Page 8 of 16 Focus December 4, 2015

Feature

Vancouver and Toronto Housing Markets: Too Hot to Handle? Sal Guatieri, Senior Economist sal.guatieri@bmo.com 416-359-5295

Vancouvers housing market hit the mesosphere in November, with sales rocketing 40% y/y and benchmark prices soaring 18%. While Torontos figures (sales up 14% and prices 10%) suggest its market is merely in the stratosphere, double-digit price gains were clearly not what policy makers had in mind when they tightened lending rules a few years back. Even as tougher mortgage rulesand, more recently, plunging oil priceshave cooled markets in much of the nation, Vancouver and Toronto continue to heat up (Chart 1). But, like a good steak, their sizzle comes at a cost.

That prices are rising isnt surprising given the limited supply of land for new detached homes in these cities. But what is amazing is the relentless strength in demand in the face of escalating prices, driven by several forces (Chart 2). The Bank of Canadas two rate reductions and falling global bond yields have reduced mortgage rates about 30 basis points in the past year. This effectively lowered mortgage service costs by just over 1% of income, thereby accommodating a 3% price gain. In addition, millennials continue to drive household formation. The leading edge of this sizeable generation is now purchasing their first home, and starting careers in two cities that are serving up jobs faster than the rest of the nation (Chart 3). Laid-off oil-industry workers are also on the hunt for new jobs. Meantime, thousands of newcomers to the country continue to stream into well-established immigrant communities in both cities.

Still, strong demand likely doesnt explain why prices have become more detached from incomes (or even reality). Median family incomes rose just over 2% per annum (on average) in each city between 2010 and 2013 (the last year of available data), though it likely picked up recently given sturdy job growth. Consequently, benchmark prices now tower more than 9 times above annual income in Vancouver and 7 times above in Toronto, up more than 2 points in the past decade (Chart 4).1 The extra juice for prices likely stems from wealth: both domestically, as more parents gift down payments to their children, and from abroad.

While the CMHC is busy tallying the actual amount of foreign wealth entering these markets, we now have a better idea of the impact on at least some segments of Vancouvers market. A recent study by a University of British Columbia professor found that up to 1 For comparison, Demographias survey shows many cities in California with

ratios at 7 or higher, including Los Angeles (8.0), San Diego (8.3), and San Francisco (9.2), though most large U.S. cities are well below 7. http://www.demographia.com/dhi.pdf

-4.3

-1.4

-1.1

0.5

1.4

3.8

10.3

17.8

-10 -5 0 5 10 15 20

Regina

Saskatoon

Calgary

Ottawa

Montreal

Moncton

Toronto

Vancouver

Existing Home Prices

Two-Horse RaceChart 1

HPI composite benchmark November 2015

(y/y % chng : n.s.a. : as of October 2015)

0

1

2

3

4

5

6

4

5

6

7

8

9

10

05 07 09 11 13 15

Existing Home Sales

Sailing Sales(000s of units : monthly)

Chart 2

Toronto(lhs)

Vancouver(rhs)

Canada

Toronto

Vancouver

-2

0

2

4

6

13 14 15

Employment Growth

Wanted, Apply Within(3-mnth m.a. : y/y % chng)

Chart 3

Page 9 of 16 Focus December 4, 2015

Feature

two-thirds of detached home sales in several affluent neighbourhoods were by buyers from mainland China. Similarly, MacDonald Realty claims that 70% of luxury detached home sales in 2014 were by buyers from China. Sothebys reports that 40% of property sales worth over $1 million in the first half of 2013 were by international buyers (and 25% in Toronto). These figures, though not representative of the entire Vancouver market, suggest that external wealth could be a crucial driver of prices in some neighbourhoods, which, in turn, drives up prices in other areas. Most foreign money is likely from newcomers to Canada or non-residents planning to move here (i.e., not hot money), rather than from investors intending to stay abroad.2 Still, the survey data corroborate realtor reports that foreign buyers, including those from Russia, Iran and India, are influential players in some local markets. With Chinas government gradually easing investment restrictions on its citizens, and given the uncertain economic and political situation in some emerging-market nations, the inflow of foreign wealth isnt likely to ebb anytime soon.3

The sharp depreciation of the Canadian dollar, in particular its 18% slide against the renminbi in the past two years, has also made Vancouver and Toronto relative bargains on the global stage, at least until prices went berserk this year.

Though great news for homeowners, the explosive price growth has made life tougher for many prospective first-time buyers who cant save fast enough for a down payment. Apart from the outer rim of the metro region, detached homes are off limits for many first-time buyers. The typical family looking to buy a median-priced bungalow would need to shell out 39% of gross income in Toronto and a steep 60% in Vancouver on mortgage payments. Thats up from 35% and 49%, respectively, a decade ago, even though borrowing costs are about three percentage points lower today.4 Add an extra 9% or so to cover other housing-related costs, such as property taxes, insurance and heating, and theres not much left over for the finer things in life, like food and clothing.

Many first-time buyers in these cities are now left with just two options: longer commutes or smaller condosresulting in a lower quality of life. Notably, demand pressures are starting to emerge in areas outside the metro regionwitness double-digit price gains in B.C.s Fraser Valley. Gratefully, condos are still affordable, with the typical buyer in Toronto needing just 22% of income to service a mortgage on a newly purchased unit. Thats little different from a decade ago, as falling interest rates and rising incomes have offset moderately rising prices. While a

2 The CMHC finds that 3.5% of condo units in Vancouver and 3.3% in Toronto are currently owned by foreign investors, up from 2.3% and 2.4%,

respectively, last year. 3 Unlike its Canadian peer, the U.S. National Association of Realtors has been collecting data on foreign buyers for years. Last year, buyers from

China (plus Hong Kong and Taiwan) surpassed Canadians as the biggest overseas buyers of U.S. real estate, accounting for just over 2% of U.S. home purchases by dollar volume and a greater proportion in more expensive markets in New York, San Francisco, Los Angeles, Washington D.C. and Miami. While some realtors have reported that demand from China has slowed this year due to the decline in Chinas stock market and currency, most believe the pullback will be temporary given the strong desire for better schools, cleaner air and a perceived safer haven for money.

4 We assume the property is purchased with a 10% down payment and financed over a 25 year period at an interest rate of 2.79% (BMOs current 5-year special fixed rate). Median family income in 2015 is estimated using average growth in the ten years to 2013.

Canada ex. Toronto, Vancouver

Toronto

Vancouver

2

4

6

8

10

05 07 09 11 13 15

House Price-to-Median Family Income Ratio

Lofty Valuations(multiple of annual income)

Chart 4

Median family income is estimated after 2013 using average annual growth in previous 10 years. Price is HPI benchmark.

Page 10 of 16 Focus December 4, 2015

Feature

Vancouver condo eats up a larger 27% of income, thats actually less than in 2005, as prices were little changed from 2008 to 2014 (prior to this years 14% moon-shot).

In addition, the declining affordability in the Vancouver and Toronto detached markets suggests both cities (home to one-in-four Canadians) are at high risk of a correction when borrowing costs rise. Though likely to climb slowly, interest rates could be two percentage points higher in 2018. Assuming home prices increase no faster than incomes (perhaps not the most reasonable assumption given current demand forces), mortgage service payments on a benchmark bungalow would require 48% of income in Toronto and a whopping 74% in Vancouver. While a Toronto condo would remain affordable at 27% of income, Vancouver units would be more challenging at 33%, with other housing-related costs pushing this figure above the 39% guideline required to obtain an insured mortgage.

Unaffordable detached homes, tinier condos and longer commutes will eventually spur home seekerspossibly even some wealthy foreignersto look elsewhere, curbing price growth but also long-term economic growth. Lofty prices could increasingly become a deterrent to workers considering moving to Toronto or Vancouver and wanting a detached home, leading to skills shortages in coming years. Moreover, businesses could be forced to boost salaries to attract workers, reducing their global competitiveness. For determined buyers still looking to move to these areas, sky-high prices could compel them to take on larger mortgages that increase their vulnerability in the event of a loss of income.

Bottom Line: As long as interest rates stay put, Vancouver and Toronto housing markets could remain vibrant amid strong demand from international migrants, millennials and an apparent influx of foreign wealth, suggesting prices will continue to increase in 2016, even after this years boffo performance. However, with detached homes becoming an ever-distant dream for many first-time buyers, neither region is likely to avoid at least a partial correction if interest rates increase materially, as buyers are likely to look for more affordable options elsewhere. A bigger concern is that the more prices probe the outer reaches of the atmosphere, the greater the risk they will come tumbling back to earth later on.

Page 11 of 16 Focus December 4, 2015

Feature

General Disclosure

BMO Capital Markets is a trade name used by the BMO Investment Banking Group, which includes the wholesale arm of Bank of Montreal and its subsidiaries BMO Nesbitt Burns Inc., BMO Capital Markets Ltd. in the U.K. and BMO Capital Markets Corp. in the U.S. BMO Nesbitt Burns Inc., BMO Capital Markets Ltd. and BMO Capital Markets Corp are affiliates. Bank of Montreal or its subsidiaries (BMO Financial Group) has lending arrangements with, or provide other remunerated services to, many issuers covered by BMO Capital Markets. The opinions, estimates and projections contained in this report are those of BMO Capital Markets as of the date of this report and are subject to change without notice. BMO Capital Markets endeavours to ensure that the contents have been compiled or derived from sources that we believe are reliable and contain information and opinions that are accurate and complete. However, BMO Capital Markets makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this report or its contents. Information may be available to BMO Capital Markets or its affiliates that is not reflected in this report. The information in this report is not intended to be used as the primary basis of investment decisions, and because of individual client objectives, should not be construed as advice designed to meet the particular investment needs of any investor. This material is for information purposes only and is not an offer to sell or the solicitation of an offer to buy any security. BMO Capital Markets or its affiliates will buy from or sell to customers the securities of issuers mentioned in this report on a principal basis. BMO Capital Markets or its affiliates, officers, directors or employees have a long or short position in many of the securities discussed herein, related securities or in options, futures or other derivative instruments based thereon. The reader should assume that BMO Capital Markets or its affiliates may have a conflict of interest and should not rely solely on this report in evaluating whether or not to buy or sell securities of issuers discussed herein.

Dissemination of Research

Our publications are disseminated via email and may also be available via our web site http://www.bmonesbittburns.com/economics. Please contact your BMO Financial Group Representative for more information.

Conflict Statement

A general description of how BMO Financial Group identifies and manages conflicts of interest is contained in our public facing policy for managing conflicts of interest in connection with investment research which is available at http://researchglobal.bmocapitalmarkets.com/Public/Conflict_Statement_Public.aspx.

ADDITIONAL INFORMATION IS AVAILABLE UPON REQUEST

BMO Financial Group (NYSE, TSX: BMO) is an integrated financial services provider offering a range of retail banking, wealth management, and investment and corporate banking products. BMO serves Canadian retail clients through BMO Bank of Montreal and BMO Nesbitt Burns. In the United States, personal and commercial banking clients are served by BMO Harris Bank N.A., Member FDIC. Investment and corporate banking services are provided in Canada and the US through BMO Capital Markets. BMO Capital Markets is a trade name used by BMO Financial Group for the wholesale banking businesses of Bank of Montreal, BMO Harris Bank N.A, BMO Ireland Plc, and Bank of Montreal (China) Co. Ltd. and the institutional broker dealer businesses of BMO Capital Markets Corp. (Member SIPC), BMO Nesbitt Burns Securities Limited (Member SIPC) and BMO Capital Markets GKST Inc. (Member SIPC) in the U.S., BMO Nesbitt Burns Inc. (Member Canadian Investor Protection Fund) in Canada, Europe and Asia, BMO Capital Markets Limited in Europe, Asia and Australia and BMO Advisors Private Limited in India.

Nesbitt Burns is a registered trademark of BMO Nesbitt Burns Inc., used under license. BMO Capital Markets is a trademark of Bank of Montreal, used under license. "BMO (M-Bar roundel symbol)" is a registered trademark of Bank of Montreal, used under license.

Registered trademark of Bank of Montreal in the United States, Canada and elsewhere.

TM Trademark Bank of Montreal

COPYRIGHT 2015 BMO CAPITAL MARKETS CORP.

A member of BMO Financial Group