Four regional Canadian housing markets have received “Red Flags” from the Canada Housing and Mortgage Corporation (“CMHC”), an austere government agency that is considered the leading authority on the nation’s housing sector.

“We now see strong evidence of problematic conditions overall nationally,” the agency’s chief economist said. “This is fuelled by overvaluation — meaning house prices remain higher than the level of personal disposable income, population growth and other fundamentals would support.”

The methodology followed by the CMCH in reaching their conclusion is nothing new, but it makes for interesting reading, especially considering that the agency, which is the curator of a large mortgage insurance book, has absolutely no interest in talking the market down.

The CMHC considers four key factors in their assessment of the state of a housing market:

Overheating: Does demand exceed supply, and how does it compare to historical norms? A key indicator watched by the agency is the sales-to-listings ratio published monthly by the regional real estate boards.

House Prices: A sustained and sharp acceleration is considered a warning sign.

Valuation and fundamentals: Are houses affordable when prices are compared with income and financing costs?

Overbuilding: Supply of new homes and current inventory of unsold homes is compared with demand.

Given these considerations, the agency comes to the conclusion that many Canadian housing markets are overvalued. The table on page 3 indicates the CMHC assessment for the two most important Canadian housing markets, Toronto and Vancouver. Each market is assessed in terms of the evidence of problematic conditions in the four categories listed above, and then graded as Weak Evidence, Moderate Evidence and Strong Evidence.

Regular readers of Canadian Edge will remember that we have previously expressed concerns that the housing market is overvalued and may be heading for a correction. We also issued our own “Red Hot” warning in May 2016, but cautioned that overvaluation and irrational markets can continue for a long time.

However, we are seeing more statistical and anecdotal evidence that the housing market correction has started. Average detached home prices in Vancouver are down by 18% since the peak in February (although benchmark prices have declined only marginally) and the number of homes sold in the third quarter plunged by 26% compared to last year.

Toronto is still steaming ahead but energy and commodity-related areas such as Calgary and Saskatchewan are also showing signs of deterioration. We hold the view that a housing market correction will unfold over the next year, especially in the “hot” markets of Vancouver and Toronto. Provincial and Federal actions to cool the markets will contribute to outright price declines in some markets.

Position Your Portfolio

Real estate activity is an important component of the overall economic pie in Canada, contributing 13% of GDP in 2015. That’s larger than the mining and energy or manufacturing sectors. A sharp and prolonged real estate correction will reduce employment, income and household wealth, with a considerable negative impact on consumer spending.

The large Canadian Banks have a variety of revenue sources and relatively conservative home loan portfolios, but they all would take a hit from a sharp housing market correction. However, banks without a meaningful international profit center and with large portions of their loan portfolios extended into the domestic market, such as Canadian Imperial Bank of Commerce or National Bank of Canada, will probably be hurt most by such a correction.

Royal Bank of Canada (TSX: RY, NYSE: RY), previously part of our Dividend Champions portfolios, holds C$272 billion of home loans, which make up 56% of its total loan book. While the loans are partly insured and fairly conservatively managed, we sold the stock from our portfolio in May. This leaves us with only one bank in the portfolio, Toronto-Dominion Bank (TSX: TD, NYSE: TD), which has a smaller mortgage loan book and is more conservatively positioned than Royal Bank.