One of my readers reached out to me recently and asked my opinion of the Canadian banks. I’m obsessed with giving my readers what they want, so I thought I’d start by taking a look at Canada’s largest bank, The Royal Bank of Canada (NYSE:RY). I’ll review the latest financial results here, and compare those to the valuation, as usual. Before getting into that, though, I think it necessary to talk about the $367 billion herd of elephants in the room: Royal’s exposure to Canadian real estate.
I offer a thesis statement at the beginning of each of my articles, and this one is no exception. In a nutshell, I’d recommend investors avoid this name for the foreseeable future. The firm’s mortgage book has ballooned by about 45% over the past four years, just in time for a crisis in residential real estate up here. I think that presents risk that isn’t being factored in by the market, given that the shares are sporting the same approximate multiple that they have for years. Now, I’m a pretty risk tolerant kinda guy, but when I can earn a greater return from government bonds, I’m generally going to eschew the shares of risky stocks like this one.
I think that in order to understand Canadian banks at the moment, you need to have some background in what’s going on with Canadian residential real estate, so before I get into my discussion of The Royal Bank of Canada (RY), I’m going to deliver unto you a (very brief) primer on the state of residential real estate.
In March of 2022, the Bank of Canada started raising their policy rate from 0.25% then to 5% now in order to combat inflation. The Bank of Canada was obviously not alone in this, and the move was as dramatically quick here as it was anywhere else.
What’s relevant for our purposes is that over half of all mortgages in Canada are variable rate, which means they are the most exposed to rising interest rates. Most of those are called “variable rate fixed payment” mortgages. Under this type of arrangement, your payment remains the same, though if rates go up, you pay more interest and less principal every month. It’s also worth noting that there’s something called a “trigger rate”, which is the point at which 100% of your payment is going toward interest payments, so no principal is being paid down. If you exceed that rate, the interest payments get piled on to your loan, so at the end of your term, you end up owing more, and your equity is eroded, even if we assume house prices remain flat. House prices are actually falling, so that’s troublesome.
According to de bonnes personnes at National Bank (sorry, National Bank is a French institution, and I’m worried that the language police will come for me if I don’t write of them in French), as of January of this year, somewhere between 73%-80% of mortgages originated between 2020-2022 will have hit their trigger rate. Please note that we in the Great White North have had two more rate hikes since then, so this problem has gotten far worse not better, obviously. Also, home prices are generally down across the country, so as individuals pay ever more in interest, Canadians are seeing their residential equity get wiped out.
I’ve watched a fair bit of financial content produced by Americans with a U.S. only focus. This is shocking to me, because if know one thing about the “Land of the Free and the Home of the Brave”, they’re not at all insular. Anyway, in case you were also exposed to such content, and wanted a slightly more broad perspective, consider the tale of that string of often frozen city states that sits along the northern border of the United States called “Canada.”
It’s an oft cited perspective up here that “we didn’t really get hit by the 2008 financial crisis, and our residential real estate never reached American levels of bubble crazy.” I could go on about how wrong this smug attitude is. I could go on about how Canadian culture is the only one on Earth that defines itself by what it’s not. Instead, though, I’m going to drone on about the fact that you might think you sidestepped a bubble in country X if you, sitting in smug comfort in country Y are in the same bubble! I could drone on at length about this, but I think a picture is worth several thousand of my words. Please feast your eyes on the following relationship between home prices and real disposable income. If you squint, you may notice the little dribble of a dip that Canada experienced in 2008, before house prices took off again.
Comparison of U.S. and Canadian Residential Real Estate Affordability (Financial Samurai)
Finally, it might be worth noting that outside of the provinces of Alberta and Saskatchewan (which together account for about 15% of the population of the country), mortgages in Canada are recourse loans, meaning that the lender can go after other assets if the mortgages value exceeds the value of the residential real estate. This may insulate banks somewhat, but would obviously be harmful to households, which will have knock on effects to bank profits down the road.
As someone who talks funny (from their perspective) and who’s lived on four continents, I have somewhat of an outsider’s view about Canadian culture. I think there are a few reasons why residential real estate has risen so dramatically in price here. Capital gains on residential real estate are exempt from tax. Thus, I think it’s been seen as a great way for a non-business owner to accumulate capital. Additionally, the large wave of immigrants who moved here between 1950 and 1975 did very well with their residential real estate, and they’ve inculcated in the young the idea that “housing never goes down in price.” Thus, I think the intersection of tax policy, culture, and accommodative central bank policies have created this monster. After benefiting from the monster for years, Canadian banks are now in a troubled spot, and have a great deal of exposure to residential real estate through their mortgage books. Add to that the fact that the Canadian demographic picture is not particularly great, and we have a batch of never before seen risks at Canadian banks. The Royal Bank of Canada and CIBC are the most exposed of our financial institutions, which is why I’m going to be paying particular attention to them over the next day or two. I’ll state up front that I think exposure to residential real estate is a significant risk to these companies. I’d be willing to buy them, but only if the price reflects this substantial, and growing risk.
I’ve reproduced some of the financial highlights at the Royal Bank over the last few years below for your enjoyment and edification. There are a few things that leap off the page at me here. First, I’d suggest that growth here could be characterised as “sclerotic”, given that revenue has grown at a CAGR of about 1.5% from 2019 to 2022. That written, the first half of this year has seen revenue pop by 20.5% compared to the same period a year ago. Additionally, revenue is higher by about 17.6% when compared to 2019, so this jump isn’t simply a reflection of a poor performance last year.
At the same time, though, the capital structure has deteriorated from last year to this, with cash and various marketable securities up by about $21.5 million, and total liabilities up by $84.78 million.
Most relevant of all, though, is the growth in residential real estate mortgages over the past few years. At the moment, the company has leant out $367.3 billion in residential mortgages, which is up 6.5% from last year’s figure of $344.8 billion. The growth of the residential mortgage book here is really highlighted by the fact that it is up 45.4%, or $114.7 billion from 2019. In my view, growth of this magnitude in such a short period of time is noteworthy. I feel the need to put these $367.3 billion of mortgage debt in even more context by pointing out that as of the latest financial period, the company has $111.354 billion in shareholder equity. So, I consider the exposure to residential real estate to be the greatest risk to the enterprise, and thus the dividend here. I’d be willing to buy, but only if the price is very attractive.
Finally, please note that when I look at “net income” for the Royal Bank, I’m looking at “net income” only, because I’m much more interested in trying to work out the cash flow generating capacity of the firm. Thus, I’m going to exclude from my analysis things like “net change in unrealized gains on debt securities and loans at fair value”, or “unrealized foreign currency translation gains”, “net gains on derivatives designated as cash flow hedges” and the like. I’m looking at the earnings power of the enterprise, and I consider “items that will be reclassified subsequently to income”, or “foreign currency translation adjustments” etc. to be less relevant to that pursuit.
Royal Bank Financials (Royal Bank investor relations)
In order to get me excited by the stock, I’d need it to trade at a discount to both the overall market, and its own history. We see from the charts below that the shares are cheaper than the S&P 500, but that’s been a constant theme here. The shares are not significantly cheaper than they were in 2019 when the risks from residential real estate were far less great. Additionally, the dividend yield is better than many I’ve seen recently, but it’s still below the risk free rate given by governments on both sides of the border.
In my view, an investor is taking on much more risk, and receiving less income than they would earn from the risk free alternative. In my view, this makes no sense, and so it would be prudent to avoid these shares until what I consider to be the inevitable residential real estate drama here works itself out. Finally, I think comparisons to U.S. banks are a bit naïve given the very different dynamics involved in both places. If you’re an American investor and you assume that Canada is just “America light”, please reconsider that thesis. Risks here are substantially greater than they are down in ‘Murica.
Lastly, it may come as a surprise to many of my readers, but I actually do have some friends, and some of them are real estate lawyers. The number of stories they’re telling about people trying to walk away from firm offers of sale speaks to a residential real estate market in crisis. A typical story involves a buyer making a firm offer with no financing clause at the height of the market, then being unable to consummate the deal when the market drops, causing the appraisal to come back light, so the bank’s only willing to lend a fraction of “X”, rather than “X.” I think this emerging crisis in real estate values will eventually come back to haunt the Canadian banks, and so I would generally steer clear of them at the moment.
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