SEPTEMBER 21, 2012
The two Canadian real estate markets I've written most extensively about are the Vancouver market in general and the Toronto condo market. The Vancouver market is now well into correction mode while significant signs of stress are building in the Toronto condo market. Portions of the report below were sent to clients over two months ago, but the trends outlined have only intensified since then. I've updated some of the key charts with the latest data.
1) Recent resale trends in the condo segment: Sales down, inventory up
In this report, I'll set aside the red-hot detached market in Toronto, which I believe likely has at least two more quarters of strong year/year price gains as a result of some legitimate supply constraints and strong demand. I am concerned about the future of this market segment, though I don't see nearly as much risk here as I do in the condo sector.
The August resale data showed a 22% y/y decline in condo sales in the GTA while at the same time, active condo apartment listings in the GTA rose by 21% y/y. Meanwhile, average resale prices fell 4% y/y in the city and fell 2% y/y in the GTA.
Condo research firm Urbanation also reported in August that new condo sales plunged 50 percent in the second quarter to 4,769, from a year earlier while there were a record 18,123 unsold new units.
This trend has continued into the first half of September, with sales falling 32% y/y in the city and 28% in the GTA while new listings across all market segments rose 14% over this time last year. Although this is in comparison to record sales in 2011, rapidly rising inventory and rapidly falling sales are categorically bearish signals.
2) Case study: The downtown Toronto condo market
The downtown Toronto area accounts for 30-40% of all condo sales in the city and 20-25% for the entire GTA. It also acts as an interesting case study since the reasons given for ongoing strength in the condo market (lack of buildable land, strong immigration, highly desirable location, etc) would seem to logically apply first and foremost to this area.
Below are the latest sales and inventory figures for the downtown Toronto condo market:
Note that sales were at record monthly highs as recently as May yet have now plunged below the 2008 low water mark for the past decade. At the same time, MLS inventory remains at the highest point ever for the month....and by a substantial margin. Barring a strong reversal in these trends, there's little doubt that this supply/demand imbalance will continue to weigh on prices. And if there's significant weakness in this key market segment, I have a hard time seeing continued strength in other areas.
3) Despite falling sales and rising inventory, developers keep breaking ground
In spite of the trends highlighted above, developers continue to launch new products, and at an eye-popping pace. In August, housing starts in the multi unit segment (primarily condos) soared 108% over last year.
There are now 63,400 residential dwellings under construction in the GTA, a rise of 26% over last year:
The current condo boom in Toronto dwarfs all other North American cities:
4) Specu-vestors are still driving new condo sales
70-80% of the condo units currently under construction have been pre-sold. However, "investors", and not end users, remain the primary buyers of pre-construction units. As noted by Urbanation's Ben Myers in a recent interview:
"We have hit the peak of the market, we had 28,000 suites hit the market last year, and conservatively speaking, 18,000 to 20,000 of those were bought by investors."
In another recent op-ed, Myers also discussed the rationale behind buying a condo as an investment:
“There has been much discussion on whether renting condo suites results in being ‘cash flow positive’ on a monthly basis based on a minimum 15 or 20 percent down payment, when factoring in the monthly mortgage carrying costs, property taxes, monthly maintenance fees and other expenses. Based on examples from our Urban Rental report, it would be unlikely that you would be in the black when renting a unit in a downtown condominium building completed over the past couple years with a minimum (i.e. 20%) down payment.
So why are people still buying new condominiums for investment? There are two simple answers and a lot more difficult ones. The first simple one is that a lot of investors are taking a long-term investment outlook; they are willing to sustain short-tem monthly losses…as the value of the suite increases, rents increase and they pay down their mortgage. Eventually they will be in a situation where their tenant is paying their mortgage and they are pocketing the difference. The second simple answer is that a large portion of investors are putting more than the minimum payment down on their suites.”
Speaking to realtors in Toronto, the typical new condo in the city sells for $500-$700/sqft and rents for between $2-$3/sqft per month. Minus taxes and condo fees which amount to roughly $1/sqft monthly, investors are seeing a net 2.4% to 3.4% cash-on-cash yield which I would suggest is vastly insufficient to compensate for the risks inherent in this particular asset class at this point in the market cycle.
The only rationale for holding such an investment, as Myers pointed out, is to take a short-term monthly loss “as the value of the suite increases”. Let’s call a spade a spade; Buying cash-flow negative condo units in the hopes of selling at some point for a profit is speculation, while putting more money down to achieve a positive cash flow, and not accounting for the lost opportunity costs of those funds when calculating overall return, is just dumb. The dangers of this level of investor/speculator activity is discussed below.
5) Estimates of required new construction to meet population growth are way off base
The mental gymnastics required to justify the current pace of construction in the condo market are incredible. Nowhere was this more on display than in a recent RBC research note, which used some unbelievably bad math to project a base case for condo demand in the city.
The central point of the report is that the city requires 38,000 new dwellings annually just to accommodate population growth, hence any current overbuilding is likely minor.
Let's breakdown the math, but before we do so, we need an understanding of several important facts:
1) According to Census data, the most authoritative source on Canadian population, the Toronto CMA grew by an average of 94,000 individuals annually between 2006 and 2011.
2) Stats Canada data shows that the vast majority of the growth in population in Toronto is via immigration.
3) Stats Canada data also shows that the average new immigrant family is 50% larger than the Canadian family (3.5 vs 2.3).
4) The average household size in all of Toronto is 2.68 individuals
This is all Stats Canada data that can be easily confirmed.
If we take the current rate of population growth and divide it by 3.5 (the size of the average new immigrant household, which comprises nearly all of the population growth in the city), we get an estimate of 26,800 new dwellings required annually to accommodate growth.
If we divide population growth by the current size of Toronto households (which is a stretch given the composition of population growth), we still only get 34,800 new dwellings annually.
How the authors of the RBC study came to an estimate of 38,000 new dwellings required annually is a bit of a mystery to me, particularly given that their counterparts at National Bank produced a similar report the following week estimating that the city needs only 33,000 new dwellings annually.
But all of this is a bit of a moot point given that housing starts in the 12 months leading up to August totaled 46,000 in the GTA, blowing away even the highest estimate of demographic demand. Toronto is overbuilding, plain and simple.
6) Rental market still tight. Speculation the huge unkown.
CMHC estimates that the rental market for condos currently has a roughly 1% vacancy rate. This is supported by anecdotal evidence of strong demand and even reports of bidding wars for rental suites in certain high-demand areas. Despite this, condo rents are rising only about 3% y/y according to Urbanation.
At the surface, this would argue that the current pace of construction may be absorbed as rental stock with potentially little impact on prices, and condo bulls are quick to point this out. Yet I would remind readers that real estate booms are invariably tied to speculation and misallocation of capital, and one massive question remains: How prevalent is speculation in this market, and how likely are we to see new rental units hit the market to compete against existing stock?
In these discussions, most people focus only on pure speculators, those who buy a unit and hold it vacant expecting to flip it at some point in the future. This clearly the most significant form of speculation, but I would define a speculator, for the purpose of this discussion, as any individual who is *likely* to sell a unit or try to rent a vacant unit if prices soften and they feel compelled to sell or at least realize some cash flow to compensate for declining valuation.
We have no numbers on "pure speculators", but I would suggest that anyone in downtown Toronto in the evening count the lights on in any of the many condo towers that have been completed and occupied in the past few years. Or if you're there in the day, particularly during the summer, see how many balconies have any sort of furniture on them. It's a very crude method of estimating how many units are vacant, but it's pretty shocking nonetheless. I won't ruin the surprise....you'll have to see for yourself. The issue here is that these speculators are notoriously prone to knee-jerk reactions and are very likely to either list their unit for sale or rent it out to at least see an income stream should prices soften.
I have no clue how prevalent pure speculation is in this market, but I'd suspect it's high enough to make any policy maker uncomfortable. But that's only one form of speculation. There are several others that concern me. Let's call these the "soft speculators".
1) Condo investors who hold cash-flow negative condos are inherently speculators who must realize a capital gain to make a buck. While they may be happy to hold these cash-sucking units during boom times, or at least when they THINK boom times will continue, how will they respond when they are faced with a falling market? These soft speculators would compete with existing units for sale but otherwise would have little impact on the rental market.
2) Presale "investors" who have assignment clauses or who plan to sell upon completion. An assignment gives the buyer of a presale unit the option to sell that unit prior to completion. These units effectively compete with existing inventory. If they cannot be sold prior to completion you can bet that they will either be sold upon completion or rented to realize cash flow. Brad Lamb recently wrote an excellent article calling the condo assignment market in Toronto a "potential monster".
“Ten years ago, we saw few of these transactions; today, they represent a significant component of the annual sales production of condominiums…When I first started selling buildings for developers 16 years ago, we never allowed these transactions…This discouraged speculators/gambler-types who had no intention of closing, from buying in a new development.”
[...] “The stability of the closing process, where a development is successfully handed off from the developer to the buyer, is the cornerstone of our strong marketplace. This process prevents speculators from panic-selling and destabilizing the marketplace.”
[...] “Over the last five years, I have seen an erosion of the developer’s will to stop the propagation of assignments. The current strength of the investor-buyer and their realtor in the success and/or failure of a development has created a potential assignment monster.”
It's not difficult to find many examples of speculators already trying to flip these units. Below is one screenshot of a Kijiji search I just did for the city of Toronto. These are ads that have appeared in the past two hours....and they run well beyond this one screen.
These are not counted as MLS inventory but they will compete with existing inventory as these units complete, or they will very likely become rental units to provide a cash flow if the owner cannot find a buyer. It should be clear that the notion that 70-80% of these the units under construction have been sold is ridiculous. They may have been sold, but in many cases they have been sold to people who intend to resell them now or once the units complete.
As an aside, this also raises a financing risk that is discussed below.
3) The third group of soft speculators are individuals who have bought a condo but use it as a periodic "vacation" home. Barbara Lawlor, President of Baker Real Estate Corp, recently discussed this phenomenon in an article in Condo Life:
"For many, having a condo in the city is perfect for weekend getaways, or for visitors who want to soak up some of Toronto's exciting culture and entertainment. They can live like they're at home while they're downtown, rather than stay in a hotel, which is less personal and comfortable. This second home is also convenient, because when it's time to leave, they just lock the door and go, without worrying about who will mow the lawn. It's also a great investment that can be passed down through generations."
Anecdotally, I know of several people in my circle of friends and acquaintances who have done this very thing. I've had the chance to discuss this with them and their general mindset is very much as described in this article: They are in the city periodically and would rather own a condo than pay for a hotel room once or twice a month. Suffice to say, once condo fees, taxes, insurance, general maintenance, and lost opportunity cost of the money they use to purchase the condo are taken into account, the economics only favour owning a "getaway" condo unit over staying in a hotel when the market is rising. Most people simply wouldn't consider this "investment" in a sideways or falling market, and I'd suspect that a weakening market with the threat of a substantial pullback may cause some of these individuals to question how much they really want to own that getaway condo.
This is one of the fundamental reasons that household formation rates and overall demand for dwellings rise during a sustained bull market. The "investment worthiness" of real estate rises as the boom progresses. The desirability of real estate investments (both speculative and those that are cash-flow oriented) and recreational property rises as the boom progresses allowing builders to bring more inventory to market than would otherwise be required given demographic trends.
The bottom line is that rental markets are often tight during a boom precisely because of the element of speculation. It's why I believe that vacancy rates are likely a lagging indicator of house prices in hot markets. One extreme example is Miami where vacancy rates rose fourfold over the course of several years following the bust precisely because speculators suddenly flooded the rental market looking to secure a cash flow from their depreciating assets. And this was in spite of a complete standstill in new construction.
ADDED: An interesting article in the National Post from this past weekend added some additional insight into the "tight rental market" discussion:
Thankfully, many observers anticipate the situation relaxing. Ben Myers, president of condo market research firm Urbanation, says 25,000 to 28,000 new condominium units are scheduled for completion in 2013 alone. If 35% of those units enter the rental pool, as they did in 2011, we would see a 16% increase in condo rental stock in just a single year.
John Andrew, director of the Real Estate Roundtable at Queen’s University, predicts rents will come down as a result — and choice will go up. “Every one of those investors that have bought a unit, they’re all planning on renting them out,” he says. “They may not be realizing that there’s 20,000 or 25,000 people just like them…. Once all these buildings come online, people [might] have their pick of 15 or 20 units in every building.”
7) Near-term potential risks to the Toronto condo market
With all of this as a backdrop, I see several immediate risks to the condo market in Toronto:
1) Investors panic as prices flatline/fall, stop buying new units, speculators flushed out. I see this as one of the great risks to this market. Condo prices in the 416 are now negative on a year/year basis. The recent rise in inventory and fall in sales suggests that further price declines are likely. It’s hard to envision a pick-up in demand now that mortgage rules have been tightened while interest rates hover near all-time lows. How long “investors” are willing to sustain monthly losses and speculators willing hold vacant inventory off market as the hope of capital gains vanishes is the big question. Furthermore, how will pre-construction condo investors with assignment clauses react if the market softens significantly? I don’t expect those who were irrational in their buying to be any more sensible in their selling.
2) New HELOC/refi rules sap capital flowing into this speculative space. The Bank of Canada has been very clear that a significant portion of home equity withdrawal via refis and HELOCs have flowed back into real estate in a virtuous
ponzi scheme cycle. The new rules to cap refis at 80% LTV and HELOCs at 65% LTV (down from 85 and 80 respectively) will certainly have some effect on speculative demand as the downpayment on a number of these investment condos have been made with existing home equity from another property. The following two charts from the Bank of Canada show the magnitude of home equity extraction and how the funds have been spent.
3) Banks curtail lending on low ratio loans leaving pre-construction buyers stuck. This is potentially a major issue and I've spent a great deal of time speaking with lenders and mortgage brokers trying to get a sense of how this may play out. Those who were around during the last market correction remember that banks became increasingly skittish of lending into a falling market (at least without insurance) while other lenders like Home Capital left entire markets altogether. Those who think the availability of credit in the next few years will be as great as in the past decade will likely end up disappointed. They may want to begin by reading up on the concepts of "reflexivity" and "pro-cyclical bank lending".
Now that CMHC has curtailed their availability of bulk portfolio insurance to large lenders, many of these banks are becoming increasingly conservative on how they lend in the low ratio segment. Already we're hearing reports of BMO and likely other major banks lending to only 65% LTV on uninsured condo loans in Toronto. (BMO also wisely abandoned their condo loan deposit program which gave interest only deposit loans to preconstruction condo
speculators buyers). Simply put, if you put less than 20% down, you must have your mortgage insured via CMHC or a private insurer like Genworth or Canada Guarantee. In the past, if you put more than 20% down, the banks could purchase after-market bulk insurance on pools of these "conventional" mortgages from CMHC or through private insurers.
And boy did they! I wrote about this in a post titled "Credit tightening and the end of the Canadian housing bubble" and also in a Macleans piece titled, "The REAL Canadian bank bailout."
So it's no wonder that banks are suddenly very picky about what they will lend on in the low ratio segment. While it may appear that a 70% LTV loan has a built in 30% equity cushion, one needs to look no further than the 30% severity ratio reported by CMHC and Genworth Canada (which have similar capital recovery processes for their insured mortgages as the banks have for their uninsured mortgages) to realize that a 30% "equity cushion" is in fact little cushion at all.....particularly in a falling market.
Where this becomes important to the condo market is in the fact that presale deposit requirements today are edging higher, a clear indication that even the developers are nervous. An investor putting a 20-30% deposit on a condo today may find that when it comes time to secure final financing, the banks may balk if current trends are any indication. Preconstruction requirements ask that buyers get pre-approved for a mortgage, but this is simply to establish the capacity to borrow. It is NOT a firm commitment on the part of the lender to extend financing when the project completes. And if current credit tightening and procyclical lending trends continue, pre-construction buyers (and particularly investors) may find it very difficult to obtain financing at appealing rates when the unit completes....if they can find financing at all. This could force the buyer into a very uncomfortable position to say the least.
The bottom line:
The risks to the Toronto condo market remain extremely elevated and I would strongly caution any individual thinking of buying in this segment to instead sit on their cash and see how the market plays out over the next year. Prices are already softening and there is VERY little chance that you'll lose your purchasing power. Rapid price appreciation in this market segment is just not in the cards given current trends.
For assignment holders looking to sell now.....good call! And good luck with that.
For investors thinking of buying a unit in this market, particularly pre-construction, give your head a shake! Then email me. I've got some swamp land in Florida to sell you.