Canada’s largest city accounts for a disproportionate slice of its economy, primarily because of its housing sector. Toronto real estate has had over 20 years of uninterrupted price gains. The market remained steady throughout last year’s crisis and has now gone parabolic.
However, regulators and the government seem to be stepping in to cool the market. If this lowers prices or triggers a correction, several major banks and real estate investment trusts (REITs) could be caught in the downfall. If you’re wary of this risk, here are the trends you need to watch.
Toronto real estate regulations
In the fourth quarter of 2020, the housing sector accounted for nearly 17% of Canada’s annual economic output. As the largest and second-most expensive market in the country, Toronto real estate is pivotal.
Over the past few months, townhouses, condos, and detached homes across the Greater Toronto Area have surged by double-digit percentages. The average home now costs $1,045,488 — 14.9% higher than a year ago.
A frenzy like this tends to attract speculators and home flippers. Meanwhile, it compels ordinary households to stretch their limits while adopting far more debt than they can afford. In short, it creates systemic risks for the entire economy.
The government has indicated that it could step in. This week, the Office of the Superintendent of Financial Institutions (OSFI) proposed raising the mortgage stress test from 4.79% to 5.25%. When this hike is implemented in June, several households may be unable to qualify for their mortgages, cooling demand.
The stress test hike is just an early step in tackling Canada’s housing addiction. In the months ahead, the government could consider several other tools, including a potential tax on capital gains from a primary residence or a foreign buyers’ tax.
The International Monetary Fund (IMF) claims Toronto house prices will have to decline by 28.2% to be considered fair value. Vancouver would need a 13% decline. Severe declines could have a knock-on effect on Canada’s growth, banking profits, and REIT valuations.
Banks and REITs to watch
Canada’s four largest banks are all overexposed to domestic mortgage lending. Residential mortgages account for roughly 46% of RBC’s retail loan book. Recently, credit rating agencies lowered the bank’s rating due to this exposure. Shareholders who rely on RBC’s dividends, or income from any major bank stock, should pay attention to emerging trends in Toronto real estate.
Meanwhile, REIT investors should beware too. 41% of CAPREIT’s portfolio is based in Ontario, with Toronto apartments accounting for a substantial portion of that. Rents have already declined, which has impacted the company’s free cash flow. If the value of Toronto real estate declines too, CAPREIT’s book value could be vulnerable.
Bottom line
Toronto real estate is on a knife’s edge. Prices have surged at an unprecedented pace, which has caught the attention of regulators. If mortgage rules tighten and house prices drop, banks and REITs could suffer. Dividend-seeking investors who rely on these stable dividend stocks should be wary.
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