UNDERSTANDING THE RECESSION

There is a recession coming, we in Toronto will be somewhat insulated, yet all in southern Ontario will feel its effects.  Luckily, it will not last longer than a year.  This article will explain its effects on your real estate investments.

History

The present financial crush has its roots in the dot com bust in 2000, the terrorism attacks of 2001, and the Enron fiasco of the same year. These horrific events shook our confidence in our financial investments.  Stocks began to look risky as one could not trust the honesty or competence of those managing the corporations.  Investors transferred their investment portfolios to things that they had greater control over. One of those places was real estate.

Interest rates stayed low for a long time. So low, that there were often fears of inflation.  They stayed low for so long that investors had to take greater and greater risks to receive an adequate return on investment.

Housing Meltdown in the United States

The focus of the current global market correction is on the sub-prime mortgage market in the United States.  More specifically, their practice of extending mortgages to those who could not afford one.  One of their mortgage products became known as a NINJA mortgage; if you had no income, no job or assets, you were approved for a mortgage.  Others were interest only mortgages, and mortgages that began with low interest, (and therefore low mortgage payments) but increased over time.  These practices led to housing inventory being sold; but how long the owners could financially manage to occupy those homes became questionable.

What were they thinking?  There are two elements to consider.  The first, is the steady increase in the value of housing.  People were betting on this increase.  They would buy a home that they could not afford, but in a couple years, they would attempt to sell it.  By that time the value of their home would increase, and they would be left with a profit.   [If anyone is considering this strategy please don't try it! Speak with me, and together we will come up with a sound investment strategy for you.]  The second element was that because home values were reaching higher and higher levels, people would use their home as an ATM machine, they would borrow against their equity (the value of their home, less the value of the mortgage).

These sub-prime mortgages were taking advantage of people’s dreams.  Luckily, in Canada, we have regulations that would prevent these type of mortgage products being offered.  This scenario played itself out for a short while.  Home values increased because there was more demand from all those extra families who now could obtain a mortgage.  Occasionally, one of the owners would default on their loan, and their home would be taken away from them.  If there were a few foreclosures here and there, the economy could absorb it, but soon the amount of people who were walking away from their homes increased sharply.  The amount of vacant homes increased, and the number of people wanting to buy homes decreased.  Housing prices began to fall, and soon many people began to realize that these mortgages were not such a great idea.

To compound the problem further, these individual mortgages were cut up into small pieces and each little piece was bundled together with pieces from other mortgages to create an investment called a security.  Investment bundles with higher risk had higher return, and were attractive to investors.  These packages were sold to investment houses and banks all over the world!  Unfortunately, the investors did not correctly study the investment they were purchasing.  In reality, they would have learned that they bought `bad paper’ and the value of that paper was next to nothing.  World wide financial institutions paid $43 trillion dollars for this paper.

Global markets will fall to correct for these investment losses.

Stock Market Volatility

The specter of questionable trading practices and investment strategies is causing heavy volatility in global markets.  On January 21, 2008, the value of global stock prices fell sharply.  The Toronto Stock Exchange fell 4.8% (605 Points), the next day it recovered 509 of those points, and the Bank of Canada cut its key interest rate 1/4 percent to 4%.  Other nations were not so lucky and did not recover their losses.  When investors speculate who is carrying some of these bad investments in their portfolio, knowing if stock prices will rise or fall is very difficult.  Investing in the stock of a corporation becomes a precarious situation, which dissuades investors.

Manufacturing, China & the U.S. Dollar

North America is in the process of transferring its manufacturing capacity to China, India and other countries where labour is much cheaper.  So much manufacturing is done overseas, that the United States has a net trade deficit.  This, along with other reasons, erodes the value of the U.S. Dollar.  The U.S. Dollar is also the worlds most important reserve currency (other nations hold large amounts of it in cash as a stabilizing influence on their economy) because the value of the U.S. Dollar dropped considerably, China declared they would diversify its reserve holdings, by buying Euros and other commodities.  This further eroded the value of the U.S. dollar.

In comparison to the U.S. Dollar, the Canadian Dollar rose.  At its highest point, it took $1.10 U.S. Dollars to buy one Canadian Dollar.  While Canada is primarily a resource based economy, Southern Ontario is heavily focused on manufacturing, and its prime market is the United States.  However, with a comparatively high Canadian Dollar, goods produced here do not look as attractive to U.S. customers, orders have considerably slowed.  Manufacturers have begun to look elsewhere in the global market for buyers of their products in order to survive.  Manufacturers who have been unable to find these customers, have folded.  At the moment, when I drive through industrial areas of the city, there is a great surplus of manufacturing and other industrial properties available for lease.

In Southern Ontario, expect these manufacturing facilities to be converted to logistics and warehousing, as I do not foresee the economic advantage China has to wane.  In fact, the new wealth China has acquired has been re-invested in creating more capacity for manufacturing even more products.

How It all Comes Together

Why is the recession certain? Canadian financial institutions purchased these valueless investments in high risk mortgages.  This reduces the amount of money they are able to extend to other customers in this country for mortgages. The supply of credit is tighter, less people will be approved for mortgages.  Investment capital, so important to the creation of new wealth, will become more scarce.

In Toronto, we will be somewhat protected as we have a diverse local economy with strong players in the financial, communications, arts, computer software, medical research, tourism, sports and education industries.  So, while one or two industries might weaken, Toronto’s home values will be supported by strength in the other industries.

Once you get outside of Toronto, the situation will worsen sharply.  The losses of manufacturing jobs will have to be reconciled. One way it will occur is in the loss of value of real estate.  

So through all the coming troubles, contact me and I will inform you how to wisely take advantage of the situation to grow your investments.