Keeping It Real in Real Estate

Tell me, how do you know Summer is just around the corner in Canada? Daylight hours have increased, the grass has greened (well, except for those annoying, relentless bursts of dandelion yellow), but perhaps one of the most telling signs are the “House for Sale” signs popping up on lawns across the nation.

2021 has been the hottest residential real estate market on record, and this market feels different. A low inventory of homes available, and ultra-aggressive bidding on those that do get listed, have created imbalances that could be flashing warning signs, not only to home buyers and sellers but to the broader economy and to Canadian equity investors as well.

Insatiable Demand + Limited Supply = Melt up Imbalance

Collectively, we have learned much about ourselves and our families over the past 14 months of the COVID-19 pandemic. Working and schooling from home have brought families together under one roof for an extended (some might say exhausting) period. As a result, the need for a nice place to call home has shot to the top of the priority list for many of us.

Aided by generationally low interest rates, the need for a better living/working/schooling space has empowered home buyers like never before. Perhaps most impressive is that demand is up everywhere across the country and not just in the notorious big city real estate markets. When you also factor in the reluctance of owners to sell during a pandemic, you get that Economics 101 squeeze of limited supply and growing demand which leaves prices nowhere to go but up.

And up they have gone! The national average home price hit $716,828 in March¹, a 32% increase from one year ago. The largest price gains were across Ontario, B.C, Quebec, and New Brunswick. The seasonally (and market) adjusted MLS home price index jumped an impressive 20.1% year over year. This number gets adjusted to remove any distortions from the mix of sales activity in different markets across Canada.

Regardless of adjusted or unadjusted, these price increases have been off the charts by any measure.

Cheap Financing Fuels Fear of Missing Out

There are many different reasons why people have felt the need to buy and sell homes in the past year. The one consistent theme has been the ultra-low cost of money, which has been the fuel lighting the market on fire. Five-year mortgage rates hit levels as low as 1.5% (now much higher) and the idea of working from home in a larger, more comfortable space was the spark that ignited the demand for real estate. Canada is not alone as higher-priced residential real estate has been a global phenomenon and a biproduct of the pandemic.

As investment professionals, we study both the opportunities and risks associated with rapid price changes in all asset classes. Although we do not buy homes for your investment portfolio, we do think about the macro implications for the economy due to the rapid prince increases in residential real estate.

It is no stretch to say many Canadians are experiencing some degree of housing lust. Partially due to a fear of missing out, buyers have been aggressive bidders. Unlike many other countries, Canada’s housing market did not correct dramatically during the 2008 global financial crisis. As a result, we note a growing imbalance, illustrated below:

As you can see from the right side on the chart, Canadian home prices hit the stratosphere in the last two decades. At the same time, our income gains have been far more modest, which means Canadians have really taken advantage of low-rate mortgage financing.

By leveraging ourselves to this extent, collectively, Canadians have far more debt and far less financial flexibility, especially compared to our American neighbors. Canadians now hold approximately $1.7 trillion of mortgage debt, which is the equivalent to 85% the size of our total economy². The Bank of Canada recently cited that the rapid rise in house prices and the level of household debt are key vulnerabilities to financial stability³.

Internationally, Canada is known for the large role that natural resources play in our economy. Given the struggles of the energy sector of late, real estate has become the fastest growing sector in the economy⁴.

‘Real estate’ as a sector captures more than just the purchase/sale agreement. It also includes the many ancillary transactions associated with home sales including legal, financing, insurance, and, of course, the booming home renovations industry.

Data shows just how important real estate has become to job growth in Canada. The charts below show that only real estate (aka ‘FIRE’) and the public (government) sector have created job growth during the pandemic. On the right chart, you can see that real estate now accounts for 20% of our country’s private sector employment. This is now about four percentage points higher than its long-run average in Canada.

Why is this important? We need to remember that real estate is a cyclical business, especially now since we have been experiencing an extended ‘up’ cycle since the beginning of the new millennium. Any cooling off in the real estate market could impact both indebted homeowners’ future consumption patterns and potentially impact the job security of close to one fifth of our workforce. Either or both outcomes would be a headwind to the future growth of the Canadian economy.

Portfolio Considerations

The composition and diversification of an economy (like that of an investment portfolio) are measures of its strength and resilience. When it comes to your portfolios, we want to take advantage of diversification opportunities to bolster returns and mitigate risk. At present, we remain constructive on the Canadian markets.

For Canadian equities, the global reflation trade is likely to continue to put upward pressure on the pricing of commodities, and thus many Canadian resource businesses stand to benefit. Also, we anticipate Corporate Canada will see positive spillover from the U.S. government spending initiatives, a resumption of travel and tourism, and unleashed pent-up demand as economies re-open. From a style perspective, we view Canada as a more value-oriented (financials, energy) way to participate in the U.S.-led pandemic recovery this year.

However, we also feel it is important to temper our enthusiasm for Canadian equities due the delayed start of our vaccination program resulting in a delayed re-opening of our economy. In addition to being slower to re-open, Canadians have taken on a significant amount of government and personal debt during the pandemic. Debts owed impact future financial flexibility and existing mortgage debt could become a headwind to future growth and consumption should interest rates rise and/or housing markets begin to cool.