OCTOBER 13, 2011
The mental gymnastics are ramping up:
I've had a few interesting conversations lately regarding Canadian house prices in general, and the Toronto condo market in specific. Consider some of the comments coming through my Twitter feed by very intelligent people:
"preservation" is the goal...Thats why we are seeing move to condos and low yield apt buildings
Bond yields low, europe, us not well, middle east restructuring...peeps need to put $ somewhere
Many investors do not care about the monthly return on condos they now want to safeguard their intnl $
There's no doubt that there is huge demand for condos in Toronto (and everywhere in Canada it seems). We know that the latest estimates by Urbanation is that as much as 60% of new condos in Toronto are being purchased by investors, and this rises as high as 80% in the downtown core. Yet we also know that these condos do not cash flow using a traditional financing model of a 20% down payment.
Despite this, the current level of demand has been projected well into the future, as current starts attest to:
And we've seen that the current pace of highrise development in Toronto is massively outpacing New York and Mexico City, cities with 3 times the population of Toronto and twice the population of the GTA:
Despite the rampant 'investor' demand, prices have actually massively outpaced rents in Toronto using either the CPI rent index or CMHC's rent index, which should cause us to question just how intelligent these new 'investors' really are:
Of course this has the effect of compressing the 'yield' generated by these condos to the average investor. It's to the point now that the yields generated by these condos on an "all cash basis" (i.e. if you paid for it in full) are comparable to long government bonds once strata fees and property taxes are accounted for. And they fall well below the cap rates generated by the new residential holdings of most REITs, and even below the short-term bonds issued by some excellent corporations with strong balance sheets and earnings power. Something here doesn't compute.
If it's safety of capital and exposure to the Canadian dollar, Canadian bonds ought to be the primary choice.
If it's for a long-term investment, well, these investors have their blinders on. Cap rates for condos in many large US cities easily enter the 7-8% range. Good luck finding that in Toronto or Vancouver. You're lucky to get half of that. Any real estate investor understands that higher cap rates mean not only stronger cash flow, but also greater potential for future capital gains. Lower cap rates inherently means greater risk to your investment, a fact Canadian 'investors' seem willing to ignore for the moment.
So what's really the motivation?
Last week, Colliers International released a report with the following headline:
Some key quotes:
An overwhelming majority (86 per cent) of Canadian respondents indicated they are planning to expand their portfolios over the next six months. This is distinctly higher than the global investor stance (71 per cent) and up from 61 per cent the previous year. Furthermore, two-thirds (68 per cent) of Canadian investors believe the market will continue its upswing trend over the next 12 months.
The level of optimism expressed by Canadian investors is also translated into increased tolerance towards risk. Nearly two-thirds (64 per cent) of the survey participants from Canada confirmed they are willing to be more risk aggressive, the strongest level of risk tolerance among all regions surveyed globally.
This is not a market driven by international money seeking a safe home. While that is certainly happening, these are foreign speculators, not investors seeking a safe haven. The market is driven overwhelmingly by domestic demand, financed by easy access to cheap credit, with that debt being serviced in local currency either through local earned income or the pitiful yields the holdings are generating. This is a market currently sustained by speculators hoping to catch on the momentum train. What foreign capital currently is entering this market will cease as soon as momentum slows and the prospects of future capital gains diminishes. Once that happens and the speculators are flushed out, we'll quickly find out how condos are being priced by the true investors.
Condo starts nationally set to drop?
On a national basis, condo starts have remained strong.
Yet interestingly, this is at the same time that newly completed and unoccupied condo units are hitting levels not seen since the late 80s.
For the time being, unoccupied units in Toronto are relatively low, but have been rising. Inventory in Vancouver is very high compared to the levels of the past decade, certainly suggesting that the hot foreign money entering that city is starting to wane:
The bottom line is that this demand is not being driven by a flight to safety or preservation of capital. What foreign capital is flowing into this market is primarily speculative in nature. This is a market driven by Canadians taking on debt to jump into a temporarily self-sustaining market that is now reliant on more participants rather than fundamentals to justify current prices. Good luck to those taking the plunge.