Real Estate Market Due for a Correction?

There is a lot of speculation and fear about the bubble in the marketplace. While bubble concerns are visible in some marketplaces in the US and perhaps Vancouver, is there a cause for concern for the rest of Canada?

The Normal Market

Similar to the stock market, real estate market also has a cycle. First, there is the annual cycle of certain months being slower months than others – winter is slow time, summer is usually more active time for buyers and sellers. Second, demand & supply, interest rates will cause occasional adjustments in the marketplace.

It is important to note that a “Bubble” is not part of the normal market cycle. It is an artificial rise in demand – which is unjustified by fundamentals usually fueled by speculation, misinformation and greed.

What is a Bubble?

In the dot com era, technology stocks were trading at extremely high price-earning ratios, which were not supported by market fundamentals – that is, the stock valuation had a weak correlation to the profitability of the company; rather it was based on expectation (speculation). People expected dot com companies to be the waive of the future and were willing to finance it, these companies had no real income or collateral to back up the equity loans they were taking out. While some dot com companies made it big, like Amazon and Google, the vast majority failed. The technology bubble burst due to one simple reason, all of these companies came out at the same time causing an excess of supply with no corresponding rise in demand for the products it offered. Buying and trading was being done almost solely on dreams of future cash. That is the basis of almost all, if not all, “bubbles”.

What about Real Estate Bubble?

In contrast, real estate is a basic need – everyone needs a place to stay. It has a finite supply – land is scarce since no one is making anymore of it. In addition, artificial barriers introduced by government (greenbelt, conservation land, farm land) cause land to be even more scarce and push the demand up for other available land for development purposes.

Population is on the rise largely due to immigration, demand is boosted for real estate around business hubs (like Toronto, Vancouver, Edmonton, Montreal). Since land is more expensive in these areas, developers will likely address the higher density issue by building up (high rise condos) in these areas. And since the vast majority of people prefer a single family home and builder’s are expected to build less of it in these areas, these types of homes will also see a rise in price.

To sum up so far, a bubble is fueled by artificial demand unjustified by fundamentals (normal supply and demand) – people begin to buy and sell based purely on speculation with no current market justifications for the higher demand. Real estate has a consistent rising demand and a limited supply which is unexpected to change anytime soon.

It’s all up for Real Estate?

Does this mean that the housing prices will not fall, absolutely not. As part of normal real estate cycle, prices will occasionally adjust to reflect the current supply and demand situation of the market.

Let’s first look at the crash of the 90’s to see if similar fundamentals are visible in today’s market place.

Crash of the 90’s

Over 30% of the people buying in the Toronto area in the 90’s were investors, with consistently rising interest rates, these investors could no longer afford the financing costs which caused them to either sell or be foreclosed on by the banks, which caused an excess supply of properties (especially condos) in the marketplace; the excess supply caused the prices to fall. The falling in prices caused investors who had crystallized their losses recently to stay away from the market place (further lowering demand). And end buyers noticed the falling trend and decided to wait a little longer hoping that the property values would drop further and properties could be picked up for a bargain. This waiting game lasted years.

Last year, only 19% of the condos in Toronto were rental units (according to CMHC’s Housing Market Outlook from the second half of 2005) and vacancy rates are dropping. This is because more people are buying for themselves and not on speculation. So even if the rental markets slowed and vacancy rates started to rise, the real estate market is not likely to be flooded like they were in the early 90’s.


A major factor that caused the adjustment in the early 90’s was the interest rates. In May of 1990 the interest rates were a whopping 14.21% (according it CMHC), making mortgage payments $11.89 for every thousand dollars of your mortgage. This would make a $400,000 mortgage cost $4,755.97 per month. You can currently get a 5-year mortgage at a rate of about 5.25% or $5.96 per thousand dollars on your mortgage. This means that a $400,000 mortgage today will cost you $2,383.67 per month. That means that the effective cost of owning a house is half the amount that you would pay back in 1990 and yet the average price is only 5%-10% higher now than it was in 1989.


The adjustment in the early 1990s was a response to too many speculators and excessively high interest rates. In the late 90s and until now there has been another adjustment to account for the housing markets being under valued in the 90s and consumer attitudes changing to acknowledge that homes were affordable again. Now as prices are starting to reach a level where affordable houses are affordable, we are likely to see prices moderate with slower increases in price and the occasional peaks and valleys that represent a normal market.

Real Estate Market: Mistake Avoidance

When the consequence of your decision has little to no downside, you have eliminated a large majority of the risk. Elimination of risk (or prudent management of it) is much of what financial life is about. Understanding the risk factors that exist in any marketplace, real estate, stock market, small business, etc., should always be the goal as decisions made with full knowledge of the associated risk means better decisions.

The financial world changed in 2007. From the early 2000’s to the market crash of 2007, much of what would now be considered risky behavior was hidden by the rapid increase in values. Making a good decision was replaced by making ANY decision. Poor decisions were in effect negated by the fact that owning property meant appreciation. With values moving 7-10% in any one year, owning a highly leveraged property meant increasing your equity position by a factor much greater. A property valued at $300,000 purchased with 10% down ($30,000) increasing 10% to $330,000 in a calendar year meant that the equity position had increased by 100%. It was powerful math and led buyers to increasing bold and risky decisions.

When the market began to reverse course in 2008 and really begin to free-fall for the next 12-18 months, the true risk profile of each individual deal became horribly exposed to all. Properties that had equity positions of 30-40% (which was considered ridiculously conservative during the last days of the bubble) all of a sudden found themselves with little to no (or even NEGATIVE) equity. When the mortgage industry froze in place, effectively destroying the ability to monetize real estate, the ability to use property as collateral for cash disappeared and robbing Peter to pay Paul disappeared with it. This exposed the all-important risk factor that appreciation hides, cash flow.

Mistake avoidance, in its simplest form, means understanding the worst-case scenario. For many, the use of debt is the primary vehicle by which property is acquired. Understanding the true risk, not just of the loan, but what the underlying acquisition of the asset means to an owner’s entire portfolio, is the most important element of risk management. It went ignored by most up until 2008. For now, with the lessons of 2008-2012 still fresh in all of our minds, the market has begun to show a collective caution about how and what they acquire. The unchecked optimism that defined the marketplace pre-bubble is largely gone and it has been replaced by a feeling that the world is subject to change and that appreciation is not guaranteed. Cash flows are underwritten more strictly than before and far more attention is paid to a buyer’s equity contribution to any purchase.

It is a better way to underwrite.

For the next several years the market will fight to get back to normal where supply and demand is balanced and more generally accepted consensus of where the market is headed is recognized by all. We are at the beginning of a cycle that tends to last roughly 20 years (if 1987-1990 is any indication) and each cycle begins with the idea that we will learn from the past. We will see how long it lasts.

Insights From an Investor of Real Estate

I entered the real estate marketplace when residential real estate was financed thoughtlessly by lenders of many forms. Funds were flowing directly into the market rapidly from not merely banks and mortgage brokers but private investors, as well. This condition was fantastic for me due to the fact it permitted for two essential factors of residential real estate investing to take place.

Initially, I had been in a position to immediately sell to purchasers with financing properties which I had bought at a discount. This became crucial due to the fact I had received my original investment plus profit inside a brief time period. This permitted me to purchase far more houses using the proceeds obtained. Possessing a supply of purchasers with financing is definitely the essential component to making money in real estate. In 2008, the real estate marketplace changed—I will clarify later.

Additionally, there was the advantage of capital with relaxed terms. This capital wouldn’t have been accessible without the pressing desire of lenders eager to lend. Along with this the actual rates of interest for borrowing funds was low. The funding I had use of didn’t require individual guarantees. The assets bought using the loans had been all the security necessary by lenders. Once more, this was only achievable due to the significant quantity of buyers with financing within the market ready to buy households for private residence or perhaps investment.

Previously when I stated 2008 brought a massive transformation to the residential real estate sector, I meant several dramatic events occurred. The credit markets had started to stagnate. The buyers started to fall out of the marketplace; not merely did first-time potential home buyers give up; but the private capital left the marketplace, also. Investors of real estate had been left with a single strategy to sell properties. That strategy ended up being to owner finance buyers not able to acquire financing from the banks. Just about every investor in the course of that period can attest towards the fact that there had been plenty of buyers in need of financing; however with that demand, numerous pitfalls for seasoned and non-seasoned investors began to emerge.

An additional tool for me as well as for other investors within the industry that had been saddled with considerable residential real estate portfolios was to owner financing. Owner financing was the only real option to prevent investors from being foreclosed on or possessing a property which was not producing income to pay the monthly loan payment. For many investors, this was supposed to become a short-term tactic. The majority of residential investors weren’t preparing for a long-term approach to real estate investing. Most new investors believed the real estate boom would last forever. Investors interested in owner financing started taking 5% to 20% down payments for their houses which permitted household purchasers wanting to purchase a residence the opportunity. For many investors, that 5% to 20% down payment bought an additional three months to remain afloat while they hoped for a miracle.

Having received the down payment the investor would carry a short-term loan for one to three years hoping the home buyer would be in a position to obtain a bank loan which would permit the investor to pay their loan off. Well, quite a few of those house buyers couldn’t acquire loans and many of these individuals lost jobs which prevented them from paying the monthly payments to the investor. Some investors, in financing house buyers, produced mortgage notes with monthly payments much less than what their actual monthly loan payment was to the bank to prevent having to pay the whole monthly payment out of their pockets. So, you discovered a great deal of investors who had no income coming in from real estate and who couldn’t locate jobs; consequently, those investors stopped paying their mortgage payments to the banks as a way to have income to live on.

Soon, after six to nine months, the banks foreclosed on the investor’s properties; nevertheless, there was a significant issue, the investor had sold the house by way of owner finance to a family. Well, those families discovered themselves in the street soon after the foreclosure. Other investors attempted to rent the homes which became a different nightmare. A great deal of investors had been wiped out and many others left the real estate sector. A few of my partners and associates began producing videos on real estate investing, and a couple of them earned far more income in that then they ever did investing in real estate.

Adversity strengthens:

I was not able to avoid the crisis; but I had been in a position to accomplish two things. First, I had been in a position to sell my assets that had been rehabbed or not part of my general investment approach. Next, I was able to balance my activities around other elements in the real estate industry. In 2011, I launched into consulting and land development. I continued to buy houses in San Antonio when the opportunities matched my strategy; but I didn’t have all of my activities in one basket. I believe one of the most essential lessons learned in the course of that period was adaptability. You will find excellent possibilities within the industry; however, the opportunities are no longer focused on a single niche. Surviving in this new environment, an investor will need to have an understanding of all facets of real estate investing.