Front Burner - 'Too big to fail': COVID-19 and Canadian real estate

Episode Date: May 5, 2020

Could the "wealth-conjuring machine" that is Canadian real estate grind to a halt after the COVID-19 crisis exposed its worst weaknesses? That's the concern many who watch a sector that makes up a bigger part of the Canadian economy than oil and gas. Today on Front Burner, Bloomberg News' Vancouver bureau chief Natalie Obiko Pearson returns to explain how real estate became such a significant part of the Canadian economy, how Canadians went deeply into debt, and why now, the housing market in Canada could be "too big to fail."

In the Dragon's Den, a simple pitch can lead to a life-changing connection. Watch new episodes of Dragon's Den free on CBC Gem. Brought to you in part by National Angel Capital Organization, empowering Canada's entrepreneurs through angel investment and industry connections. This is a CBC Podcast. Hello, I'm Jamie Poisson. So for years now, real estate in cities like Toronto and Vancouver has been booming. Housing prices going up and up and up. More and more people working in the industry from realtors to contractors.

A sense that real estate was an infallible investment. Now with the economy at a standstill, that sense is faltering. Today I'm talking to Natalie Obico-Pearson. She's the Vancouver Bureau Chief with Bloomberg News. She's been looking at how real estate came to dominate the Canadian economy and what happens if the bubbles burst. This is Frontburner. Hi, Natalie. Thank you so much for being with us today. Great to be here. So I'm hoping we can start with you giving me a sense of what the housing market has been like in Canada over the last couple of

years, particularly in cities like Vancouver and Toronto? Well, I think as you said, it really has felt as though it was the infallible investment. The head of the world's biggest asset manager in 2015 described Vancouver condos as a better store of wealth than gold. So that sort of puts it in perspective, the safe haven that people have been turning to in recent years. Will the bubble ever burst? China money is not disappearing. It may soften and slow. It'll come back. Every time we think it's going to crash, it doesn't. I think we've said, I think people predict it's going to crash about 100 times and it never really does. It's hard to believe that this is going to be a place where it's easy to find a lovely, inexpensive home anytime.

And that came in tandem with a shriveling of the oil sector. So as Canada's economy became less dependent on commodities and in particular oil, you saw the real estate sector booming and taking a larger share of economic output. Right. This is something that you wrote about in your Bloomberg piece, which I actually didn't know about until I read it, that, you know, real estate has played a bigger and bigger role in the Canadian economy, and it's overtaken oil and gas, right? That's right. It's really quite remarkable when you look at the numbers. So real estate today has become Canada's largest sector. So when you include residential construction, it accounts for 15% of economic output last year. Energy in comparison accounted for 9%. Right. And so like, essentially, there are just a ton of jobs tied up in this thing.

That's right. There's a whole ecosystem that goes in to support the real estate industry. And so you would have the notaries, you would have the lawyers that help these transactions, you would have the property managers. So when you consider all of that, it's a huge part of the economic activity in this country. You mentioned experts talking about how this was a safer investment than gold. Why was it considered such a safe investment? Yeah, and it's a great question. And it's a sense that if you invested in a Vancouver condo, sure, there might have been a bit of a blip after the global financial recession.

financial recession. But the price of condos and of real estate in general in these two markets, Toronto and Vancouver, it's just kept on going up, up, up, up, up. Across much of the country, home prices have gone on a multi-decade run. In Toronto and Vancouver, of course, we know it's been silly. Million dollar teardowns, that sort of thing. I think there is a much bigger global backdrop to what's happening here. And we're talking about a couple of decades where it was very cheap to borrow money. So anywhere you were in the world, if you had a lot of cash on hand or you were able to borrow a lot of cash, you were thinking about where you could put that money to best use, where it was going to be safe to put it and where it was

going to make money. And Canada has been a very open economy. And so you saw people plowing in to buy these assets. And in tandem, you also had Canadians thinking the same thing. It was sort of the sure bet that if you put your money in a Vancouver property or in a Toronto property, it was just experience was telling you over the last two decades that it wasn't going to fall. And so because of that, people kept on borrowing money. It kept on inflating the prices of property. And the party didn't seem like it was going to stop. But all of these types of cycles end at some point. Fair for me to say, too, that a lot of people wanted to live in these cities in Toronto and Vancouver and work there.

And this also has been contributing to the rise in prices that we've been seeing. Absolutely. I mean, that's fundamental to it. So, I mean, if you talk about the two things that are fundamental to the housing market, it's jobs and it's immigration. Canada is an incredibly attractive place for people to live, you know, great health system, you've got great education, you've had a, you know, what seemed like a pretty solid economy, lots of jobs available, very low unemployment. So you had these people piling into places like Toronto and Vancouver, and we know what great cities they are to live in. So as long as there's that demand feeding the market, there's going to be people needing homes and the prices are going to keep going up higher. Right. And so we're talking about these prices

that have gone up and up and up and up and up. And I want to move now to a related piece of the story. And that's Canadians levels of personal debt. And so, you know, one effect I know of homeowners seeing the value of their property go up so much is something called the wealth effect. And can you describe this phenomenon to me and how it played out in cities like Vancouver? Yeah, and I think that's where you see the story start to stray away from just simple demand for housing to something else that's been driving the market. And it's what I've been calling the wealth conjuring machine. So when you own a piece of property in Toronto or Vancouver, and suddenly its value is going up

year after year in Vancouver at one point at the peak, 40% in one year. So just to sort of bring that home, what that means, without even stepping out of the house, if you had owned a home in Vancouver in 2016, your net worth would have ballooned on average by $1,600 a day. And so in one year, the city's properties surged in value by $47 billion. That's more than the entire cumulative take-home income of Vancouver's residents that year. So what happens is you start to feel richer. You may not necessarily sell that home that you're living in that's suddenly worth $2 million when it was only worth $1.5 million last year, but you feel $500,000 richer than you did. And a lot of these people are thinking, great, well, I can sell my house anytime and I'm going to have $2 million in the bank, so I may as well live it up. Let's go

out to restaurants. Let's run up the credit card. Let's go take a vacation. Even better idea. Let's take out a second mortgage on our home, something called a HELOC, and maybe we can buy a second property and see that one go up. And so that's what I call the wealth conjuring machine. Everyone was feeling rich. Right. And there are striking levels of household debt across the whole country. It's something that we've talked about on this podcast before with our business correspondent, Peter Armstrong. We encouraged, we dropped interest rates to encourage consumer spending. Is the concern that we created a second crisis to get us out of the first? That's right. And the thing to note here is that the global financial crisis,

you saw a lot of households in the world reduce their debt levels. That was sort of the great reckoning that happened in the US market in around 2009. Canada never deleveraged. Households here didn't really reduce their amount of debt. They kept on going. They kept on spending. And so now we are at the point where Canadian households owe more in terms of their income than any other G7 country. And so what does that mean? That means the average Canadian household today owes $1.76 for every dollar that they earn in income. In Vancouver, that spikes even higher. It goes to $2.30 of debt for every dollar of income. That ratio in Vancouver puts it on par with Iceland before

the global financial crisis. And if you remember, Iceland was the poster child of excess and its entire economy blew up. Yeah, this did not go very well for them. Lance Bankey is the second Icelandic bank to be taken over to prevent a collapse of the country's banking system. Foreign investors scrambled to withdraw cash. The country ran out of foreign currency. Soaring inflation, as well as a weak local currency, have all been disastrous. So essentially what you're saying here is we've had this market that's been soaring. It's been seen as very safe. Prices have been going up and up. At the same time, people across the country have been taking on record levels of debt

and now enter COVID-19, right? This pandemic and this massive economic shutdown, we've essentially put our entire economy into like an induced coma. And I want to play for you something the global chief economist for Manulife Investments, Francis Donald, had to say about this. Heading into the COVID-19 shock, there were a lot of things going right for the Canadian economy. And even as people would say, there's a bubble in housing market in Toronto and our economy is not diversified enough. We were capable of saying we have a lot of immigration,

which is propping up population growth and we have record low unemployment rates and wages are rising pretty quickly. And then COVID-19 arrives and it comes with this series of shocks that almost as if they were carefully crafted, pinpointed Canada's largest weaknesses. And so walk me through, Natalie, how this crisis has pinpointed Canada's largest weaknesses. That's right. So what the coronavirus has done is it's sort of, it's become the worst case scenario that none of us would have ever predicted. And what do I mean by that? In the run-up before these lockdowns started, everyone always said, okay, household debt is really high,

but the thing is, nothing's going to happen to the housing market if people still have their jobs, and if we still have immigration. Well, guess what? We suddenly have this unfathomable situation where one out of every three workers is applying for emergency income support. I think you would be naive to think that immigration is going to keep happening at the pace that it has been happening at. The government is likely going to be pulling back on the number of people let's into the country if Canadians themselves don't have jobs and just sort of it's become much more difficult to to travel and to move so you've got the two pillars of the housing market that have suddenly collapsed in a way that nobody would have foreseen and it also happens to be hitting the sector that has mushroomed to become the biggest part of Canada's

GDP. And so all of that is sort of this crisis that nobody could have imagined, but that really does sort of hit at all of those points in the Canadian economy. And the thing to consider here is, well, you know, everybody has pointed to how Canada emerged, was so resilient in the face of the global financial crisis. I think what we're seeing now is that that very resilience has now turned into a weakness because what pulled us out of the global financial crisis? It was consumer spending. It was consumers going on a shopping spree for two decades, and now they can't do that anymore. When we come out of this crisis, consumers do not have the ability to go on a spending spree the way they did in 2009. They simply have too much debt.

In the Dragon's Den, a simple pitch can lead to a life-changing connection. Watch new episodes of Dragon's Den free on CBC Gem. Brought to you in part by National Angel Capital Organization. Empowering Canada's entrepreneurs through angel investment and industry connections. Empowering Canada's entrepreneurs through angel investment and industry connections. I want to get a sense of how these shocks might be felt already on like an individual level by someone who, you know, like you mentioned earlier, was already carrying a lot of debt. You know, this story comes from a Toronto insolvency trustee, Scott Terrio, who gave our producer Imogen an example of the kinds of situations some people are finding themselves in now. And I'll just play this for you. So my florist who called me, and I was actually working with her before all this, and we had a nice plan in place, you know, that she was just about due for a refinance on her

house and her flower shop was doing really well. And then this happened a week after, on her house and her flower shop was doing really well. And then this happened a week after and she's toast. Like she said, I may already be done, but if it goes any longer, I'm really done because now she's not going to refinance her house because the bank's going to go, well, hold on a second, you're self-employed and you run a retail flower business. Like, whoa. Right. And so like those kinds of people are, are essentially looking at selling their homes because that's the only thing she's got is the $150,000 equity or something in her house. She's got a $700,000 mortgage. What are you going to do with that? And that was her nest egg was her house.

So now that nest egg is going to be gone because I don't see how else she gets any way out of this. Because now she's in rent arrears with her commercial landlord. So her debts, which were 100 grand, are now going to be 130 grand. So now doing a proposal on those debts is going to be more because the debt is more. So the creditors will expect more. Well, she can't handle that now, right, without any income. What do you think when you hear that? It strikes me

that it's pretty illustrative of what you were explaining before. Yeah, and I think what it brings home to me is that this is going to snowball. What's interesting about the real estate market is there's a lag. So right now we're in these lockdowns. It doesn't seem like suddenly people are selling their homes right left and center and now we have the first 17 days of april from the real estate board in toronto and basically 69 drop in the number of homes changing hands compared to the same period last year but what you're going to find is when we are pulling out of the lockdowns how long is it going to find is when we are pulling out of the lockdowns, how long is it going to take Canada to recover? And that's where it becomes really difficult. These people who are going to have to

sell their homes into a market where there's not going to be a lot of demand, anyone who's managed to sort of pull back from the brink, they are not going to want to start spending freely overnight. It's going to take time. And can you even imagine, say there's a bunch of foreclosures and those will take time to happen because the courts are closed right now. But even the banks, if they've got a bunch of people foreclosing, what do they do with these properties? And so why household debt is this thing that people look at so closely is because we've seen in the past that with recessions, if you have very high household debt levels, it makes recessions much deeper and much

longer to come out of because people don't have that extra cushion of resilience to be able to sit out a couple of slow months. And then when it's time to pull out, they don't have the money to spend anymore. If you take a look at the city of Vancouver, they're actually worried about the city becoming insolvent because an early survey already showed that people were saying, we're not going to be able to pay our property tax this year, much less our mortgages. Kennedy Stewart is the mayor. If even one in four homeowners do end up defaulting on their property taxes, that would mean an additional loss of $325 million in revenues.

We simply don't have the reserves to deal with a half a billion dollar shortfall. And this is what keeps me up at night. So the longer this goes on for, the more difficult it's going to be for the economy as a whole to recover. You know, I don't want this to sound callous, but there are a lot of people who have not been able to even dream of buying a home in the cities for some time now because of how expensive homes have become. So might there be some sort of silver lining here if these bubbles were to burst? Yes, this could be that reckoning that happens in the Toronto market and Vancouver market that bring down house prices, but at what cost? And I think there, what people have to realize is that if home prices correct that steeply, that means it's going to be a very dark economy. It's going to be because

businesses are shutting down because people are losing their jobs. So it's not going to be the situation where the young people who weren't able to get into the housing market suddenly find this very affordable house and they've managed to keep their jobs through the whole experience. And so if you don't have a job, how does a 40% correction in the house price make it any more affordable to you, right? It's a bit of Canada's housing sector has gotten too big to fail. That kind of a correction is going to mean a very, very painful downturn for everybody, not just homeowners. And then do you think we're going to see instead measures put in place by

governments or by banks in an effort to try and prevent this? That's precisely it. So to your point, whereas a lot of people would love to see housing become more affordable, the reality is that the government and the banks are stepping in in a way that they never have before to support the housing market because they realize what a bust could mean, how painful it would be. So you've seen the government coming in and basically trying to stimulate, trying to support the mortgage market. You've seen the banks coming in and offering these deferrals, sometimes on multiple properties. And it's not entirely palatable because why should somebody who's invested in four properties be getting financial

assistance? And yet it's all sort of intertwined. And if you let that housing market collapse, the entire economy collapses. One question I have for you, we talked about how people have been calling these markets, in particular, a bubble for years. We're not actually seeing the prices drop at the moment. What we're hearing from real estate boards, or even now StatsCan piling on, is that yes, listings are falling, and they're falling precipitously. But so far, at least, prices are holding up pretty well. But late last week, one of the biggest risk advisory firms, Moody's,

warned that Canadian real estate prices could drop as much as 30%. But also, I will note that there isn't consensus, right? Like TD Bank, for example, says the average Canadian home price is going to be 6% higher at the end of the year. And, you know, one question I do have for you is, is it possible that these markets will just be okay? Because, you know, everyone has been saying this for years. I think it's very difficult to predict what happens. But the only thing I'll point to is, maybe Toronto and Vancouver will emerge from this unscathed, but that doesn't

change the fact the underlying fundamentals are not healthy. Does that mean that you're just sort of kicking the can down a little bit further? Because there is no way that homes, you know, carry more than two times their income in debt can continue on that way. And I think in either case, you've got to assume that the kind of acceleration in home prices that we've seen in the past are over, that they're not going to just come racing out of this and climbing higher the way they did. Okay. Natalie Obiko-Pearson, thank you so much. Thank you. Okay, Natalie Obiko-Pearson, thank you so much. Thank you.

We'll leave the last word today to Frances Donald. There may indeed be a structural shock to this concept of housing as an investment, and particularly one as a stable investment. When I was growing up, my father always told me, buy a house you can't afford because it always goes up in price and so too does your income. But since 2008 and now with COVID in play, we've learned that that's simply not true. Maybe home prices don't just shoot up in a straight line after all. That's a difficult lesson. It can be a once in a generation type of lesson. The U.S. learned that lesson in 2008, but Canada did not.

This may be the moment where Canada has to recognize that the way we thought the world operated, with straight lines higher on all the things that we buy, just really isn't sustainable over the long run. So before we go today, an update on what's happening in Quebec. Last week, we told you about the province's plans to start opening back up some schools, construction and retail. Well, yesterday, Premier Francois Legault had to partially push that back. Retail business in the greater Montreal area will now remain closed until the week of May 18th. That's a week later than originally planned. He said that the crowding in Montreal hospitals

prompted the change of heart. That's all for today. Thanks so much for listening to FrontBurner, and we'll talk to you soon.