F— You, I’m Short Your House

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!

69 thoughts on “F— You, I’m Short Your House

  • June 10, 2013 at 6:47 am

    Great analysis on the Canadian Housing market.

    I’ve always consider shorting individual sectors/stocks an important part of an overall diversified portfolio.

    Shorting this particular sector, long-term makes sense to me, but will require patience. We know this sector is overvalued. We just don’t know when that tipping point will occur, causing housing prices to tumble. (1, 2, 5 years… we just don’t know.) At that time, consumer deleveraging will occur and stocks such as the Canadian banks will suffer.

    Insurance. In essence, what you’ve done here Nelson, is purchase insurance. I’m assuming that you own real-estate property yourself. Purchasing these put options will provide you with a future cushion against falling real estate values.

    Assuming this short represents a small/reasonable portion of your overall portfolio, then yes, I like this ‘insurance strategy’. Best wishes to you.

  • June 10, 2013 at 7:09 am

    See the kind of great piece you can write when you don’t lead with a dick joke? Seriously, well done!

    Couple of questions: Did you keep your long positions in the Canadian banks (I know you had BMO at one point)? Can you give us a sense of how much you’re putting (get it?) into this short position? Percentage of your assets or net worth, or just tell us the dollar amount?

    • June 10, 2013 at 8:51 pm

      1. No, the only financial I’m long is IGM Financial (Investor’s Group) which does have a small mortgage component. The stock goes ex-dividend in a couple weeks and I’ll look at selling once I’m assured I’ll get that last dividend.

      2. This is my biggest position in my equity portfolio. The second biggest, France Telecom, is about half the size. It makes up about 20% of my stock market portfolio.

  • June 10, 2013 at 7:54 am

    What about Winnipeg? I hear lots about the other big cities but Winnipeg always seems to get left out. I would like to buy a slightly larger home that is closer to work so I have been trying to pay attention to house prices and such. From what I can tell starter homes are still selling high, prices at 150 selling for 175. The 250 000 house are selling lower or for exact.

    Im not buying stocks or anything like that yet but I still appreciate an article like this…and I read the whole thing

    • June 10, 2013 at 8:45 pm

      The average price in the Peg is $275,000. Average income is $72,000, so you’re looking at a hair under 4x. Based on that it’s overvalued, but not ridiculously so. The market is hitting record highs, and buying things when they’re at record highs rarely work out well.

      Q1 sales were down 22% compared to last year. Condos seem to be about as weak as the rest of the country.

      I’d stay away. Prices are up, what, 75% over the past 4 years? Stay on the sidelines and you’ll be able to get that $250k house for under $200k.

    • June 10, 2013 at 8:48 pm

      What are your rental options? What slightly larger houses closer to work are available, and what do they rent for?

      • June 11, 2013 at 6:33 pm

        @ Potato- renting is not an option for me with two 60 pound dogs. I was hoping to rent the house Im in now and buy/live closer to work.

        Houses very close to my work are usually around 250 and up.Its a nicer neighborhood than where I am now. I think to rent they would be around 1200+.

        @ Nelson- under 200k?! I hope so.

        • June 12, 2013 at 7:07 pm

          Have you looked? It is hard — very hard — but I don’t know if I’d say it’s not an option. Lots of people have pets; the landlord might charge a bit more (or you might offer a bit more) as insurance or in the expectation of damages, but if the price:rent is out of kilter enough, it might still be worth it. You will find some large percentage of landlords don’t want dogs in their houses, but you only need to find one who’s ok with it.

          Anyway, if you estimate $250k to buy and $1.2k to rent, that’s a price:rent of 208X. That’s in “better to rent” territory, though if it makes you feel better it’s not as bad as Toronto’s~250X or Vancouver’s 300+X. On the flip side, it’s only $250k, so whereas in Toronto the ownership premium might be ~$10k/yr on a $500k house, with your lower price:rent and lower house price the ownership premium might only be say $3k/yr (I haven’t plugged it into my spreadsheet to check).

  • June 10, 2013 at 12:18 pm

    Interesting premise. I don’t disagree with the likely over-valuation of the real estate, but I have a concern with the short strategy. I have been led to believe that most risk was with CMHC, so the banks don’t really have a lot to lose in the event of a real estate correction. Also, as we know, the pesky little banks do make money from other methods as well. If this is the case, and they are able to make money from non RE business, and don’t lose much even when RE goes down, then is this the best strategy to capitalize on the likely correction in RE? (I’m actually asking, those question marks are there cause I don’t know.) My other issue with the strategy has to do with timing. Buying puts, even 2016 puts, means you are betting the correction will “correct” by then. I believe someone smart like Buffett or Neil Peart of Rush said something along the lines of ” the market can be wrong longer than you can afford to stay in it until it gets right”. (paraphrasing of course). All I’m saying here is that there seems to be a big timing bet, and I think Garth etc have been calling this market overpriced for a long time. Could go a lot longer than any of us expect. My two cents of course. Thanks for making us think.

    • June 10, 2013 at 8:36 pm

      You are right, the timing of the bet is the big issue. As I outlined in my reply to Potato, I think the timing is right, but I’m really guessing.

      As for the CMHC issue, you’re right, losses will be minimized. There are a few reasons why I don’t care.

      1. The ticking time bomb of HELOCs, which are mostly uninsured.

      2. Mortgages make up more than half of the big bank business. I also think the Canadian economy heads into a recession when all this hits the fan, further weakening the business of the big banks.

      3. Market sentiment will be very negative.

      The other option to short is to borrow the shares (average interest rate: 6-7%) and you’re responsible for the dividend (~4%). 11% a year to short? That’s not very lucrative.

      • June 11, 2013 at 9:01 am

        Thanks for the replies. If in fact things play out like you predict, and the economy goes into recession, then the market as a whole should take a beating. Would it not be possible to just short the entire market (through an ETF or some such product) which would allow you the gain when the market goes down without having to worry about the timing or the strength of the banks in the meantime?

        That just got me thinking that most of my investments are in dividend paying stocks with reasonable valuations, so although they may take a smackdown in a recession, I think the majority are strong enough to keep paying dividends and bounce back relatively quickly. So while I hold my current stocks, would it possibly be sensible to short the market as a whole for insurance? Hmmm. Now my brain hurts.

  • June 10, 2013 at 12:22 pm

    I didn’t make the list of notable bears? :(

    Anyway, nice post, agree with Robb 😉

    I’m still having trouble with the idea of shorting the vanks (or buying puts). I fully believe they won’t do well as housing corrects, but they won’t come under the kind of balance sheet pressure the American and Irish banks did, with the baked-in government bailout. That could limit the updside to a short position, and strech out the resolution (you could be right on the thesis but wrong on the timing with puts). Indeed, the timing with puts is my biggest problem with the strategy. It could be years before any change in valuation happens…

    • June 10, 2013 at 8:30 pm

      You nailed the biggest problems with my trade, and those are the questions that keep me up at night.

      I think everyone is underestimating the ticking time bomb of HELOCs, which aren’t included in mortgage equity numbers and are generally not insured. I also think market sentiment and mutual funds rushing out of the big banks will send the banks a lot lower than people think. Most of the earnings growth of the banks have come from the banks growing their mortgage and HELOC business. Mortgage growth will grind to a halt and no bank wants to do a HELOC in a declining market. I think these factors all combine to send bank earnings lower and, in turn, their share prices.

      As for the timing, this one is a little more difficult. I like that certain markets are rolling over (V-City, Ottawa, Montreal, Toronto’s condos) and we’re seeing actual yoy price declines. And it feels just like 2006 in the U.S. But I could easily be early.

  • June 10, 2013 at 12:47 pm

    Shorting the banks is out of my league, but I agree with your analysis of the RE market. I do feel like a total outsider around here, though – everyone is still bingeing on RE and seeing nothing wrong with the fact that the average SFH costs over $400K in a so-called blue-collar town.

  • June 10, 2013 at 1:18 pm

    I personally believe they are hyping the housing market. I see too many vacant houses and those with for sale signs for all these new constructions to be going up. And a lot of them are on the market for months and then get put up for rent no one wants to buy them. I usually buy calls never bought a put option before.

  • June 10, 2013 at 7:13 pm

    Lol hey at least I didn’t insult you :) I acknowledge that I may come out ahead with renting but renting with a dog is pretty expensive here in Vancouver. I’m planning to rent out the place after anyways. I know I might lose money but I gained some already. So you win some you lose some :)

    • June 10, 2013 at 8:21 pm

      Have you crunched the numbers on how much you’ll get for rent when you rent it out after? Because I have, and your market won’t even give you enough rent to pay the interest on your mortgage which is at record low levels. Congratulations, you will never make any money renting it out.

      Your attitude when it comes to hundreds of thousands of dollars is mind boggling. “If I lose it, oh well!” Protect your capital Y&T. Warren Buffett says that’s rule number 1.

      • June 10, 2013 at 9:21 pm

        Aye, we have a cat; friends have a dog. It’s harder, but not impossible to find pet-friendly rentals. And “pretty expensive” doesn’t even begin to cover owning in Vancouver.

        And as Nelson says, it’s about managing risk as much as it’s about doing the financially optimal thing.

  • June 10, 2013 at 7:23 pm

    I really liked this post. Personally, I’ll hold onto my house because I’m planning on living here for at least another 7 years – looking at the “recovery” in some areas of the States, this seems to be the long-term.

    I guess my question is if you believe that houses are overpriced and the market is going to crash, why not go really short on real estate and sell your house? You could collect the (tax free) capital gains, pay cheap rent somewhere, invest in a relatively risk-free investment, and then re-buy when the market actually tanks and you can pick up your house 30% cheaper?

    It would be a pain to move your stuff, but after your blog post about your “new” chair….your furniture may be replaceable for a couple hundred bucks.

    Just curious – I like the analysis, it is very different then your normal posts.

    • June 10, 2013 at 8:16 pm

      While I believe we’re in a national bubble, real estate is still local. I’ve crunched the numbers for my local market and I’d say it’s 15-25% overvalued.

      What makes my real estate different than most people’s is every one of my properties produces income. I rent out my basement of my principle residence and the other 3 make up a nice portion of my passive income. Plus I’m sitting on significant gains on the rental units, so I’d have to pay taxes.

      I couldn’t replicate the passive income from my houses if I were to sell them and invest the proceeds somewhere else. I rode them up and I don’t mind riding them back down.

      As for my principle residence, I plan on owning it forever, so that’s a moot point.

  • June 10, 2013 at 9:35 pm

    As an outside observer (I like to lead with that – all I bring to the table is an analytical mind and recycled jokes about Crack Shack or Mansion?), I’d also be worried about the timing of the trades. Like every G-Man’s favorite Economist once said, “The market can stay irrational longer than you can stay solvent”. That said, what sort of time-frames can you get on long-dated Canadian options, whatever the Canadian equivalent of LEAPs are?

    Second, and I know it’s incidental to your post since it isn’t directly related to making money on this trade, but… Canada is ~13/14th largest by GDP. Any predictions on the fallout when this goes down? If 12-25% of your GDP is Real Estate and Construction while the rest of the world is still in a funk… we’d probably have to trot out that word “Contagion” again.

    Third, I will counter any ad hominem attacks on your formal education that crop up. As the quote goes – anyone who has ever questioned your smarts has mistaken education for intelligence. Unfortunately for your detractors, a degree doesn’t always signal the latter.

    • June 14, 2013 at 12:23 pm

      Hear hear. Plenty of non-diploma’d folks are smarter than the ones with diplomas, particularly with how crappy the education system is from elementary up.

      Did the U.S. professors predict the U.S. crash? No. Just a few outliers did. Just because you can read a lot, doesn’t mean you know a lot.

  • June 11, 2013 at 5:57 am

    I like it. I won’t be following you down that road (at least not with my money), but I am interested to see how this plays out. Would you be willing to share where you get your housing information. Even in the comments, you’re trotting out stats on Winnipeg pretty casually.

    Like other commenters, I was also nervous (curious?) about the timing issue of buying puts. Is there any reason not to sell call spreads (or straight calls) rather than buying puts? By all your logic, there is no more real growth room in the banks, so why not profit from stagnation? I didn’t actually look at the numbers, maybe the profit isn’t there, but it would eliminate the timing issue.

    I also wonder what you’ll do if bank prices go up to the point that your put values decrease significantly. Ride it out or buy more?

    In any case, I can’t say I’ll be rooting for you since you’re short my house too, but I will be watching.

  • June 11, 2013 at 8:36 pm

    Nice post. No penis references, no chip references, and no desperate cries for female attention. Coherent, on topic, informative… heyyyyy,… wait a minute… are you a ghost writer or somethin’? What’d ya’ do with Nelson? :)

  • June 11, 2013 at 10:49 pm

    Hey Nelson – first of all, I love your daily posts (I was very upset by the lack of cleavage resulting from no weekend dump this week), but this one was pretty special. Like you I read a lot of investing crap. Unlike yourself, almost none of it makes enough logical sense to me to abandon my indexing strategies. This article makes so much rational and logical sense to me I think I’m ready to jump on board. I mean what’s the alternative or defense to this argument? That 90% of Canadians can own their own homes in an ever-escalating market? All this to say, kudos my friend. Great article.

    Here is my question. I get the whole shorting strategy you’ve outlined, but if a person wanted to keep it simple what do you think about the HFD ETF? Here is an overview: http://www.horizonsetfs.com/pub/en/etfs/?etf=HFD&tab=overview

    I realize it has a very annoying MER of over 1%, but it looks to be a very simple way to make this a long-term play. It certainly has the exposure to the banks your looking for and it’s even leveraged.

    • June 12, 2013 at 7:12 pm

      Those inverse ETFs are nasty. Nelson can buy puts out to January 2016, and even then I was concerned it might be too hard to get the timing of it right. With something like HFD you need to get the timing right to a matter of weeks: the underlying will have to move down substantially and uniformly for you to make any money. Even if you’re right and the banks are down say 50% by this time next year, you might only make a fraction of that if the path taken on the way down has high daily volatility, a function of the daily rebalancing.

  • June 12, 2013 at 8:07 am

    Darn, I’m skewing the averages down in all of the categories you mentioned.
    So, what are your feelings on your own real estate portfolio? I assume houses are cheap and cash flow positive where you own?

  • June 13, 2013 at 10:35 pm

    Hey Nelson

    I think you commented somewhere that if you short the stock outright… you are paying borrowing cost + dividend equaling around 11%. But isn’t it still better than put option which will lose time value of money faster than that if nothing happens.

    Did you consider a bear spread instead? Like long 60 put and short 50 put will cost around $4.5 – $4.7 with possibility of doubling the money. Although I agree with you that banks may go lower due to pressure on future earning, but having just one way put with such a low strike price will only pay off if banks suffer a lot in which case you will make a lot. I am sure you probably thought about it …so can you please comment on it.

    In addition HCG.to has a 2% dividend, which will make it a better candidate for a short compared to a bank and they are completely in lending business. What do u think?

    • June 14, 2013 at 5:52 pm

      My strategy will be hugely profitable if I get the timing right. I’m willing to take the risk for a big potential return. I’ve got 2.5 years for this thing to play out, and I can always sell the puts in the meantime if the banks have weakness.

      As for Home Capital, I think it could very well blow up. Only something like a third of their mortgages are insured, and they’re lending to fringe borrowers, no matter how they try to spin it. Most new loans only have 20% down, and they’ve grown the business substantially over the past couple years. I thought hard about shorting it and I still might. If you’re going to short one stock to play this, I’d pick that one.

      I just like the potential reward for the puts.


  • June 14, 2013 at 11:31 am

    I lived through the housing crash in California, and I did a strategic default on my condo that went down by about $250,000 or about 50%. Let me tell you how I think it’s going to go down. First off, the condo builders in Toronto will stop their projects mid-way. They will sell their inventory as quickly as possible to get rid of their costs, or they will just go bankrupt. Condo prices will definitely plummet in Toronto. The other areas that will get hit are the recently developed areas around big cities that are far away from the core of the city. They will drop by 50%, if anything in the US is an indication. The nice areas in the big cities might get hit, but they will only go down by 15% or so. There will always be demand for the best areas of any city.

    First off, your comparison between the Canadian and US banking practices are pretty wrong. What occurred in the US during the housing bubble was nothing short of criminal. One of my friends was an assistant manager at Washington Mutual, and numerous mortgages that he denied were overruled and approved by the manager. Why? Because he got an incentive bonus for every loan that got originated. He was making $50k/month in bonuses at the height of the bubble.

    Banks were approving ridiculous loans to people without any documentation, and with little or no down payments. In additional, the non-recourse loan allowed people to short sale or foreclose on the homes with little financial risk except to their credit. As I mentioned, I strategically defaulted on a condo that was down 50% and over $250k.

    I have friends who put down $5-10k on a $500,000 townhouse with an interest-only loan. When the house prices tanked, they stopped paying their mortgage for 2 years, and rented it out for $2000/month. They ended up making money on the house, because it took 2 years to short sale the place, and they booked about $50k in cash and only lost their downpayment.

    Nothing like this is going to happen in Canada. People are on the hook for any mortgage they get. You won’t see people declaring bankruptcy en masse in Canada any time soon. This means that the houses they purchase are by definition more prudent than the purchases in the US. People with no kids were buying 5 bedroom houses because they thought when they sold the house in 1 year, they would get a better premium on the house. They would probably stay in their house instead of defaulting, which will put a damper in the economy, but it won’t tank the banks the way it did in the US.

    This is why shorting the banks is a lot harder, they’re more protected than the US. As well, I think the real estate market, while definitely too frothy and will drop, it won’t crash like the US. Canada has had market crashes before, and it will be the same, like in 1989/90, but it won’t be anything close to the US of 2008/2009.

    • June 14, 2013 at 12:25 pm

      Re: Condo builders stopping projects, it has been at least… a good 3 years in the making for this one condo on Bloor / Yonge street in Toronto.

      I kept wondering why it was taking SO LONG for them to even get started. Recently, they’ve started building again, but I think they might have to stop (again) if the economy does a deep slide down.

    • June 14, 2013 at 5:46 pm

      Highest U.S. foreclosure, by state:

      1. Nevada (recourse)
      2. Florida (recourse)
      3. Arizona (non-recourse)
      4. California (non-recourse)

      A few other weak states are also recourse, including Georgia, Illinois, and New Jersey. Most U.S. states are recourse states. So let’s squash that myth right away.

      You’re right that the sins of U.S. lenders are worse than Canadian lenders. But as I said in the post, comparing yourself to the ugliest girl in the room doesn’t necessarily make you attractive. European markets such as Spain, Portugal and Ireland also had housing bubbles collapse during the same time as the U.S., all for different reasons. Every bubble is unique, but that doesn’t make it not a bubble.

      Also, your government took many steps to minimize the effects of the bubble popping. The Canadian government will probably do the same.

      “Canada has had market crashes before, and it will be the same, like in 1989/90”

      That crash was localized mainly in Toronto. There was also a regional bubble in Western Canada in the early 1980s, which brought down a few local lenders. Canada has never had a national bubble to this extent. Sorry, it won’t be the same because the bubble isn’t the same.

      • June 14, 2013 at 10:52 pm

        There will always be demand for property of type X: waterfront, single family homes within decent commuting times of downtown, properties right in the core, etc. Virtually every property type has this myth about it. But though there may always be demand, there isn’t demand at any price. If downtown properties (or waterfront, or single family, or all of the above) are significantly over-priced relative to fundamentals, then they are at risk of being hit. People may still want to live there, and there may be plenty of liquidity in the market, but that doesn’t mean that prices are immune. Indeed, this kind of thinking helps people ignore the risk of high prices (yes, we’re buying at 300X price-to-rent, but there will always be demand to live in moist Vancouver!), which increases the risk.

        Further to Nelson’s comment about the government taking steps: keep in mind the government did take steps once already. Things were looking very bleak in 2008/2009. Toronto prices were down about 10% in under a year. Alberta centres corrected by ~15% and had elevated default rates for some time after. But after dropping rates, clearing bank balance sheets with CMHC purchases, increasing the CMHC limit, and other measures like the home renovation tax credit, the worst of the damage was avoided (the rest of the world stabilizing the GFC also helped). Alberta managed to pull into a mild correction and soft landing, a rare and impressive feat.

        Of course in Toronto, Vancouver, and elsewhere all that stimulus to avoid a collapse of the bubble at the time overshot the goal, and just drove the market with frenzied energy to new heights. So some of those tools to stop or moderate a crash have already been used (rates, for example, can’t be lowered so drastically a second time; CMHC is likely full-up; people just renovated their houses, another round of tax credits won’t have as much of an effect), and policy-makers may be a little more hesitant to pull them out a second time even where they do have another round.

        Anyway, banking practices were worse in the US. Most of those helped define the accelerating factors the drove the cycle down faster and provide great anecdotes for the insanity at the top. But ultimately the valuation gap will say how far it is to the bottom.

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  • June 22, 2013 at 10:46 am

    I’m copying my comment from PK’s blogpost riffing off yours; hope you don’t mind.

    Also, I have always been amazed about the laxity of Emili appraisals up there in Canada. It seems like essentially a Z-Estimate from Zillow if I’m not mistaken? Here, yes banks are dumb but they at least send a professional out to take a look at the condition of the house:


    Also, in terms of HCG, if you don’t qualify for an insured loan (not even Alt-A) do you really “deserve” to be given $300k toward 70-80% of what is probably a pretty poor-condition house in likely not a great neighborhood in Toronto?

    My comment from PK’s site:

    “In reality most of the loosening/tightening these days comes from CMHC, the government mortgage insurer that along with 2 private insurers – which are themselves 90% government-guaranteed – dominate the origination market, outside of very subprime + very jumbo ($1m+, a recent limit which has hurt the out-of-control Vancouver market).

    Seems like the market has a good month in terms of volumes/pricing when CMHC tells banks “I will insure anything you can send my way” and not-so-good months when CMHC says “please only send me X number of mortgages this month.”

    The process of how that works is a bit murky to me vs., say, the process of U.S. banks selling conforming mortgages to the GSEs. In Canada, there is a “cap” on the amount of notional exposure at CMHC and even though CMHC is below that cap, I think it serves essentially as a way for politicians or bureaucrats in Canada to keep CMHC from doing massive volumes of loans every month. So the CMHC process of telling each bank how many mortgages to send over every month has something to do with the cap, but it gets opaque to anyone outside the industry exactly how this works.

    Also it is still common to get well up into the mid/high 90s in terms of true LTV at origination through a personal (bank) loan on top of the insured mortgage. Before the “tightening” you speak of, which hit last summer/fall, it was possible to obtain a home with very little house money down.

    Not-a-bubble proclaimers usually harp on a few things:

    1) Canadian net worths are not as levered as in the U.S. (true because of equity in housing due to the price runup and Canada’s stock market is even more frothy than its U.S. counterpart)

    2) tight supply/demand in major bubble areas (true but can reverse quickly if people anticipate falling prices)

    3) “reasonable” debt-service costs to incomes – implying that the regional Toronto/Vancouver economies are simply extremely strong so people can afford large mortgages. My problems with this argument: I don’t think debt-service cost to income of 35%+ is reasonable – and this is with Canadian interest rates at 1%. Unlike in the U.S. Canadian mortgages are ARMs (mostly 5/1) not 30-year fixed. Therefore there is huge underlying risk of benchmark rates normalizing to say 5% and mortgage rates going from 4% to 8%.

    4) Better fundamentals than the U.S. due to faster population growth. The growth is from immigration, as Canada’s immigration rate as % of existing population is significantly higher than the U.S. In addition some of these immigrants come from China/SE Asia and of these, a subset is wealthy enough to afford expensive housing. British Columbia is particularly attractive to them. While this certainly helps the housing market, I doubt Chinese would like to buy into falling markets, and I am also skeptical that there are SO MANY wealthy Asians moving to/”investing” in Canadian housing that they could be a significant % of total homeowners, although they may currently be a decent % of buyers on the market today.

    5) Toronto and Vancouver are mature, prosperous, dense cities and should have similar housing valuations as NYC and SF Bay Area. That’s fine, except if you look at the numbers both places are significantly more expensive than their U.S. “counterparts” despite having lower household incomes.

    Vancouver has an economy and climate similar to Portland/Seattle – incomes worse than Seattle but better than Portland – yet homes in the city limits are 2-3x the price, and for a similar-sized home in the city limits more like 5x (Vancouver has a lot more condos, which tend to be smaller). In the burbs Vancouver is something like 2.5-3x Portland and double Seattle.

    Toronto has an economy and climate very comparable to Chicago – wages and family incomes are the same in the metro areas – yet a single-family house is 3x in greater Toronto vs. Chicagoland. Inside the city limits the discrepancy widens to 4x.

    I will say that a small reason for a price premium in Canada is that Canadian cities are significantly safer (in terms of crimes-of-opportunity and property crimes) than nearly all similarly-sized U.S. cities, and similar to very safe U.S. cities like Portland and Seattle.

    On the flip side, the climates are significantly colder which is a reason against a premium. There are many other issues to consider when coming to fundamental valuations (diversity/underlying strength of economies, tax rates, rental yields, trajectory of rents, currency under/over-valuation, etc.). On balance, in my subjective view U.S. housing overall is probably fair-priced with significant pockets of both under- and over-pricing. Canada, even in “cheaper” cities like Montreal and in Alberta, is expensive and Vancouver/Toronto metros are obscene.”

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  • July 3, 2013 at 10:55 am

    Hi Nelson,

    Tell me why again you don’t outright short? at those premiums, you have to be very right and right within that time frame. It’s not a bad thing but are paying dividends on shorts and some outside fear that these stocks pop overnight the main reasons you are using options here? Just comparing to taking staggered short positions as the opportunity unfolds (or not).

    Though I can also see why if you want to keep mostly cash during uncertain times and just risk an option premium. And going out to 2016 should give you breathing room. Just curious if your past trading has given you reasons to go this way (I’m a new reader)

    Also want to add that if your Home Capital is like our Countrywide, then I would be testing small outright shorts (selling at false breakouts) on that because Countrywide did indeed blow up. Though B of A didn’t do too well either so maybe the large banks are fine too:)



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  • January 22, 2014 at 6:38 pm

    Ive been buying and operating rental properties since 1997. When my former business partner and I saw prices shooting up in 03 we both did a simple bit of math. How do the rents relate to the price. Prices can rise but rents are constantly being challenged in the day to day market. So even as we saw house prices in the area where we were invested go up by as much as 300 percent in a few years we KNEW that rents had gone up by way less. So.we sold 5 of 7 multi families in 06 and cashed out properties that neither of us ever thought would be more valuable at sale than as rentals. Normally prices of bldgs do track w inflation but thats it, if you’re lucky. Bottom line. Money is like fertilizer. If banks get enough of it cheap enough they can make things grow that would normally never be sustainable. Look south Canadians at us Americans who exported ponzi capitalism to you and hold ur money and just pay rent for till the bubble pops. Good Luck

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  • May 14, 2015 at 10:36 am

    I’d just like to say that I completely agree with your real estate analysis. Having said that I haven’t had the balls to short the market as crazy at it is.. Sorry to see that this trade isn’t going well for you.. Granted you have a few months left, but just curious, are you still holding on to these options?!

    • May 18, 2015 at 9:05 am

      No, I sold at a loss months ago.

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