Little reason to fear Canadian housing correction: Merrill Lynch

At first blush, the housing sector in Canada “appears overextended and eerily reminiscent of the U.S. pre-crisis market”, the report notes. “But a closer look suggests that while valuations are lofty, there’s little reason to fear a painful correction. We see homebuilding edging down this year, with the pace of house price gains set to slow to the rate of inflation.”

Merrill says that it doesn’t see a bubble for a couple of reasons. For one, it says that speculation does not appear to be a big factor, and “Housing bubbles are often characterized by the presence of fickle speculators who enter and exit with great speed to benefit from rapidly rising prices.” Also, mortgage credit growth has slowed, which points to a steady cooling in housing demand, it says.

“The recent flurry of condominium construction looks on the surface like a sign of oversupply. But much of the activity is just a catch-up after underbuilding in earlier decades,” it says. “Today, with apartment vacancy rates at a low 2.2%, and with some of the frothiest condo construction markets, namely Toronto and Vancouver, seeing tight rental conditions, the recent increase in supply appears well absorbed.”

Indeed, Merrill says that valuation is the only key metric that looks stretched, as house prices have outpaced inflation and disposable income growth in recent years. “But that need not signal a sudden plunge in house prices. Instead, we could see a more measured unwind in an environment of economic growth and historically low interest rates,” it says.

Additionally, the report notes that Canada’s housing market is not the same as the U.S. market before its crash. In Canada, subprime lending accounts for less than 10% of the total Canadian mortgage market, while in the U.S., the figure was closer to 20% prior to the crisis, it says. Also, mortgages delinquency rates are much lower, and many households are paying off their mortgages faster than required.

“This less-risky environment is driven by conservative practices by both borrowers and lenders,” it says, which stems from tighter bank regulation in Canada and the fact that mortgage interest is not tax deductible as it is in the U.S. so Canadian households are incentivized to pay off their debts as soon as possible.

The report allows that an unexpected external shock, such as a global recession, could trigger a crash. “But barring that extreme scenario, we see the risks to housing as contained,” it says.

Absent that, it says that the future path of interest rates in Canada is the most important variable for housing markets, and it sees a slow and modest rate hike cycle beginning in 2016. “Our base case assumption for the housing market is a 0.5% decline in homebuilding activity and a slowdown in house price appreciation to roughly 2% this year,” it says.

Indeed, low rates and positive economic growth could forestall an outright decline in the price of residential properties in 2014 and 2015, Merrill suggests. “As the BoC nudges up its policy rate, house prices could gradually decline by 5% – 10% over the span of a couple of years as higher borrowing costs discourage demand.”

“Increasingly prudent lending standards, the absence of speculation driving up prices, and reasonable supply metrics suggests that the Canadian housing market is built on stone, not sand,” it concludes. “While the residential market will likely lose some of its earlier momentum over the next several years, we don’t expect a downturn that triggers financial or banking sector woes, or that requires a policy easing from the BoC.”