Why I’m not shorting Canadian real estate

• Comparing Canadian real estate to the US, Canadian underwriting is tighter.  Compared to the peak of the US subprime bubble, Canadian underwriting is far more conservative.
• Comparing real estate to oil&gas and mining, there is far less fraud in real estate.
• Based on price per square foot… the most overpriced market is China, then Australia, then Canada, and then the US.

I do think that Canadian real estate is expensive and should be priced a little lower.  New supply will come online and eventually shift the market from boom to bust.  However, I don’t think that housing related stocks will get into that much trouble.

Underwriting

Characteristics of Canadian lending:

1. Higher downpayments.
2. Recourse mortgages.  In the US, a few States are recourse.  In practice, recourse may not matter.  US lenders rarely pursue the borrower because it is normally difficult for the lender to locate assets that they can go after.  Despite being a recourse state, Florida was one of the most extreme markets during the subprime housing bubble.
3. I believe interest-only mortgages are less prevalent in Canada than in the US.  They are not mainstream in either country.  Thankfully negative amortization mortgages are gone.
4. To some degree, Canadian regulators prevent financial companies from doing really stupid things.  During the subprime bubble, Canadian lending was far less risky and the lenders were far better capitalized.
5. Canadian mortgages must be renewed every several years.  This effectively makes the mortgage similar to a variable-rate mortgage, shifting interest rate risk from the lender onto the borrower.  Prepayment penalties in Canada also shift some risk onto the borrower.
6. Slightly shorter amortization periods than the US (25 years versus 30).
7. Riskier mortgages with lower downpayments are insured by the Canadian government via the CMHC or by private insurers backed up by the Canadian government (at a 90% rate versus 100%).  This makes mortgages far less risky for private lenders.  The private insurer Genworth Canada (MIC.TO) may effectively be making the riskiest loans in Canada.

Fraud

At the peak of the US subprime housing bubble, many applicants lied about their incomes.  Some brokers fabricated documents to fraudulently inflate borrowers’ incomes.  I believe that extensive fraud does not occur today.

In Canada, the CMHC uses its automated valuation model called EMILI to determine home values.  It does not use broker price opinions or full appraisals.  One way to game the EMILI system is to inflate the square footage of a property.  For example, a condominium might include a proportionate share of the square footage of common areas and amenities (e.g. the roof).

Other ways to game the mortgage system:

1. Borrowers are not supposed to use borrowed money towards their downpayment.  This is because borrowers who use their own savings as a downpayment are lower credit risks.  There are various ways around this (e.g. taking a gift and lying about where the money came from, borrowing money from a bank, etc. etc.).
2. Individuals who borrow money to finance investment properties are more likely to strategically default on their mortgage.  Normally mortgage insurers discriminate against investors with higher rates.  However, investors can lie and say that they intend on living in the property to obtain lower rates on a mortgage.

Overall, the fraud in Canada seems tame compared to the peak of the US subprime bubble.

Other industries in Canada have far more fraud

Smallcap mining and oil & gas companies have extensive fraud when it comes to reserves.  As well, there are many overpaid management teams that pay for questionable stock promotion, are the part-time CEOs of several companies at the same time, live lavish lifestyles with shareholder money, overpay themselves, etc. etc.  I would characterize many of these companies as scams attached to real businesses.  I do not see these excesses in real estate.  Going forward, I think that the TSX Venture will perform worse than real estate stocks.

A less important consideration is the number of stocks in Canada engaged in risky real estate.  If I were to spend the time to understand Canadian mortgage insurance, the only stock I could short is Genworth Canada (MIC.TO).  I am not aware of a good way to short Canadian real estate via the CMHC or Canada Guaranty.  Similarly, there aren’t many pure play lenders in Canada engaged in risky real estate lending.  The time investment is not worth it.

*Disclosure:  No position in MIC.TO or HCG.TO.