Investors have played a large role in the Canadian housing boom, accounting for a large and growing share of buyers in recent years. This is a double-edged sword. On the one hand, outright speculation adds to market froth, stretching valuations and affordability. At the same time, investors help bring new projects to construction and much-needed rental units to the market. Does real estate investment make sense at this stage of the cycle? And if not, what are some implications?
The path and near-term expectations for interest rates have driven real estate activity. Three major questions as they relate to the mortgage market: Are interest rate hikes done? When will we see rate cuts? And, what level will rates settle into through the next cycle? The near-term outlook is becoming clearer with inflation fading closer to the Bank of Canada’s target. That, combined with softer economic data, should compel the Bank of Canada to keep rates on hold, likely leaving this tightening cycle complete. Rate cuts remain a story for next year.
The more important question for investors with longer time frames surrounds where rates settle. Those banking on a return to COVID-era lows, or even levels that prevailed during the past decade, could be disappointed. Indeed, the post-GFC era of global disinflation pressure, deleveraging in the U.S. economy and suppressed interest rates could prove to be the exception rather than the norm. Looking ahead, it would be wise to assume that neutral levels of mortgage rates are higher than in the past decade. With our forecast for interest rates as a guide, that means mortgage rates in the mid-4% range are again ‘normal’.
Weaknesses of Real Estate Investment
An interest rate environment that has reset higher requires an adjustment in valuations across asset classes. We’ve seen it in the bond market; we’ve seen some of it in the equity market; and, we are in the process of working through it in real estate. Focusing on the residential sector—and using Toronto as an example—cap rates have historically traded roughly 1.5-to-3.5 ppts above 10-year GoC yields. But, the abrupt backup in bond yields has all but eliminated any meaningful spread. If history is any guide, cap rates that shrunk to around 3.5% at the market peak are likely in the process of resetting higher, to around 4.5%-to-5% based on our current interest rate outlook. This can come quickly through price declines, or more gradually through robust rent growth.
From a similar perspective, a new income property investor would be deeply cash-flow negative with 20% down at current prices and mortgage rates, and a 25-year amortization. While this was the case before the tightening cycle as well, it was mitigated by the fact that ultra-low rates allowed a building of equity below the surface. Now, investors are largely cash-flow negative even on the interest portion of their payments. Unless prices are rising at a brisk pace, which they are not, the case for investment is a tough one to make at this time.
The economics get even tougher on a relative basis given that investors can secure better yield in dividend stocks, or sit tight in risk-free cash/government bonds until conditions are better. The comparison to dividend stocks is an especially interesting one because both offer long-term capital appreciation potential, and both will see their payouts grow over time at least in line with inflation. But, dividend investors also benefit from a much lower tax burden (39% at Ontario’s top marginal rate versus 54% for rental income); they have access to instant and partial liquidity; and face minimal transaction costs. At the same time, payout risk is generally low, especially when diversified across a basket of stocks. In the rental market, however, small investors are highly exposed to non-payment risk, especially considering rental laws are tilted heavily in favour of the tenant, and given long backlogs in resolving conflicts. Real estate investment should command a risk premium (it historically has), but current pricing does not offer one.
Strengths of Real Estate Investment
Leverage is a big equalizer in real estate. After all, you typically don’t buy a $1 million equity portfolio with 20% down. Steady long-term gains in real estate, along with persistently declining mortgage rates, have made leverage a powerful force juicing real estate. Of course, the tables can also turn in an instant, as many pre-construction ‘investors’ who had no intention of closing on and/or renting their properties are about to find out.
That aside, the long-term performance of real estate in Canada has been impressive. Going back to 1990, we estimate total annualized returns from a simple Toronto rental apartment would have run at about 7% annualized. Direct comparisons with equities and bonds are very difficult because of different tax treatment, capital expenditure requirements, and the inability to reinvest rental income back into fractions of real estate (unlike a dividend reinvestment program). But the point here is real estate has held its own, and with less volatility.
Meantime, real estate has a proven record of inflation protection, and ownership of a physical asset during times of widespread inflation uncertainty might be one of its most favourable aspects. Table 1 shows inflation-adjusted price changes across various asset classes, and both Canadian and U.S. real estate have held their real value during times of inflation, outperforming stocks, bonds and cash.
Market Impact
The current environment suggests that investors are backing away from real estate, largely because the cash flow arithmetic doesn’t compute, and robust price gains are far less certain. Anecdotally, pre-sales are under pressure and some new construction projects are being shelved. According to Urbanation, new unsold Toronto inventory is near 20-year highs. At the same time, there are 380k units under construction across Canada, a record high in both raw and per-capita terms. As these come to completion and spill over onto the resale and rental markets, it could take some pressure off affordability.
However, given that investors play an important role in pre-selling projects, allowing builders to secure financing and break ground on construction, a dearth of investment demand would weigh on new construction in the years ahead. It has been abundantly clear all along that lofty supply targets are not the solution to the affordability crisis, most simply because they just can’t be hit—and this backdrop reinforces that. Bank of Canada rate hikes have appropriately taken the speculative froth out of the market, and policymakers should also ensure that international immigration flows—another demand-side factor—are calibrated appropriately.