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The Globe and Mail

Merrill: 'Classic bubble' signs in Canadian housing market

Tim Fraser/tim fraser The Globe and Mail

Canada's housing market shows the "classic signs of over valuation, speculation and over supply," but Bank of America Merrill Lynch says that's no reason to think that there will be an epic crash of American proportions.

In a report issued Monday, the bank's Canadian analysts said record Canadian household debt and increased joblessness are cause for concern over the next year. There will likely be fewer sales, and prices could slip as much as 5 per cent in the next year.

"Canadian home prices set new highs in 2011 and are now showing many of the signs of a classic bubble," they wrote. "We estimate the housing market nationwide is about 10 per cent over valued. Even so, the only way these valuations can be explained is by the record low mortgage rates. Under more normalized interest rates, home prices would actually look 25 per cent overvalued based on current prices."

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Best case scenario

"We expect housing investment to contract about 5 per cent in the first half of 2012 as the economy flirts with recession, and housing starts to trend down to more normal levels by the end of 2012. While single-family home construction has already landed softly below its long-run average, the condo market has surged back to previous highs. We expect most of the weakness in housing construction to come from a pull back in the multi-unit segment, with the risks of a harder landing very elevated. Home prices will likely contract slightly in the first half of 2012 as housing demand slows on tougher jobs and income growth environment, but end the year flat as economic activity accelerates in the back half of the year."

Worst case scenario

"Under the more adverse scenario outlined in our economics year ahead, the Canadian housing market would likely experience a hard landing as it is highly leveraged to jobs and income growth. Moreover, the household balance sheet is stretched and highly susceptible to adverse shocks. A spike in the unemployment rate would certainly lead to a pull-back in credit demand and leave the multi-unit market significantly over supplied. This market would also likely result in a rise in delinquencies and forced selling, which would see homes prices decline by around 10 per cent."

Condo crisis?

"What drives the housing cycle up, inevitably drives the market down as well. Builders in the multi-unit segment are currently responding to elevated home prices and robust pre-construction sales. Anecdotal evidence suggests the vast majority of pre-construction sales are to investors who intend to sell the units on completion or rent them out. As these condos in the construction pipeline are completed, this inventory of units will be dumped on to the rental and/or re-sale market just as sales momentum and housing demand ebbs. Our estimates indicate there will not be enough renters in Toronto to occupy these units as they are completed. As a result, some investors will be left holding vacant units. Since most investors are unlikely to hold onto negative-carry investments without a reasonable prospect of price appreciation; this will put downward pressure on home prices. We have already seen this dynamic play out in some smaller markets on Canada's west coast where prices have corrected 15 per cent."

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