My hand started to quiver as I stared at the screen. All I needed to do is fill in my password and click ‘ok’, and it would be done.

I paused.

Could I do this?

Various thoughts raced through my head. I’ve never actually shorted a stock before. What if I was wrong? Whenever I go long, there’s always a built in margin of safety. The stock usually is trading under book value, usually with very little debt, which fills me with some sort of confidence that the company isn’t going bankrupt. There is no built in margin of safety with this trade. It’s very much an all-or-nothing deal.

What about all the people I know who own houses? Most Canadians have very little in wealth besides the equity in their homes. I thought about my one friend, T, who has diligently paid off his house over the past 7 years, finally getting to the point where it’s almost paid off. I thought about other friends who have been spending money improving their house, investing in the sure thing because they just don’t understand enough about the stock market to trust it. I even thought about myself, since I, like the majority of you, have a big chunk of my net worth tied up in real estate.

Can I really bet against the wealth of all my friends? Did I really want to profit if their houses fell?

Then I thought about Daisy, who bought into a market that is overvalued using every metric, and didn’t even bother to spend 15 minutes analyzing it. She just put her blinders on and moved forward, fundamentals be damned. I thought of Young and Thrifty, who clearly bought a condo without crunching some numbers and realizing that she could invest her down payment and rent the same condo and end up thousands of dollars ahead every year.

And then I got mad.

When both these girls were thinking of buying, I waded into their comment sections and warned them. I gave them the condensed version of why they’d be screwed if they bought now, and how they’d be almost certain to lose money. I did my civic duty, and they didn’t listen. Daisy went as far as insulting my intelligence when she wrote the ‘I bought a house’ post, implying that my opinion didn’t matter because I never went to university. Daisy’s expert opinion came from a professor, which is delightfully ironic.

Then it was easy. I clicked the button, and soon enough, it was done. I ended up being short 4 banks, Royal Bank, TD, BMO, and National Bank. I only sold BMO a handful of days before I went short.

I can’t take credit for the title. It comes originally from The Big Short, Michael Lewis’s tale about a handful of hedge fund managers who, collectively, made billions betting against the U.S. housing market in 2005-07. Specifically, it comes from a bond salesman from Deutsche Bank, Greg Lippmann. In 2005, when Lippmann was beginning his crusade to convince as many people as possible that the U.S. housing market was collapsing, he was accused of being a “chicken little” when it came to the economy. The title is his response.

A warning before you commit too much time to today’s post. It’s going to be long, and may get fairly technical for some of you. The comment section is all yours if you want to ask any questions. I promise I’ll actually get around to answering them.

If you’ve been around here for a little while, you know I’ve been bearish on Canadian housing for some time. I’ve made fun of other bloggers for buying a place while ignoring the underlying fundamentals. I’ve outlined a potential way for average investors to short the market using options. I’ve probably wrote about it in other ways too, but I’m too lazy to link back to them. Don’t worry about clicking on those links, since this post will cover most of the information covered in those, along with a bunch of new stuff. Consider this my penultimate piece on the matter.

I intend to show you, the average investor, why the market is overvalued, and how you can profit from it. Unlike some bloggers who only outline their trades once they’re finished, I’ll let you guys know exactly how I’m playing this, the exact price I paid, and we’ll track the success and failure of this together.

There are a half a dozen different paths I want to explore, each one further proving the market is overvalued. Let’s start with price to income and price to rent ratios.

What’s a reasonable price to rent ratio for real estate in 2013, in a low interest rate environment? I’m greedy, I wouldn’t buy a rental property that traded below a 6x P/R ratio, which is a 15% gross return. I bought 3 properties between 2001 and 2004, all easily qualifying. And then, in my town, values shot up. The market increased some 50% between 2005 and 2006, and my 15% return requirement became nothing but a pipe dream. So I stood on the sidelines.

I watched cap rates continue to decline. As I type this, the gross return in my small town maxes out at about 6%. Once you factor in expenses, you’re looking at a 3-4% return, which is about the same as a basket of corporate bonds. How about nationally?

As I outlined in one of the earlier posts, Vancouver has a price to income ratio of 40x. To put that in perspective, it would take 40 years for a renter to pay for the property, and that’s assuming the landlord wouldn’t pay a nickel in maintenance, and the property would never be vacant. When I was buying property, I was looking at a 6 year payback, assuming ideal conditions. One of those buyers has a built in margin of safety, which is essential in real estate. The other one needs capital appreciation to make their investment work.

Right now Toronto has an average price to income ratio of around over 30x, and most other major centers in Canada aren’t far behind. This chart is from 2011, but things haven’t changed much since then.

Notice the difference between my earlier Vancouver number and this one

Notice the difference between my earlier Vancouver number and this one

The bottom line? People who buy a property in a major center in Canada are speculating that the price will continue to go up. They will never make money on cash flow alone, and they will get absolutely hammered when interest rates go up.

Meanwhile, we have price to income ratios. Much of what I said above applies there too. Price to income ratios are at record levels across Canada. The average property in Vancouver costs more than 10x the average income. Toronto isn’t far behind, at about 8x. Calgary is right there too, at just about 7x income. Montreal is up there too, coming in at 5x income. Canada’s 4 largest cities, home of approximately half our population, are all significantly overvalued compared to historical norms, which is right around 3.5x income.

There’s one problem with comparing price to income to historical norms, and that’s the level of debt most Canadians have. The average Canadian owes 164% of their disposable income. This is above even what Americans owed when their real estate market peaked in 2006. The average consumer cannot afford all their debt once interest rates start to go up.

Here is a national price to income chart for Canadian real estate. The trend is about as obvious as my crush on Taylor Swift. This data is only current until the end of 2010, and it’s only gotten worse since, albeit not be a whole lot.



Debt Levels

Staying on the topic of Canadian debt, we are, collectively, maxed out. And mortgages are a big part of that. It’s not that Canadians are recklessly taking on all this consumer debt – we are, but not at levels exceeding the U.S. – it’s that a large portion of our overall debt growth is mortgages, including the silent killer, HELOCs. More on those later, assuming any of you are left reading. Let’s look at a chart.

Ch2_Chart 20_Household Debt_v2



This chart is a year old, and doesn’t show the recent gains up to over 160% of debt to disposable income. I used it because it shows the U.S. peaked at just a hair over 160% as well.

People often cite the amount of equity Canadians have in their homes as a reason why a U.S. style housing correction won’t happen here. Up here, Canadians own, on average, about 70% of their homes. Unless things get really bad, Canadians will still have equity in their homes. It’s all fine and good, except that number is highly affected by the large number of Canadians that own their home outright.

In fact, 50% of Canadian homeowners have less than 20% equity in the homes. These days, the average down payment for first time buyers is a paltry 7%. We are a nation of some financially responsible people and a bunch of financially irresponsible people.

Plus, the equity numbers don’t factor in HELOCs, the ticking time bomb mentioned above. The growth in home equity lines of credit has been absolutely staggering, and they’ve covered all sorts of financial sins. Get in too much credit card debt? Just replace it with a HELOC. Want to buy a car? Borrow against your house. Plus, all you have to pay every month is the interest. Who cares about paying down principle, we can do that when we sell the house.

Seriously, look at this chart.


Still think you shouldn’t be concerned with HELOC growth?

First Time Buyers and Condos

Next up is home ownership rates. As we stand, Canadian home ownership rates stand at right around 70%. In 2006, in the United States, they peaked around… wait for it… 70%. (Are you detecting a pattern yet? You should be.) Every now and again a bank will trot out a survey saying a certain percentage of Canadians intend to buy a house in the next 5 years, (the latest one, from  BMO, pegs the number at 48%) but all that does is measure the sentiment of the average Canadian. This is the same person who has watched their house go up in value, borrowed heavily against said house, and probably has the majority of their net worth tied up in that house. But hey, keep thinking the average Canadian’s opinion matters about housing.

Canada is running out of first time buyers. And what do first time buyers usually buy? Condos. Too bad the condo markets across the country are clearly rolling over.

Why would anyone buy a condo? We’ve already established there’s no money to be made renting them out. There are barely any first time buyers left. Even speculators are beginning to get out of the market. I read one estimate that 50% of Toronto’s condos are owned by “investors.” If you own a condo that barely covers the expenses, you’re not an investor. You’re a speculator that’s hoping for a huge capital gain using someone else’s money, and I’m happy to profit from your misfortune.

How about the health of condo markets across the country? Well, Toronto has 55,000 condos coming on the market over the next 2 years. Over the first 3 months of 2013, 4,133 units moved, and there are currently over 7,000 condos on the market, not counting the thousands that are listed privately on Kijiji and Craigslist. It’s already a buyer’s market in Toronto, and that’s without the giant glut of upcoming inventory.

How about other markets? There are record condo listings across the country, including Montreal, Quebec City and Ottawa. The only reason Vancouver isn’t joining the party is because sellers are simply taking their property off the market. The only market across the country that is showing any significant strength is Calgary, and I can’t figure out why it’s so strong.

If you own a condo in Ontario, Quebec, or in Greater Vancouver, you are especially screwed. I’d advise you to sell, but you should have really done that six months ago when I first started talking about this.

The Economy Runs On Houses

We are, as an economy, increasingly dependent on real estate and real estate related activities.

More than a million Canadians are employed in construction, with housing being the main pillar of the strength in that sector over the past few years. The ranks of real estate agents and mortgage brokers have swelled as well. I’ve seen estimates that real estate and related activities make up anywhere from 12-27% of our GDP.

Then it becomes a perpetual motion machine. People work in real estate, make money, use that money to buy houses, watch those houses increase in value, and then borrow against those houses to buy other stuff. It keeps going and going, eventually stopping in the worst of ways.

“Prudent” Canadian Lenders

Canadian lenders are often cited as being more prudent than their American counterparts. So called “liar loans” didn’t exist up here, and we made sure we lent money to people with good credit ratings. It’s often touted that Canada doesn’t even have a subprime market. And that’s kind of true. We had alternative lenders come in and do deals big banks wouldn’t touch, but they never captured a significant part of the market. That’s because we used CMHC to make subprime lenders more attractive to our big banks.

I spent time as a mortgage broker, and I can assure you borrowers pull out all sorts of tricks to get loans they have no business qualifying for. Here are a few examples.

Co-signers are common, especially among those with damaged credit. All somebody needs is a relative (or friend, or person who can fog a mirror) to lend their good credit to a deal. Suddenly the guy with a garbage credit score qualifies at the same interest rate as someone with a pristine rating.

Gifted down payments are common, especially among first time home buyers. As long as a relative signs a letter that states there’s no expectation of repayment, a borrower is free to use it as if it was their own. Often there is an expectation for repayment behind the scenes.

Banks giving borrowers cash back for their down payments was common up until 2012, when the practice was stopped by OSFI, the big boss in charge of Canada’s banks. You can still borrow the down payment though, as long as you get it from different sources and disclose it. Or you can do with some people do, and that’s borrow your down payment 3 months in advance, stick it in your account, and not bother to disclose it to the lender. Since the bank only asks for 3 months of bank statements they’d never know.

Mortgage brokers quickly figure out which lender is a little lax with documentation, and will often send their borderline deals to that one particular lender. Thanks for making my life easier, Scotiabank! Whoops. I mean, uh, unnamed bank. Oh hell, it’s not like anyone is still reading at this point.

Condo speculators will often borrow against their existing property to buy condos that aren’t even built yet. They put down their 5% deposit and then sell the unit as it nears completion. Assuming you did this on two $400,000 properties, you’d have a grand total of $20,000 of your own cash controlling $800,000 worth of real estate. Bear Stearns went down at less than a 40-1 leverage ratio.

One last thing about the underwriting process. Hardly any properties that get insured by CMHC are physically appraised. Certain values are input into an automatic valuation system (called Emili) and it instantly spits out a value. It’s pretty easy to see the weakness in that system, and people in the industry know it. Emili is ridiculously easy to scam if you know how.

Everybody lauds the lending practices of Canadian lenders compared to American ones. It’s a flawed comparison. Comparing yourself to the American banks is like being 5’3″ and weighing 250lbs, and saying “well, at least I’m skinnier than this chick.” Saying something is better than the worst thing ever is hardly a testament that it’s great.


I’ve spent 2500 words explaining why I think the Canadian real estate market will fall. Others share my opinion, notably Ben Rabidoux (who’s site, The Economic Catalyst, was a terrific source of information, and is worth a few minutes of your time) and Garth Turner, who was the guy who originally sold me on the idea Canada was overvalued.

Now us on the other side of the fence are starting to gain popularity. People are starting to see things our way. National newspapers and magazines are putting this story on their front page. Ben and Garth are doing media because people think they’re right, not because they’re some amusing sideshow.

And still, the naysayers are everywhere. We are still a minority. A vocal minority, but still a minority.

I don’t mind. After all, if everyone agreed with us, there’d be no money to be made. Everyone would be short the banks and we’d all be waiting for the inevitable crap to hit the fan. Debate is what makes a market, and it’s more fun to be proven right when you stand alone, against the crowd. It just bugs me when naysayers say stuff like this, from the National Post.

…said Mr. Booth. The investors betting against the Canadian banks “have no idea of the difference between the Canadian and U.S. housing markets.”

That quote comes from Laurence Booth, a finance professor at U of T, so we know Add Vodka is already taking his opinion as gospel. With respect to Mr. Booth, that quote is an insult to the intelligence of everyone who has actually gone out and researched the market and found out just how overvalued it is. There are huge differences between the markets, but the underlying fundamentals are the same. By every metric, house prices are expensive.

The Juicy Part. How To Short Them

Congratulations, you’ve made it to the good part. Or you’ve just skipped ahead, looking for the reward without doing the work. I like the cut of your jib.

There are various ways to play this. You could short Genworth, the private alternative to CMHC. You could also short Home Capital, Canada’s largest alternative lender, which lent a whole bunch of people money who didn’t qualify for CMHC insurance. They keep all their loans on their own balance sheet. It could blow up.

Instead, I want you to short the banks. Not in the traditional way, but by using options.

It’ll be Monday morning when you read this. If you buy the Royal Bank January 2016 $50 puts you’ll pay right around $5. Or you can buy the $46 puts for around $4. I own the $46 puts at a slightly lower level, $3.50 per share. What does that mean?

If the share price goes down to $45, you’ve broken even on your $50 puts. If it goes down to $40 you’ve doubled your money, if it goes to $35 you’ve tripled your money, and so on. However, if the price doesn’t reach $45, then you’ve lost all your money. Unless you sell the option sometime in between now and January of 2016.

I also own the National Bank $70 January 2016 puts. I paid $8.50 per share for those. Considering the weakness I see in Quebec and their exposure to Le Belle Province, I think this might be my favorite play of the bunch.

I own smaller positions in TD and BMO. I paid $7.50 for the January 2016 $56 puts for BMO and $9.40 for the $78 puts from TD, for the same expiry date. There’s really no reason to spread yourself around as much as I did, buying Royal Bank would be sufficient.

The banks are a somewhat imperfect way to play this. Home Capital Group would be the ideal way, but the longest put offered on it expires in January. I’m considering it, but I think this takes up to a year to really shake down.

That’s it. Thanks for your patience and for actually wading through 3,000+ words. Again, the comment section is open for your questions or for you to tell me how wrong I am.

Tell everyone, yo!