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BofA still bearish on Canadian housing

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Canada's hot housing market -- using low interest rates as kindling -- is showing no signs of slowing. But economists at Bank of America Merrill Lynch maintain their bearish view on the housing sector, telling clients that it's showing "classic signs of over valuation" that could result in a major pullback in price.

"The Canadian housing market would likely experience a hard landing as it is highly leveraged to jobs and income growth," Ryan Bohren, an economist at Bank of America Merrill Lynch told clients in a note on Monday.

"Moreover, the household balance sheet is stretched and highly susceptible to adverse shocks," he adds.

Bohren says the housing market continues to suffer from an excess in supply, with housing starts still well above the natural household formation rate. Housing starts recently surged to 213,000 over the summer, far higher than the natural formation rate of 180,000. Toronto's condo market in particular, he says, is over-built.

"By our estimates there are enough [condo] units in the pipeline to satisfy this fundamental demand for the next 5 years," he says. Bohren says anecdotal evidence suggests that many of the condo units in Toronto are being sold to investors and "there will not be enough renters in Toronto to occupy these units as they are completed."

"As a result, some investors will be left holding vacant units. Since most investors are unlikely to hold onto negative-carry investments without a reasonable prospect of price appreciation; this will put downward pressure on home prices."

WHAT'S TO BLAME?

Bohren pulls few punches when it comes to what's contributing to soaring home values: low interest rates.

"The only way these valuations can now be explained is through the record low mortgage rates," he says.

He believes a "normalization" of interest rates would make Canadian home values appear 25 percent overvalued.

"If mortgage rules were reverted back to where they were in 2000 and the maximum amortization for an insured mortgage was 25 years, instead of the current 30 years, we believe home prices would be almost 20 percent over-valued," he says. "If the effective 5 year fixed mortgage rate was a more normal 5.0 percent, instead of the current 3.3 percent, we believe home prices would be just over 25 percent overvalued."

A low interest rate environment, he says, has simply allowed for greater leverage among Canadian households.

"Simply put, in 1982 the discount factor was around 6 times, meaning for every $1 of income available for borrowing the average household could borrow $6," he says. "Today, the discount factor is closer to 20 times, implying that same dollar can be levered up to $20."

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