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  • KPB & Co Research

The housing bubble has been the hot topic in Canada for quite a while with many investors anticipating a meltdown, and many others hoping for home prices to continue expanding. The Canada Mortgage and Housing Corporation released data today that shows that there is one group of people that are "dancing to the tune" of higher prices. Homebuilders continue to build homes at a rapid pace in July - 2019. Housing starts came in at an annual run rate of 222,013, which is 9.8% higher than the run rate seen at the same time last year. Relative to the previous month, housing starts were lower by approximately 9.5%, reflecting mostly seasonal factors. At the same time the difficulty in buying a home remains elevated as mortgage qualification requirements remain high, interest rates remain high, and economic growth slowed going in Q1 of 2019. Why then are more cranes going up? As we look into the incentives that homebuilders face, a couple of motivations jump out, and some of these motivations have been in place for more than a decade.

Consistent Influx of Immigrants and Huge Non-resident Demand

Every year about 300K immigrants come to Canada, a significant portion of which will need a home, if not immediately at some future date. This presents a consistent source of demand that has to be met by more dwellings regardless of the increase in prices. Canada is also seen as one of the few stable democracies in the world, which makes it a very attractive place for non-residents to park cash. Real estate has been pretty hot and so naturally, wealthy global investors will seek-out select geographies in Canada to own property, geographies such as Toronto and Vancouver.

high Financial Incentives

Over the last decade, interest rates have been at extraordinarily low levels ( 2% to 6%) which makes it easier for middle-income people to buy homes, especially when the required down payment is minimal. Add to this, the fact that a significant portion of the mortgages that have been issued are insured by the government. This insurance structure creates a huge incentive for more lending, as banks will be better able to manage the credit risks of the mortgages they hold on their balance sheet. With a greater capacity to borrow, customers will be more inclined to buy homes which allow homebuilders to make more dollars.

In times of increasing uncertainty, investors typically become cautious and hold back investments until they are more confident about where things are heading. In the housing market today, at least some of the incentives have been eroded. The Central Bank of Canada has been on a rate-hiking cycle, which has pushed up the mortgage rate somewhat. In addition, monetary and fiscal authorities have imposed tough restrictions on the way consumers qualify for mortgages. Also, despite relatively low unemployment rates, wage growth has been moderate at best, and in some industries, hourly wages have declined. Finally, starting in Q4 of 2018, the threat of a worsening employment situation has grown as GDP growth has decelerated.

At this point, homebuilders are looking towards the light at the end of the tunnel. When one considers the fact that the core incentives remain in place, the uncertainties pointed out may not be seen as big deals, especially when some of the uncertainties appear to be moderating. Before the Bank of Canada made any reductions to their key policy rates, the market had anticipated that monetary conditions will ease, which have resulted in lower mortgage rates at the banks. The lower mortgage rate had only a muted impact because the stress test qualifying rate of 5.34% was higher than the rates offered by the commercial banks. This stress test qualifying rate was adjusted downwards to 5.19% on July 18, 2019, after being set way back in April 2018. Recent actions by the U.S. Fed to cut their key policy rate will surely add a degree of confidence that, not only will the posted rate remain low, but also that the Bank of Canada may cut their key policy rates at their next meeting. The unemployment rate also remains low at 5.7% despite inching up by 0.2 percentage points in July, and the central government themselves have come up with a plan - The Housing Affordability Plan - to incentivize more homeownership.

As the housing market moves towards the future, homebuilders are likely to continue building homes until the credit market dries up. No one is 100% sure if that will happen. On the one hand, interest rates remain low which is highly supportive of continued credit expansion. On the other hand, if economic conditions slow materially the short term impact may be devastating on the housing market even with low rates. This sort of scenario, admittedly, would be unusual, but then we have been in uncharted territory since 2008.

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