The Canadian Housing Bubble

And How To Fix It At One Fell Swoop

“If it happened once — perhaps it’s a random event, if it happened twice — perhaps it’s a coincidence, if it happened three times — it’s a pattern” — Ian Fleming

At my recent meeting with one of the largest Canadian Real Estate Investment Trusts (REIT) — the initial topic of a conversation quickly changed. What started as a discussion about the anticipated impact on real estate prices caused by Nanogrids and Microgrids linked to Campus, Institutional, Military, Commercial & Industrial distributed energy generation — swiftly shifted toward the Canadian housing bubble. Not a big surprise.

BACKGROUND

For more than 10 years, year after year, month after month, housing sales have been rising — especially in Vancouver and Toronto. Both cities contributed to the rise of sales activities by 18.7 percent on a year-over-year basis in February 2016, standing 12.7 percent above the 10-year average for the month. Year-over-year price growth in Greater Vancouver has reached +22.18 percent followed by Greater Toronto’s +11.30 percent.

To make things worst, clear evidence has emerged about unprecedented growth of foreign ownership of real estate in Vancouver and Toronto — especially from China. Alarm bells went off with the latest reports that Chinese investors bought $28.6-billion (U.S.) of real estate in the U.S. housing market between March 2014 and March 2015. In Vancouver and Toronto alone, Chinese investors have spent $19.7 billion (U.S.)

The anecdotal evidence of the bidding wars and the final sales closing at 30% to 40% over asking — are way too common. In addition, one also hears about the Sales Offices of new condos in Vancouver and Toronto being staffed by Chinese sales people — who barely speak English and cater almost exclusively toward the Chinese buyers.

PROBLEM

• On one hand, sky-rocketing real estate prices are heavily impacting Canadians, especially first-time buyers and families with young children — who can’t afford suitable housing
• On the other hand, since most of the mortgages in Canada are underwritten by Canadian banks, the overexposure to overvalued housing is a major concern to the banking industry — in case of rising interest rates and possible foreclosures

In light of the above, a hodgepodge of provincial, municipal and even local solutions to the foreign ownership problem are being considered — raising racial tensions and xenophobia. My concern was that without the root-cause solution to foreign ownership — we all risk pitting province against province, city against city and neighbourhood against neighbourhood.

SOLUTION

As a natural problem solver, I see things others miss and seek patterns others don’t. In turn, it makes me reach conclusions and set the goals and priorities that lead to accomplishing such goals. After dealing with data mining/pattern recognition in technology, finance and renewable energy for over 30 years — I started to look for a PATTERN.

I asked myself: Canada is not the only safe-haven for foreign capital, so what makes our housing market globally attractive to Chinese investors and/or Russian oligarchs?

My search brought me to the December 2014 document prepared by DBRS: “Home Price Indices: A Fifty City Comparison — The Best and Worst Housing Markets Over The Past Decade”

The study reviewed 50 major housing markets across Australia, Canada, UK and US over the past decade. The most STRIKING finding, however, was the fact the first US city, Portland, was ranked as the 21st best performer. The highest CAGR spots were all taken by Canadian, Australian and UK cities.

Since, “if it happens three times — it must be a pattern”, I wanted to further investigate what is so unique about the housing bubble in Canada, Australia and UK? Lo and behold, it became clear to me, that in all three countries, the real estate market is TAXED the same way:

• Mortgage payments are NOT TAX DEDUCTABLE
• Capital gains on a prime residence are NOT TAXED

The taxation in US is exactly the opposite: mortgage payments are tax deductible and when you sell your home, you will pay taxes on capital gains.

The mystery behind the foreign investments has been solved! If you are a foreign investor, you are not paying any taxes in Canada already, so the lack of mortgage payments deductibility is not an issue. Moreover, in many cases, the foreign investors pay cash — and there is no mortgage to begin with. So your biggest benefit relates to not paying taxes on capital gains — and you are in love with the housing bubble.

But wait, the biggest losers are the Canadian tax payers, whose housing affordability is further reduced. The mortgages get bigger and so are the monthly payments. Without the mortgage deductibility — it becomes even more difficult to service the loans. In addition, if Canadian government is not taxing foreign capital gains, it foregoes significant revenues attributed to housing prices appreciation — with, or without the foreign buyers.

The Bottom Line: In order to reduce the appeal of Canadian real estate markets to foreign investors — the housing taxation needs to be changed. The desired framework is well understood and it is much closer to the real estate taxation in US — than it is to the taxation policies in Australia, or UK.

The Canadian real estate bubble can be burst. Without the market distortion and with greater housing affordability — the sound economic principles will return. Better yet, a lot of Canadian families may welcome the change and find a reasonably priced home in cities they love….

Structural changes to Canadian Tax code make a lot of sense. Yet, let’s not forget that there are additional, tried, tested and true tools — available to Federal Government. One such tool has been used for over 40 years — The Foreign Investment Net Benefit Test.

In many cases, foreign investment can be highly beneficial for the Canadian economy. But when massive real estate purchases by wealthy foreign investors cause out-of-control housing bubbles — it is not!

Foreign investments in Canada are already subject to approval by the federal government, which reviews such within a regulatory framework. Essentially, any foreign investment will be approved by the Government of Canada — only if it’s likely to be of net benefit to Canada.

So why are we allowing foreign real estate purchases in Canada, indiscriminately? Since economic activities related to real estate markets are such a large part of Canadian GDP — wouldn’t it be prudent to consider NET BENEFIT of foreign purchases, every year? Year after year?

In practical terms, when housing market is overheated — disallow foreign real estate purchases all together! When the economy gets sluggish, open the taps wide open. Most importantly, be proactive, and offer Canadians protection from foreign speculators — because you can!

BTW, foreign investment in natural resources companies are often de facto treated differently than investments in other types of businesses in reviews of proposed foreign investment. Adding real estate review provisions — could be next.

In many of my posts, I’ve been talking about BrightSpots. It’s not complicated. When you see something that works well in one area, replicate and reuse in other areas, too! Foreign Investments Act is such a BrightSpot — that served Canadians well for the last 40 years. Replicate!

In Summary:

I forwarded a copy of my blog to Prime Minister’s Office. Since then, my email was forwarded to, and reviewed by CMHC — and then forwarded once more to the Minister of Finance. I was hoping to hear back even a single question enquiring about my strategic recommendations. Instead, I was told that the biggest problem is the lack of data on foreign ownership …..so let’s spend another $3MM, or so, to study the subject! Right?

In general, I watch various housing bubble TV segments such as: Grappling with the High Cost of Housing with….great sadness. All the pessimism around the table and all the gests resigning and capitulating to the so called … MARKET FORCES — is hard to watch.

As if MARKET FORCES are downing upon us with some inter-galactic vengeance? Please, as if markets have not been manipulated enough already? Have we forgotten the financial crush of 2007?

IMHO, any “house-flipping” taxes as well as “special taxes” imposed on a high-end property will probably help — until market manipulators find another way to do it. Instead of such “new” programs, that will be costly and difficult to administer — a much simpler and broader change to mortgage taxation will also help reaching the “tipping point” — sooner. Why not present a UNIVERSAL solution working for both: Canadians AND Foreigners?

In summary, my proposal ensures:

1) Reducing Speculation Attractiveness

• As there will be no more capital gain exemption at the time of sale

2) Increasing Home Ownership Affordability

• By deducting mortgage payments from a taxable income of hard-working Canadians

3) Restoring Supply & Demand Economics

• To an overheated real-estate market driven by greed and opportunism of foreign buyers

4) Additional Tax Revenues

• That will be shared more equitable with the government — in case of unusual home value appreciation

Instead of piece-meal approach involving different provinces & cities — it’s time to take Real Estate capital gains advantage AWAY from foreign speculators & money launderers. Bring federal tax reforms to help young Canadian families with mortgage deductibility reforms.

After all, foreign money launderers and real estate speculators will do all they can to create housing bubbles and cash out. Tax real estate capital gains FOR ALL and make it less attractive to money launderers and foreign speculators.

KGB-like lists of foreigners will not help fighting housing bubbles, nor money laundering. Make Canada’s Real Estate market less attractive to criminals and more attractive to young Canadian families through mortgage deductibility & capital gains, instead.

Yes, AI can help make RCMP and FinTRACK investigations into foreign real estate speculations and money laundering more productive. But don’t think for a moment that we DON’T NEED any more human investigators — leaving the fight against such crimes to a bunch of … shiny robots.

Fighting foreign real estate speculators and money laundering is not easy. I know it, as I was sent years ago by the World Bank in Washington to help Central Bank of Estonia — to fight Russian money laundering. The biggest AI problem in this case … was lack of reliable and unconvoluted data.

Remember: we need more investigators, not less — to succeed fighting organized crime behind housing bubbles and money laundering. Leaving it to AI is not going to work for a long time. Until it does — bring tax code modifications to make such crimes less appealing …

As long as STRUCTURAL problems (below) are not properly addressed — we are not going to solve the root causes. And if our politicians think that KGB-style “Foreigners List” is going to solve all the problem — God help us all.

We might as well join hands and start singing Kumbaya, or “The Prayer” by Armenian poet-laureate/songwriter — Bulat Okudzhawa. Below, I give you my loose translation of “The Prayer” …

As long, as the earth keeps turning,
As long, as the sun shines above,
Almighty, please, give to us all,
Happiness, health and love

Grant long life to the wise man,
The coward, give him a horse,
Make this world a better place,
And don’t forget truly yours.

Oleg Feldgajer is President & CEO of Canada Green ESCO Inc. Oleg is positioning the company to become a leader in financing AI enhanced green energy projects and ventures. CGE’s mission is to guide DISRUPTIVE businesses in ENERGY & TRANSPORTATION toward profitable business models. Oleg is passionate about such mission, and firmly believes that without AI based innovation, we will all prematurely choke on polluted air and dirty water. CGE delivers 100% financing (levered and unlevered) to its clients — and utilizes large equity pools, and non-recourse debt. Oleg offers creative, fresh ideas to open-minded businesses — that embrace both: logic AND opportunistic intuition. CGE stands against mediocrity & its modus operandi is quite simple: If CGE is not invited to join your BOD, or Advisory Board — we failed!