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Canadian housing boom over, economists say

After years of growth, economists say the real estate boom is over and predict Canadian housing prices to flatline over the next decade.

A TD Economics study, Long-Run Rate of Return for Canadian Home Prices, predicts a “string of lacklustre performances” over the next few years. The annual rate of return for real estate will be about 2% over the next decade, meaning that prices will simply match the pace of inflation.

Meanwhile, another report warns that a severe economic shock, such as the kind that hit Japan in the early 1990s and California and Nevada in 2006, could knock Canadian housing prices down by 44%. While not predicting the extent or cause of a large-scale house price depreciation in Canada, Moody’s Investors Service included the figure in a report on its proposed approach to analyzing the credit risk of non-insured mortgage pools.

“There is some overvaluation in the housing market — home prices have moved away from their underlying economic fundamentals — and that overvaluation has to unwind,” said Sonya Gulati, senior economist at TD.

This adjustment, however, will be gradual, she added. “With the U.S., it was a housing market bubble and all of a sudden, a pin came and pricked it. It completely burst. The way you want to think about the Canadian housing market is that there’s a balloon that’s been inflated but instead of a pin coming and pricking the balloon, the air is going to be slowly let out.”

Canadian residential home prices grew by an average of 5.4% per year between 1980 and 2012, climbing about 7% per year in the last decade.

The market has cooled over the last six months and will continue its slide over the next few years as tighter mortgage rules, modest economic growth and higher interest rates push rates downward. The economists project a 3.5% annual rate of return on real estate beyond 2015, a low rate that has not been seen since 1980.

However, Moody’s Investors Service analyzed housing prices in the event of a pin coming along.

A 44% decline, were it to occur, would be driven primarily by the phenomenal upswing in Canadian home prices over the past decade, Moody’s said.

Canada joins Spain, as well as the United Kingdom and Australia, in the ratings agency’s assessment of countries where growth in housing prices over the past 10 years has driven their values away from sustainable market fundamentals and into “overheated” territory.

“As with Australia, Spain and the U.K., we expect house prices in Canada to suffer the most due to the misalignment of current house prices with historic fundamentals,” Moody’s said.

The ratings agency released the report Monday that included its housing market analysis, along with request for comment on its proposed approach to analyzing the credit risk of non-insured mortgage pools.

“Moody’s Investors Service is in no way predicting the extent nor the causes of a large scale house price depreciation in Canada,” spokesperson Thomas Lemmon said in an emailed statement.

As with Australia, Spain and the U.K., we expect house prices in Canada to suffer the most

Moody’s is the second ratings agency in as many weeks to seek input on a proposal to change the methodology used to analyze securities linked to mortgages.

Last week, London and New York-based Fitch Ratings unveiled a proposed a two-step model that reduces home prices to a “sustainable” value based on a number of factors including data provided by Canadian banks. It then further subjects the homes to a “stressed market” value decline assumption.

Fitch said Canadian home prices are overvalued by about 20%.

Ratings agencies came under harsh criticism in the aftermath of the financial crisis of 2008 for what was perceived as a failure to predict the U.S. housing market meltdown that precipitated it.

Since then, there has been an attempt to strike a balance of thorough analysis with timely analysis, according to Grant Connor, an associate in equity research at National Bank Financial who previously worked on structured finance at Moody’s.

The model proposed by Moody’s on Monday determines house price “stress” rates by looking at variable factors such as house price and income growth over 10 years, and fixed factors such as monetary policy.

The analysis of housing prices in the event of economic shocks includes data from Finland in 1989, Japan in 1991, and Hong Kong in 1997, as well as Ireland, Nevada, and California in 2006.

The “variable” analysis assesses how much current house prices have departed from “sustainable” market fundamentals. The assumption is that, in the event of a severe economic shock, expected demand that has been baked into current house prices will not materialize.

In Canada, the growth in house prices over the past 10 years has ‘’far outstripped” the growth in incomes, according to Moody’s.

“Think of it like an elastic [being stretched],” explains Mr. Connor of National Bank Financial. “The snap back is going to be a lot harder.”

Moody’s also assesses the “fixed” factor, which rates how vulnerable the consumer is to economic shocks, whether there is a large oversupply of houses, how effectively monetary policy can alleviate the shock, and how dependent the economy is on the real estate sector.

Canada scores better in this area, says Mr. Connor, because the stability of the country and its monetary policy is taken into consideration. While Canada’s household debt to income ratio is very high, at 154%, Moody’s notes that savings rates are higher than in some jurisdictions such as the United Kingdom.

In addition, Moody’s does not seem overly concerned about an over-supply of housing with the possible exception of the condominium market.

David Fleming of Bosley Real Estate Ltd. in Toronto says he is extremely skeptical of reports of any significant declines in housing prices.

“What I’m seeing out there working in the trenches every single day? Not enough single-family properties, prime houses are still getting 10 to 12 offers,” he said. “I would predict that the luxury condo market… that stuff might go down 25% because it was so grossly overpriced to begin with. But no matter what happens with the market, there will be properties with increasing value.”’s experts predict that mortgage rates will remain unchanged for the foreseeable future. This month, BMO brought back its 2.99% five-year fixed-rate mortgage as concerns of a cooling housing market has banks becoming increasingly competitive about roping in new customers.

“This year and next year, interest rates are not going to be moving too much. But when they do start to increase, we think they’s going to be some degree of sticker shock,” Ms. Gulati said. “Some small increase, people are going to look at it and think to themselves that it is much higher than what it actually is, because they’ve been normalized to these low interest rates.”

Barbara Shecter and Melissa Leong | 13/03/11 | Last Updated: 13/03/12 11:46 AM ET

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