toronto, which will be Canada’s tallest residential building. Tower Toronto opened January 31st.

What is also interesting is the number of units being constructed. These condos are bigger and more impressive than ever before. Condo builders seem to be competing in an effort to get taller and more luxury units into one building.

“The number of units under construction is quite high, start levels have trended up, and the number of units coming to completion is growing,” says Shaun Hildebrand, a senior market analyst for the Greater Toronto Area with Canada Mortgage & Housing Corp. “Supply at all ends of the development process is growing quite quickly.”

Too much supply.

Toronto currently has 199,000 condo units, but another 27,504 are under construction right now. That will boost supply by roughly 14%. In theory that much extra supply dumped on the market should cause prices to drop roughly 8 to 12%.

If the condo market sees a price drop it will also effect home prices as the supply of cheap condos will make new home buyers think twice about whether to buy a house in the suburbs or a condo downtown.

Add in Toronto's slow population growth and you also realize 14% extra condos seems abnormally high.

“If builders stopped building today, there’s five years worth of supply that is about to be delivered, relative to what normal population growth is,” says Sheryl King of Bank of America.

Then there is the problem of over-investment.

Investors are flooding Toronto’s condo market because of cheap borrowing costs and taking a risk that real estate prices will continue to go up. Its the same risk that the USA was taking in the 2000s before the market collapsed.

“They’re being bought because the interest rate is very low,” says John Andrew, a real estate professor at Queen’s University. “They’re financed to the hilt, so they’re very sensitive to the refinance risk when the loans come up.”

Meanwhile all of Canada's big banks are selling mortgage bonds to investors overseas, worried that when the market does collapse the banks would take a huge financial loss. Bank of Montreal and Bank of Nova Scotia sold $4.5 billion of their mortgage securities last month, after a record $25 billion of sales in 2011. They're getting rid of those debts because they sense the danger on the horizon.

Part of the problem is that when the recession in the USA hurt investment many foreign investors turned to Canada with their money because Canada seemed like a more stable option. They flooded the Canadian market with extra credit and now Canadians are mortgaged and indebted over their heads. Those foreign investors are going to be hurting when the real estate bubble in Canada bursts.

“The stability of Canada has moved it to the forefront of investor preference, in some cases ahead of the U.S.,” states a draft analysis of Toronto’s condo market, but that overconfidence in Canada's stability will be our undoing.

Right now investors represent roughly 25% of Toronto’s condo market and while high-rise home sales are at record heights (62% of Toronto's real estate market is condo sales) the demand still isn't enough to compete with the 14% increase we will see in the next 4 years.

And mortgage lenders aren't expecting demand to keep going up. They're expecting condo demand to hold steady as long as the economy remains stable.

Toronto accounts for 11% of Canada’s economic output. The city is home to Canada’s five-biggest banks, two of the three largest Canadian insurers as well as some of the country’s largest pension funds, asset managers and financial-services firms. Toronto is epicentre of Canada's finances.

So the theory goes that between immigrants, investors and young urbanites condo demand will continue to grow. And yet if that were true, why are the Canadian banks selling those debts overseas unless there was a real danger of a collapse?

Do the banks know something we don't?

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