Look for 5% to 10% drop in home prices in first half of 2012

Christine Dobby 
Financial Post

Canadian home prices are likely to drop 5% in the first half of 2012 as the economy slows and could slide as much as 10% if the unemployment rate rises above 8%, economists at Bank of America Merrill Lynch said.

Ryan Bohren and Sheryl King warn the market is overvalued and flooded with supply.

The economists have taken a bearish stance on the real estate market before, warning of a possible 15% correction to the Toronto condominium market in an October report.

In their 2012 outlook for housing released Friday, Mr. Bohren and Ms. King noted that while Canada is somewhat shielded from the situation overseas it is not immune to the European turmoil and the economic fallout here could worsen if unemployment creeps up to 8%.

“In our view, the housing market is one of the most vulnerable sectors to this weakening economic environment, showing classic signs of overvaluation, speculation and oversupply,” they said in the report.

“We are not calling for an all-out rout in the market, but caution is now decidedly warranted,” they said.

“We’re not looking at a doomsday scenario here,” Ms. King said in an interview. But she noted that the six-month outlook for the domestic economy is “pretty soft,” with the net loss of 73,000 jobs over the past two months and a fairly weak prognosis for income growth boding ill for the Canadian housing market.

“We think the risks are definitely strongly skewed to the downside,” she said.

The authors’ base-case scenario, to which they assign a 50% probability, is for a soft landing for the housing market. They see home prices dropping by about 5% in the near term but rebounding in the second half of the year to end 2012 about flat.

Their more adverse outcome, to which they assign a 40% probability, is based on a global recession and sharp drop in commodity demand, pushing the Canadian economy into “outright recession” and unemployment above 8% from the current level of 7.4%.

Linked as it is to jobs and income growth, expect a hard landing for the housing market under this scenario, the authors said.

A spike in the unemployment rate under the bearish outlook would likely result in a rise in mortgage delinquencies and forced selling, producing a decline in home prices of about 10%, they said.

The economists said one of the biggest concerns is the condominium market, which is probably in the late stages of an inventory cycle, with Toronto particularly vulnerable.

“We estimate there are already enough units in the pipeline to satisfy fundamental demand for the next five years,” the report said.

Home valuations are already overheated, primarily due to record low mortgage rates allowing households to leverage more than ever before.

Using a fair-value model for average home prices that takes into account disposable income and interest rates to measure what households can actually afford from a cash-flow perspective, the authors found home prices in Canada are about 10% overvalued.

In 1982, for example, for every $1 of income available for borrowing, the average household could borrow $6; now, that same $1 can be levered up to $20, the authors noted.

They also pointed to longer maximum amortization periods as a factor in inflated valuations.

“If mortgage rules were reverted back to where they were in 2000 and the maximum amortization for an insured mortgage was 25 years, instead of the current 30 years, we believe home prices would be almost 20% overvalued,” the authors said.

Changing the effective five-year, fixed-mortgage rate to a “more normal” 5% versus the current 3.3%, they said, shows home prices to be about 25% overvalued.

“If we removed both of these effects [low rates and longer amortization periods] on our fair value model, home prices would look about 35% overvalued,” they said.

For investors eyeing the sector, the authors noted that shares in Canadian homebuilders and non-bank financials with direct exposure to the housing market turned negative in April and could fall further in 2012,

Their base scenario is probably priced into the 30% decline homebuilder stocks have already experienced since an April high, the authors said.

“However, housing sensitive financial stocks are only down 13% from April and will likely fall further as home prices and home sale activity slows into 2012,” they added.

Their more adverse scenario could mean a further 20% decline for both homebuilders and housing sensitive financial stocks.

 

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