Is there a “hidden” real estate bubble in Canada?
This is a question I asked myself since last week when I started receiving panicked phone calls from people that purchased real estate during the height of the Toronto real estate market.
Specifically, they purchased properties prior to April 21 2017 before the Non-Resident Speculation Tax came into force.
There are two phone conversations that stand out in my mind which I’ll discuss…
Investment Property Purchase
Last week I received a call from a real estate investor who also happens to be a mortgage broker. He purchased a rental property just north of Toronto on Steeles Avenue in early 2017. It was financed with two mortgages from two private lenders. The value of this property has gone down since then by approximately 20% and now he’s unable to refinance. The first mortgage is up for renewal in January 2020.
I informed him that there was nothing I can do for him since the mortgages are secured debt and the mortgagees have rights to enforce their security (i.e., the rental property). I then asked him why he bought this property in the first place when he should have known the risks as a mortgage professional.
He explained that China’s capital controls (to prevent an outflow of money from China) are now having real adverse effects on the global real estate sector (not just Canada’s) and he didn’t foresee this happening. He also owns two properties in the Toronto downtown core (full leveraged) and if he were to sell these today, he’d just be barely breaking even. Therefore, he simply wouldn’t be able to sell the downtown properties and use the sale proceeds to pay off the shortfall from the Steeles property.
My advice to him was to arrange to surrender the Steeles Avenue property to the first mortgagee and if there is a shortfall he’d unable to pay, he can attempt to settle with whichever mortgagees suffered shortfalls on their loans. I informed him that such a settlement would likely have to be facilitated through a Division I proposal rather than a consumer proposal as his debts will likely exceed the $250,000 threshold for the latter type of engagement.
Residential Real Estate Purchase
During the same week I received a phone call from a lady who purchased a home in Brampton, where she resides with her husband and two children. Like the gentleman who purchased the investment property on Steeles Avenue, she purchased her home in early 2017 during the height of the real estate market – in her case she bought it for $1,000,000. The home is in her name only.
She financed the purchase through 3 private lenders because her creditworthiness was insufficient to obtain a conventional mortgage through a bank. The total outstanding mortgage balances to the three mortgagees is $1,040,000. The home is currently valued at approximately $800,000. The third mortgagee has started enforcement proceedings against her because she could no longer afford to make interest payments. Moreover, her second mortgage is up for renewal in February 2020.
I asked her why she decided to buy her home at the height of the real estate market in 2017. She told me that:
My mortgage specialist told me that the value of my home will only go up and because of that, I’d be able to easily get refinancing when the mortgages come due.
She recently tried contacting the mortgage professional she was working with without success. She told me that “he’s hiding out somewhere and not returning any calls“. So she called my office in a panic not knowing what to do.
As in the first example, I informed her that there was nothing that I can do for her as mortgagees are secured lenders who have a right to enforce their security. I suggested that she find rental accommodations as soon as she could and upon doing so, arrange to give the first mortgagee the keys and let him deal with the property.
Given the size of the shortfall she’ll likely incur once her home has been sold under power of sale proceedings, she’ll probably have to file for personal bankruptcy as her income would be insufficient to finance a settlement with her creditors through a consumer proposal.
Are Private Mortgages in Canada Contributing to the Problem?
After contemplating the conversations I had with these two individuals and their potential significance, my curiosity was piqued. I started asking where the money for these private mortgages was coming from.
I received a fairly thorough answer from a Toronto area mortgage professional, whose response to my query is as follows:
Private mortgages tend to come from 1 of 2 entities, a MIC, or direct private lender.
Mortgage Investment Corporations
A MIC is a Mortgage Investment Corp; here’s a few examples for any one “Google Happy” today. MCF Mortgages, Fisgard Capital, Oppono, River Rock Mortgages, Owemanco, and best for last, New Haven, and on and on, there’s alot of MIC’s..
These entities, are private largely unregulated lenders that will lend to most anyone, provided there is an equity position to lend on. They are backed by direct investors, to whom they pay an annual return out to for investing.
The other source of private funds is Direct Lenders, this is the scenario where you come to me and say you need $500k, in first position, no questions asked, for 60% Loan to Value, and I say “Ok, I know a guy, he’ll charge 7% interest only, 2% lending fee, and I’m charging 1% to put it together. Can close in 48 hours.“
Now, there are still 2 types of direct lenders: (1) guys who do it to make serious money; and (2) folks that just do it to pad other investments. The ones who do it for serious money are the folks that have significant capital, and this is their primary source of income/investment and they tend to have deep pockets of liquid cash.
The other type tend to do smaller deals, probably a bit higher risk, and often second position. The advantage here is bigger return. Many of these folks tend to lend directly from their RRSP as well for smaller debt consolidation loans etc..
Not “many” lenders are lending on borrowed funds, but it does happen, I personally know a number of actual brokers who keep a $200-$500k HELOC available to lend on files to make the return personally on files they like. But I’d say it’s not the norm…
Most of this money flying around that isn’t in MIC’s, are just wealthy individuals playing in real estate for the high return…I mean you can personally vet each file, and get a 10-15% return most often, there’s certainly risk of course..
Low Interest Rates and Unintended Consequences
To summarize, here’s my take on what’s going on within a segment of the real estate market where owners are highly leveraged with a less than stellar credit score:
- The Bank of Canada has kept interest rates too low for too long (approximately 10 years as of the date of this article) which has contributed to inflation in the Canadian real estate market (i.e., a bubble) and an attendant increase in consumer debt. BOC Governor Stephen Poloz was called out on this by Andy Wood of BNN Bloomberg during a recent press conference. Governor Poloz’s reply was disappointing but not surprising (starting at 1:45 in the video):
I think the fact that inflation is on target today suggests that the Bank of Canada has done its job. Now if there are side-effects, and one of them that you’re mentioning, well, those are secondary effects (i.e., household debt levels). They are not our prime mission. Our prime mission is to stablise the economy and keep inflation on target, and we’ve succeeded with that.
- As a consequence of the “secondary effects” mentioned by Governor Poloz in the quote above, there’s too much demand for real estate from purchasers who have too much access to cheap money relative to supply. Why is there a demand for real estate? Because you can get a higher return on real estate than depositing your money into a chequing account which will essentially pay you zero interest thanks to the BOC’s low interest rate policy.
- To address this problem, the Office of the Superintendent of Financial Institutions (OSFI) introduced a mortgage stress test on January 1st 2018 in an attempt to cool down the real estate market.
- However, what this has done is to push real estate purchasers out of the regulated mortgage market (i.e., borrowing from chartered banks, credit unions, etc.) and into the unregulated private mortgage market, as described above.
- And because the BOC has kept interest rates so low, many investors are eager to invest their money in MICs and private mortgages within an unregulated mortgage market to generate a return on their money. They are looking for yield in a low-interest rate environment.
- Moreover, if a market is unregulated, it suggests that the Government of Canada might have no idea on what’s actually going on in this market nor its size. How can it possibly know the amount of private mortgages outstanding? And although CMHC estimates that private mortgages make up 1% of the market, how reliable is this information? And how can it be aware of the number of mortgages that may be on the verge of defaulting when they renew?
Hence, the title of this article – “Is There A Hidden Real Estate Bubble in Canada?” Nobody will really know the answer to this question until “the music stops playing”. And it may be triggered by one of several possible events:
- A significant decline in real estate purchases from foreign buyers, particularly from China, triggered by tightened capital controls (as discussed above) or a significant downturn in the Chinese economy resulting from the U.S.-China trade war.
- Canada enters into a recession resulting in significant job losses in major real estate markets such as Toronto and Vancouver.
What you’re telling me is that the music is about to stop, and we’re going to be left holding the biggest bag of odorous excrement ever assembled in the history of capitalism.
Do you care to know why I’m in this chair? Why I earn the big bucks? I’m here for one reason and one reason alone. I’m here to guess what the music might do a week, a month, a year from now. That’s it – nothing more.
And standing here tonight, I’m afraid I don’t hear a thing. Just silence…
What Do Real Estate Professionals Think?
Of course, the two examples I discussed at the outset of this article are anecdotal based on a limited sample. In preparing this article, I reached out to real estate professionals in the Toronto area to determine if this is the start of a broader trend in the real estate market.
Here are some thoughts from Payam Ahangar, a mortgage broker and real estate agent in Toronto:
We are in a perpetual real estate bubble but due to the unique and complex dynamics in Toronto the behaviour is not like any normal bubble.
This is mostly due to the fact that the foundation of this price bubble is a credit bubble facilitated by banks and the shadow banking system. The banks have tightened but the shadow banking has a much higher appetite for risk
The problem is no matter how much appetite there is from the lenders, there are very solid limits to the borrowers’ appetite and ability to service the debt.
The average person might be making 10% more income than a few years ago but now they have to borrow hundreds of thousands more to buy the same house as few years ago. People will continue to take on the debt as long as they think the price will continue to go up , until that sentiment changes.
Given all this, we still have such influx of capital and new residents into Toronto that there is always demand for property and the the required credit. I think this means that the market itself is not in danger but most borrowers will basically be under severe financial pressure for the years to come.
If you’re a real estate professional and wish to contribute your commentary to this article, please reach out to me.