Housing may have met its match

Canada's unstoppable housing market faces a challenge. To stay unstoppable, it needs mortgage rates to remain low and affordable. But to keep setting new sales records it also needs more people to land more jobs so they can afford to buy more homes.

The problem is it's next to impossible for the economy to produce both these happy outcomes. Interest rates usually stay low only if unemployment remains high. Once jobless numbers start falling, mortgage rates typically shoot upward. Hoping for both low interest rates and lots of jobs is like a farmer praying for both dazzling sun and buckets of rain.

Whatever happens over the months ahead, the real estate market will face resistance from either higher rates or continued unemployment. If you've been betting on continued strong increases in home prices, it may be time to take a moment and ponder what you would do if home prices went sideways for a while -- perhaps for a very long while.

A sign of what is in store came yesterday, when Royal Bank of Canada and Toronto-Dominion Bank announced they were raising interest rates on some fixed-rate mortgages.

The hikes are small -- the equivalent of an extra $70 a month on a $200,000 fiveyear fixed mortgage -- but they look to be the first move toward more painful increases.

You can blame the pain on the surprising strength of Canada's economic recovery, which has removed the case for keeping the bank rate at the lowest levels in Canadian history. Mark Carney, the governor of the Bank of Canada, is expected to start raising rates this summer.

How high will rates go? The prominent economists who make up the Monetary Policy Council of the C.D. Howe Institute are urging the Bank of Canada to hike its key overnight interest rate by 1.75 percentage points over the next year.

If other borrowing costs follow course, rates on fiveyear fixed mortgages will be nudging up against 7% by this time next year--and that will start to pinch. On a $200,000 fixed-rate mortgage, new homeowners would be paying a couple of thousand dollars more a year than they would be now.

The last thing many Canadians need is an added expense of that magnitude. Household debt levels have galloped ahead over the past few years. Personal bankruptcies per capita are at their highest levels in nearly 20 years.

The Bank of Canada recently looked at what a moderate increase in interest rates would mean to household finances. It found that if the "effective borrowing rate" -- a mix of various mortgage and consumer credit interest rates -- edged upward by slightly more than a percentage point over the next couple of years, the portion of households deemed to be financially vulnerable would hit a record peak of 9.6%, more than half again the average of the past decade.

The technical term for this is "scary." And what makes it scarier is that Canada's real estate market may already be in bubble territory.

Average prices for a resale home in Canada have doubled over the past decade and with little apparent reason. If a genuine shortage of accommodation were behind the galloping prices, rents should also have surged. But they haven't.


The International Monetary Fund says that home prices in comparison to rents are higher in Canada than any other developed country with the exception of Sweden. David Rosenberg of Gluskin Sheff, the Toronto money management firm, has looked at Canadian home prices in terms of both price-to-rent and price-to-income and concluded that current home prices are 15% to 35% above levels that would be consistent with housing fundamentals.

So how will this all end? Canada is unlikely to suffer a U.S.-style housing collapse for several reasons. Borrowers in most provinces can't simply walk away from their debts as many U.S. homeowners are doing. Most high-risk mortgages are insured against default through Canada Mortgage and Housing Corp., a government-owned corporation. And the strong recovery looks as if it will create jobs that will help people make their mortgage payments.

Most likely is that we will see a period of flat home prices as real estate comes back into line with economic reality.

In a recent thesis, Alexandre Pestov, an MBA candidate at the Schulich of Business at York University, compares the merits of buying versus renting a typical two-bedroom, two-bathroom Toronto condominium. He assumes that the market doesn't crash and real estate goes up by 3% a year. Even so, over a 25-year period, a typical renter winds up $600,000 ahead by putting away the money saved from renting and investing it in safe bonds.

As Mr. Pestov points out, you don't have to count on a housing crash to conclude that renting in many areas is already a better deal than buying. As more and more people do the numbers, Canada's unstoppable housing market may finally meet its match.

(prepared by Ian McGugan/Financial Post/National Post)