When Warren Buffett stepped in with a rescue plan for Home Capital Group (HCG), Canada’s beleaguered non-bank mortgage lender, Canada’s hot housing market drew the attention of the international financial press.  Bloomberg news had several articles on the Canadian housing market in the current month. The Financial Times this past weekend drew attention to the Canadian housing market, citing the risks associated with its soaring prices over the past decade. The article ended with the warning that the Toronto market is out of control. Unquestionably, housing costs in Canada have now garnered attention well beyond its borders.

Canadian single family house prices have been on a tear; average home prices in Toronto over the past 5 years have increased by about 70%. (Figure 1). There have been no end of Canadian press reports of sellers receiving multiple offers well over the asking prices. Housing prices are a constant topic of conversation.

Figure 1

More importantly, the price difference between the two major cities, Toronto and Vancouver, and the rest of the country is even more dramatic (Figure 2). Even after adjusting for the lower Canadian dollar, Toronto and Vancouver prices exceed home prices in some of the larger metropolitan areas in the United States.

Figure 2

Let’s look at what is driving this market.

On the demand side, Canada took in over 300,000 immigrants in 2016 and the Federal government expects that figure to rise to 400,000 in 2017. Well over half of these newcomers will settle in Toronto and Vancouver, generating an additional demand for 90,000 new dwellings a year in those two cities alone. This is on top of the natural growth for housing from the indigenous population. Housing starts in Canada have been in rough balance with demand for several years. There is no supply overhang that would drive prices downward. The Ontario government earlier this year introduced a speculation tax on purchases by non-residents in the mistaken belief that overseas money is driving housing prices in the greater Toronto area. It was a political sop to those who think Asian capital is behind the housing shortage. The tax does not play any role in determining housing prices.

On the supply side, Toronto and Vancouver face land shortages, forcing developers to seek greater density in the core areas to satisfy demand. Land shortages cannot be ameliorated in the short term, yet demand has to be met in the short term. The shortage of housing in the greater Toronto area has forced up prices in the peripheral communities in southern Ontario, such as Hamilton, St. Catherine’s and Kitchener.

Lenders to the housing industry continue to believe in its strength and remain comfortable with their collateral. The Canadian banks supply approximately 75% of all mortgages. Over half of the mortgages are insured by the Federal government and private insurers. Unlike many places in the United States, mortgages are full recourse to the borrower, discouraging anyone from just walking away from their obligation. Nationally, Canadians have over 65% equity in their homes and this serves as a large cushion to any sudden downturn in the market.

HCG is an interesting case of how an overzealous regulator can lose perspective. HCG was hit hard by charges of fraud and poor disclosure. A handful of mortgage brokers were cited for improper documentation and were subsequently removed from the coterie supplying HCG with new clients. The company cleaned up the situation and paid the fine. However, its reputation was severely damaged. Depositors withdrew funds, forcing the company to sell a large chunk of its mortgage book and to undertake an onerous line of credit to continue operations.

Enter Warren Buffett. Buffett recognized that the housing and mortgage industry in Canada is on a solid footing. Moreover, he recognized that HCG has a valuable book of assets that would satisfy his collateral requirements. Berkshire agreed to take a 38% stake in the company for about C$400 million and will also provide a $2 billion line of credit on much more favorable terms than the one currently provided by a Canadian pension fund. As expected the stock price soared by nearly 30% the next day. Large Canadian banks stepped in to provide credit facilities to rivals of HCG who suffered knock-on effects. No one thinks this investment is altruistic for Berkshire as it does receive a significant discount to market for its share purchase. But at the same time, it is being viewed as a strong vote of confidence in a company that has, needlessly, suffered at the hands of regulators.

Meanwhile, the housing industry remains very healthy. Housing starts are at a 5 year high across the country and prices remain very stable at these elevated levels. Short sellers beware.