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Tuesday, February 11, 2014

Toronto home prices are a big risk says BMO

Toronto home prices are a deep concern to Canadian banks - and they're banking on a drop in real estate prices.

So much so that surge in Toronto prices is described as a major economic threat in a new Bank of Montreal report.

In an economic forecast for North America released this week, BMO noted three "risks" to the North American economy, namely:

1. embattled emerging markets.
2. the continuing tussle over the U.S. government debt ceiling.
3. residential real estate in Canada’s biggest city.

Seriously, Toronto's housing prices / real estate bubble has bankers quaking in fear and using words like "collapse", "crumbling", "major economic threat", etc.

For months some economists have been trying to downplay the worries of big Canadian banks - who stand to lose a lot of money if the Toronto real estate bubble bursts. Some have tried to describe the impending doom as "a minor setback", hoping that when it happens it will simply be a market correction that causes prices to drop a mere 10% - whereas the Toronto real estate market's bubble is overpriced by about 40 to 50%. A realistic market correction would be ballparked at between 25% to 45% drop in real estate prices - and a huge unemployment rate that would send construction workers, auto manufacturers and bankers running for the hills and wanting to hibernate in a cave (bear market pun) until the chaos is over.

I find it really funny when market analysts try to downplay the size of Toronto's real estate bubble. Let me explain by doing a little economics lesson.

What is Toronto's two biggest industries?

#1. Banking.

#2. Construction.

We don't really manufacture anything, Toronto's economy is basically just banking, construction and the service/sales industry. Money pours into Toronto from Canada and the USA thanks to Canada's big banks - and a lot of that money - the lion's share - is from mortgages.

If housing prices drop, Canada's big banks lose money. If housing prices drop significantly, the banks lose a LOT of money.

Simultaneously if housing prices drop, the construction industry dries up. Construction workers are laid off, they and their families stop spending money, and thus the economic down spiral begins. A local recession ensues and many jobs are lost as companies "tighten their belts" by shedding jobs of anyone they don't see as necessary.

If Toronto has a robust manufacturing sector that ships internationally, this wouldn't be as much of a problem. South Western Ontario has a lot of manufacturing jobs, but that is over near Hamilton, Guelph, Kitchener. The auto manufacturing sector will be hit the hardest - but other types of manufacturing will be fine for the most part.

The problem however is that home prices in Toronto have skyrocketed at a ridiculous rate during the last 20 years - largely due to foreign investors in Toronto's condo market. That means that when prices start going down it won't be any minor dip. It will be more like a landslide as investors suddenly sell off their assets and flee the market in droves.

"In Canada, accelerating home prices in Toronto (7.1 per cent year-over-year in January) risk straining affordability further, causing a correction when interest rates normalize and the market is trying to absorb a record number of newly built condos," says BMO senior economist Sal Guatieri.

Mr. Guatieri’s comments follow last week’s report from the Toronto Real Estate Board, which showed the average selling price in January surged more than 9 per cent to $526,528 from a year earlier. The so-called benchmark price rose 7.1 per cent, as the BMO economist noted while warning that real estate price growth is outpacing family income by a huge margin.

In layman's terms that means Toronto home prices have become so ridiculous people can barely afford them - so a single large economic hiccup could be the flea that breaks the camel's back. The real estate market in Toronto is the keystone that holds Toronto's economy in place - give it a big bump and the whole structure collapses.

In Toronto, this is one of the bigger risks, more so to the local economy, Guatieri says in an interview. Guatieri worries what will spark trouble over the next few years is when interest rates rise.

The higher interest rates would cause people to slow their home buying - which is already slowing - and result in people looking to sell to drop their prices in an effort to find buyers. If they see a collapse coming they will be rushed to market and try to sell faster rather than later when prices will be even less.

Consider, too, that according to the latest report from the Canada Housing and Mortgage Corp., also released this week, which showed Toronto ignoring the national trend when it comes to residential construction starts.

While those across the country edged down, housing starts in the Toronto area climbed to an annual pace of 36,186 units in January from 32,281 in December - mostly bought on credit from the banks.

The six-month moving average puts the number at 36,367, up from December’s 35,547.

"Apartment starts remained high as the relatively high number of projects which began selling in 2011 reached sales targets that allow construction to begin," CMHC said of the Toronto market.

Across Canada, housing starts slipped to an annual pace of 180,248 in January from 187,144, the agency said, with the six-month moving average declining to 191,456 from 194,518.

Which means the Canadian economy is cooling, but Toronto is steaming ahead fueled by easy credit.

"The decline in starts is an indication of housing supply falling into alignment with demand in most major markets (Vancouver, Calgary, Edmonton, Quebec City)," says economist Connor McDonald of Toronto-Dominion Bank.

"However, we expect Toronto to follow suit as homes under construction reach completion and more supply comes online. Over all, the recent cooling of housing starts supports our view for a soft landing of the Canadian housing market in 2014 and 2015."

See his choice of words? "Soft landing" is his wishful thinking. He is just thinking in terms of supply and demand, he isn't thinking of what will happen when those same construction workers are laid off and the economy sours - and housing prices drop at a sharper rate than he is expecting.

In his report Guatieri notes how the boom in Canadian housing is largely over as potential home buyers adjust to tighter mortgage insurance rules brought in by the government to head off Toronto's real estate bubble - a tactic designed to prevent it from bursting.

"Not so in Toronto, however, as its prices continue to outrun median family incomes, which averaged slightly over 2-per-cent growth from 2001 to 2011," says the BMO economist.

"Consequently, affordability continues to deteriorate even with relatively steady and low interest rates. While Vancouver remains the least affordable city in Canada, some softening in prices there has allowed Toronto to rapidly narrow the gap."


Yada yada yada, Toronto can't afford these ridiculous high prices in homes so the bubble is going to burst when too much supply outpaces demand and the construction workers are all laid off.

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