Real estate markets are healthy because there’s a low level of defaults, right? Not exactly. Junk economists (and that cousin of yours that gives unsolicited investment advice) often explain that the lower the levels of mortgages in arrears, the healthier the market. In actuality, it’s the opposite. Low levels of defaults are a sign that markets are highly liquid, and therefore getting closer to the top. High levels of defaults occur at the bottom of a crash. Why? It’s actually pretty simple.
Toronto Real Estate Prices And Defaults
To explain this trend, we’ll look at Toronto real estate. The 1989 peak of Toronto’s last bubble saw an average sale price of $273,698. One year later, prices declined by 6.82% to hit $255,020. That was the year Canadian banks decided to start collecting a comprehensive data set of mortgages in arrears, which at that time were only 0.18%. In 1991, prices declined a further 8.12%, and mortgages in arrears tripled to 0.5% of all mortgages. As more data was collected through the 90’s the trend generally shows a higher percentage of defaults as prices continued to drop.
This trend doesn’t have a clear reversal until 1997, the first year Toronto real estate experiences a strong price reversal. That year prices rose 6.64%, and mortgages in arrears fell 13%, both experiencing the strongest positive trend since 1990. Average sale prices have increased every year since then, and mortgage defaults generally fell as well, showing a clear trend. In 2016, Toronto real estate reached an all time annual high of $729,922. Not coincidentally, mortgages in arrears reached an all time low of just 0.13% of all mortgages. This isn’t something isolated to Ontario either, the same trend can be observed in BC (where prices started falling about a month after we noted defaults hit an all-time low).
Toronto Mortgages In Arrears
Prices peaked in 1989, and 1990 experienced the first drop in over 20 years of Toronto Real Estate Board data. It wasn’t until the second year of price declines that mortgages started to fall into arrears. Source: Canadian Bankers Association.
Defaults Are Low When There Are Lots of Buyers
The explanation is actually really simple, supply and demand – although not in the way you might think. Don’t confuse demand for shelter with demand for buying a home – this is the latter. As prices increase, more buyers assume it’s a safe bet to jump into real estate. Eventually, people that can barely afford the payments hop in the market because they’re tired of being left out. This creates a sudden surge, as the buyer pool explodes. In a market like this, even homes that typically wouldn’t be desirable to buyers start selling at a profit well beyond fundamentals.
This market is highly liquid, as there are way more buyers than there are homes. There’s little reason to fall behind on your payments, because if you do, you just list it for sale. You leave with a profit, and feel like an investment genius. People rarely fall behind in this market.
Mortgages In Arrears Vs. Toronto Real Estate Prices
As you can see, a significant increase of mortgages in arrears only appears after a significant decline in real estate prices. Source: Canadian Bankers Association, Toronto Real Estate Board, Better Dwelling.
Defaults Rise When There Are Fewer Buyers
The converse is also true, if prices are declining there are fewer buyers. Declining prices aren’t exactly inspiring investments, so buyers need a little motivation to get into this market. This further applies pressure to prices, and creates more desperate sellers. Smart money is often the first to sell at a peak, since they’re willing to accept a small loss rather than chase people down.
This market is not very liquid, and you’ll have a harder time selling a property. Homeowners that find themselves unable to keep up with the bills, will have a harder time selling their house. What took weeks to sell when there were lots of buyers, might now take months. This increases the chances of their mortgage falling into arrears, and thus default rates rise.
Market liquidity is a fundamental part of a healthy market. A highly liquid market where buyers outnumber sellers will appear to have less issues since you can dispose of commodities quickly. The more liquid an environment, the higher the risk of a market pullback. There’s a reason the saying is “buy low, sell high” and not “buy high, hope it goes higher.”
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