In the hunt for yield, valuations of stocks that pay dividends or other forms of income have risen sharply.  The real estate investment trusts (REITs) have been bid up to valuations that are almost as high as in 2007.  While the REIT sector’s financial leverage has come down some from above 55% in 2007 to about 47%, it is still quite high compared with the 1980s and 1990s. This makes REITs vulnerable to rising yields and corporate bond market distress, and it exacerbates losses in property downturns.  We see more risk ahead for this sector as the high valuations begin to compress and the real estate market in Canada goes through a downturn.  A downturn in Canadian real estate will also impact the banking sector, which is why we have seen such aggressive ‘short selling’ (bets that a stock will fall) on the Canadian banks by many large, U.S. investors.  We don’t worry as much about the overall banking system in Canada as the major banks all have outstanding risk control measures, are well diversified, have expanded foreign operations and growing wealth management businesses.   However, they would not be immune from a downturn in Canadian real estate as mortgages still account from about 15% (on average) of the outstanding asset base.   The reason that many U.S. investors have been so aggressive in implementing a negative view on the Canadian banks has more to do with their view of our real estate market and how it mirrors what was happening in U.S. real estate a decade ago.   The chart below shows residential investment as a percentage of overall GDP in Canada (red line) versus the U.S. ten years earlier (blue line).Canadian real estate bubble?

It doesn’t take much imagination to create a pretty negative picture for Canadian residential real estate sector if we follow anything close to the same path!  While we can argue that lending and mortgage structure in Canada has not been nearly as ‘creatively financially engineered’ as the U.S. lending market was 10 years ago, we are not without some risk.   Recent warnings of an overheated market from the CMHC, more stringent loan conditions from the federal government and the restrictions on foreign buyers in the Vancouver area all indicate that we might be closer to a downturn.  Buyers and investors be warned!

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