When prices drop 20% or more overnight, it should be concerning.
They passed a law in Ontario, taxing foreign investors on properties and taking other actions to limit folks from speculating on real estate. Almost overnight, property values dropped by 20% or more, according to some articles. Others claim it is a temporary drop, and that the expanding market, driven by the economy and jobs, will bring prices back. Both sides are right and wrong.
Someone who just paid $900,000 for a house in suburban Toronto, which is now worth $700,000 (but still mortgaged for over $800,000) is finding themselves suddenly "upside-down" on their house. They are likely shitting their pants. Worse yet, their friends, who were thinking of buying a house see this happening and think, "Um, this may not be such a great deal - suppose prices go lower?"
Worse yet, suppose the upside-down guy loses his job and can't make the payments? Or suppose he was one of those speculative investors who paid $900,000 for a $700,000 house? He has little to lose in walking away from the investment. The net result is a foreclosure sale, and the bank (and presumably the government guaranteeing loans) taking a hit, which in turn could turn into a snowball effect we saw in sub-prime lending here in the States. Banks will become more reluctant to lend, which in turn makes it harder to sell, which in turn drives down prices, and a death spiral ensues.
The second half of the argument that favors naysayers is how quickly this new law brought down prices - this seems to validate that much of the market was driven by speculation - foreign speculation at that. Part of the new law is aimed at taxing "empty houses" which tells you where this is coming from. Prices are not being driven up organically by working people looking for a place to hang their hat in the evening, but people looking to make a quick kill in a rising market. If there were few investors and speculators in the market, prices would not have been affected as much. This new law ended up illustrating how many of the buyers in the Toronto market were not interested in living in the homes they bought. And those are just the foreign buyers, too.
On the other hand, others argue that the boom in real estate prices in Toronto and Vancouver are driven organically by rising wages in a rising economy. People can afford to spend a million or more on a house, so they do. And if you look at housing prices in many major American cities, they seem to be tracking what is going on in Toronto. The land that my house in Virginia sat on, now has two houses on it, selling for a million apiece. My friends, who all paid $150,000 to $250,000 for their modest tract homes in suburban developments near the Beltway, are all sitting on $600,000 to $800,000 homes, which unfortunately, they have re-mortgaged several times. I literally could not afford to go back and live in Virginia at this point - even though I own a condo there (whose monthly cost is more than my house on a resort island!).
So long as there are jobs and people make the money to afford the mortgage payments, such homes are "affordable" although they take a substantial portion of a paycheck to afford. And of course, one thing driving affordability is staggeringly low interest rates. When mortgages dropped below 4% in America, well, it made houses incredibly affordable - at a time when no one had any money. Today, rates are higher and of course prices are higher, as demand has risen. But interest rates keep creeping up, and this is not good news for real estate prices.
Even a rise of a percentage point or two can make a house change in value dramatically. For example, for every $100,000 you borrow at 4%, you pay $477 a month in mortgage payments. If rates rise to 5%, you pay $537 a month - a 12% increase in monthly cost. And due to the non-linear way interest works, each subsequent increase will raise costs even more dramatically. People buy based on what monthly payment they can afford - or at least working people do. Speculators spend cash, but they buy based on what they think an ultimate customer is willing to pay.
It will be interesting to see how this works out. In general, rapid increases in real estate prices are usually followed by at best, a flat market, if not a decline or outright free-fall. When no one can afford to buy a house and the only people buying are speculators, well, watch out. The game will be over, and over soon.
As I noted in another posting, acting like an extreme market (with 30% price increases annually) is a "norm" is one way to set yourself up for a fall. And yet Americans (and apparently Canadians as well) believe that a high-growth economy should be a normal thing, and incredible periods of growth should be infinitely sustainable - despite the fact that our history shows that fast growth has always - always - been followed by a period of retraction.
Whether the Toronto market will recover from this setback from the new anti-foreign investment law remains to be seen. The poor schmuck who bought a condo on spec a few months ago (and is now upside-down to the tune of $100,000 or more) is probably not sleeping well at night, that is one thing for sure.
