The housing market is strong in many parts of the world. However, the Canadian housing market is most likely in a bubble. Canadian home prices have decoupled from fundamentals.
Canadian housing buyers in 2021 and beyond should be careful because valuations are extremely high. If you must buy Canadian real estate, then it's vital you do the following:
- Spend no more than 5X your household income on a home
- Spend no more than 30% of your gross income on a mortgage payment
- Put down at least 20% or more and have at least a 5% cash or semi-liquid buffer
- Own the property for 10 years or longer
In other words, given the Canadian housing market is in a bubble, you must buy responsibly. If you buy within your financial means, you'll better be able to ride out any corrections that will most likely occur over the next 10 years.
If you spend too much on housing in Canada and are forced to sell within five years, there is a high chance you will lose money given the cost to sell housing is still quite high.
How Big Is The Canadian Housing Bubble?
To show the Canadian housing market is in a bubble, let's compare Canadian home prices to Canadian disposable income. In a normal market, home prices should roughly follow disposable income higher or lower.
It is when home prices decouple from disposable income growth where a bubble starts forming. Below is a great chart that compares U.S. home prices and income to Canadian home prices and income.
Compared to the U.S. housing market, the Canadian housing market is clearly in a bubble. U.S. disposable income is roughly 10% higher than Canadian disposable income. However, Canadian home prices are roughly 75% more expensive!
Then, if you just study the Canadian home price and disposable income data, it is also clear the Canadian housing market started decoupling from fundamentals starting in 2005. It hasn't stopped since.
Today, the gap between Canadian home prices and Canadian disposable income is at the widest it has ever been. In other words, the Canadian housing bubble is huge! Beware.
Is The U.S. Housing Market Considered Cheap?
Another way to look at the data is to question whether the U.S. housing market is actually cheap and the Canadian housing market is not in a bubble.
I believe there can be two truths: 1) The U.S. housing market is indeed good value and 2) The Canadian housing market is indeed in a bubble.
The U.S. housing market consistently is one of the cheapest real estate markets in the world. The U.S. has a lot of land and great income opportunities. Therefore, I don't think the U.S. housing market is in a bubble. I expect the U.S. housing market to stay strong for years to come.
The data in the charts say the U.S. housing market could actually be undervalued by roughly 10 percent. Therefore, I'm a strong buyer of U.S. real estate.
The Canadian housing market shows us the POTENTIAL of the U.S. housing market. If the U.S. housing market got as frothy as the Canadian housing market, U.S. home prices could easily rise by 30% – 75%.
And why couldn't they? The U.S. has better weather, more job opportunities, more entrepreneurial opportunities, a stable government, a world reserve currency, and more diversity.
Personally, I'm diversifying aggressively into the heartland of America through real estate crowdfunding. I believe the spreading out of America will continue post pandemic thanks to technology and greater acceptance of working from home.
Best Ways To Invest In U.S. Real Estate
My favorite ways to invest in heartland real estate is through CrowdStreet and Fundrise. CrowdStreet focuses on individual deals in 18-hour cities where valuations are lower and cap rates are higher. Due to positive demographic trends, growth rates will likely be higher too.
I also like investing in private eREITs with Fundrise. Fundrise has created diversified funds with high-quality institutional commercial real estate investments they manage. Fundrise has a great track record since its founding in 2012 and provides an easy and lower volatility way to gain real estate exposure.
Of course, you can always buy real estate stocks and publicly-traded ETFs as well. However, they are often more volatile in a stock market downturn.
How Expensive Is The Canadian Housing Market?
To give you a better idea of the Canadian housing bubble, let's look at some key metrics from Numbeo, one of the largest cost of living databases online. As you can see from the latest chart below, Canada is ranked as the 17th on the Affordability Index.
Canada's housing market has a Price-To-Income Ratio of 7.24, a Gross Rental Yield City Centre of 4.87%, a Price-T-Rent Ratio City Center of 20.53X, and a Mortgage As A Percentage Of Income of 49.62%.
From these unbiased metrics, it's clear the Canadian housing market is in a bubble. Having to pay 7.24X your income for a home is way beyond what banks allow. Banks usually let borrowers buy a home up to 5X your household income. Further, spending 49.62% of your gross income on a home is also much higher than the standard 28% – 28% banks allow youth borrow.
The typical Canadian homebuyer comes nowhere close to following my 30/30/3 home buying rule. It's OK to stretch a little bit given mortgage rates have come down so much. If you just got a promotion and a raise, you can probably buy more home than my 30/30/3 home buying rule dictates.
However, to spend so much more for a home in Canada is dangerous, especially given prices have risen so much since 2002. You are playing with fire if you buy at current levels and stretch to such extent.
For the Canadian housing market NOT to be in a bubble, prices would have to decline by roughly 40%. Can you handle a potential 40% decline in Canadian housing prices? If not, then don't buy.
Reasons Why The Canadian Housing Market In A Bubble
With such long cold winters and a lack of companies paying high salaries, it intuitively doesn't make sense that a Canadian housing bubble exists. If anything, the Canadian housing market should be much cheaper than the U.S. housing market.
Just ask yourself where would you rather live and buy real estate? Now ask yourself where would you rather have your kids grow up? I bet most of you would say The United States of America instead of Canada.
Canada is a great country, don't get me wrong. However, the American dream is what millions of people around the world wish to realize.
Heck, even Canadians regularly want to live the American dream because Canadians are consistently the #1 buyer of U.S. real estate! Here is the latest data from the National Association of Realtors.
Top 5 Foreign Buyers Of U.S. Real Estate From April 2020 – May 2021
- Canada (8% of foreign buyers, $4.2 B)
- Mexico (7% of foreign buyers, $2.9 B)
- China (6% of foreign buyers, $4.5 B)
- India (4% of foreign buyers, $3.1 B)
- United Kingdom (4% of foreign buyers, $2.3 B)
Let's look at five reasons why the Canadian housing market has reached bubble status.
1) Supply and demand imbalance for the type of homes built and desired.
An imbalance between between supply and demand took place between 2011-2020. Canadian builders made too many apartments when buyers wanted detached homes. However, nearly 60% of home sales in 2020 in 18 communities in and around Toronto, Montreal, Vancouver and Ottawa were for single-family detached houses.
Then, thanks to the pandemic, demand for detached single-family homes shot to the moon. This in turn helped drive prices up by double-digits year over year. With so much demand for houses, Canadian home builders need to build more detached homes, especially as institutional investors are buying more homes.
2) Not enough land
Canada has more land mass than the US at roughly 3.9 million square miles in size. This is about 0.18 million square miles bigger than the US. However, most Canadians live in a handful the major cities that are close to the U.S. border.
The majority of Canadian jobs are located in Montreal, Toronto, and Vancouver. Other cities such as Brantford, Ottawa, Kelowna, Quebec City, Calgary, Saskatoon, Abbotsford, Halifax, and Victoria have promising job growth.
Even though Canada is a large country, it doesn't have as much livable land as one might imagine. And, as land in Canada runs out, prices get more expensive.
3) Easy for foreigners to buy Canadian real estate
Canada is often recognized for it's open-door immigration policies. Thus, it's not shocking that Canada also has a relatively open-door policy for foreigners to buy Canadian real estate. Non-residents have the same ownership rights as residents.
However, it seems like the Canadian government has made it too easy for foreigners to buy Canadian real estate. If Canadian politicians are there to fight for the Canadian people, letting wealthy foreigns drive up cost of living prices is not the way to go.
There is likely a lot of bribery of politicians to enable such high amounts of foreign buying in Canadian real estate. It doesn't make sense that Chinese investors are buying multi-million dollar homes when they can only withdraw $50,000 a year!
4) Canada is a money laundering destination
What you may not know is that a lot of money laundering takes place in Canada. According to the anti-corruption organization Global Financial Integrity based in Washington D.C. a significant amount of illicit funds is laundered in Canadian real estate.
From 2015 to 2020, roughly US$626.3 million of Canadian real estate was bought with laundered money. Nearly 90% was through residential real estate. Interestingly the $626.3 million was transacted through only 35 cases. Surely there must be a lot more undiscovered cases out there.
In addition, GFI's research uncovered that 48.6% of cases involved Canadian sourced funds being laundered. Due to the country's open-door policy for foreigners to buy real estate, Canada has become an popular place to launder funds as well.
China represents 22.9% of cases, the largest international source. This is roughly half as much as Canadian sourced laundering. The US came in the third at 11.4%, half the size of China.
Below is a chart from GFI that shows money laundered by country's origin. Canadian capital is obviously the largest source of Canadian money laundering. But China and the U.S. are ranked number one and number two.
More than half the cases, 51.4%, laundered money via company structures. The next most popular cases were third-party processing (45.7%), mortgage schemes (34.3%), and private lending (17.1%). In Canada, private mortgages are not subject to anti-money laundering rules.Â
5) Multi-generational financial support from parents and relatives
Canada has universal healthcare and subsidized college tuition. It is clear Canadians have a more socialist view of the world. As a result, it is also try that multi-generational financial support when it comes to buying homes is ubiquitous in Canada.
In the United States, it's generally frowned upon to have parents help come up with a down payment or pay for anything once you are an adult. In contrast, the Bank of Mom and Dad is more common in Canada, which helps drive up Canadian home prices.
Instead of competing against another buyer with one balance sheet, we are slowly having to compete with a buyer with two or three balance sheets (individual + mom and dad or a couple + mom and dad). As a result, a Canadian housing bubble forms.
The Canadian Housing Bubble Could Continue To Grow
The scary thing about the Canadian housing bubble is that it could continue to grow larger.
Foreign investment will likely heat up again once the global pandemic dies down. Once it does, it's safe to assume more foreign capital will flow to countries such as Canada and the United States.
The competition for Canadian real estate could heat up as buyers will now face foreign individual and institutional demand. Canada is still considered among many foreign countries as a safe haven for capital.
Canada's health care system is good and so is Canada's education system. Foreigners are happy to send their children to Canada for a better life. Compared to the United States, Canada provides a more affordable lifestyle for middle-class people.
However, as a savvy investor, I think it's wiser to invest in U.S. real estate at this time. I think there's greater than a 60% chance the U.S. housing market could turn into the Canadian housing market. If it does, expect U.S. real estate prices to rise by another 30% – 75% in addition to its normal price appreciation trend.
Check out Fundrise for an easy and less volatile way to gain high quality real estate exposure across the country. Fundrise began in 2012 and is the creator of the private eREIT product. It recently introduced its Starter Portfolio with an investment minimum of only $10.
I've personally invested $810,000 in real estate crowdfunding so far to generate more passive income. As a savvy investor, you want to allocate capital where there is the most opportunity. The U.S. housing market is much more attractive than the Canadian housing market at this point in time.
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