The COVID-19 pandemic has wreaked havoc on Canada’s real estate market —a traditional economic pillar. Sales activity in early spring was the worst in 40 years. That leaves us with a big question: Is real estate still a worthwhile investment?
Here’s a quick primer on what to consider in a pandemic-impacted real estate market.
Airbnb Goes Bye-Bye
By the end of March, when residential housing activity ground to a halt, many armchair economists were predicting the collapse of the condo market, particularly in the larger cities like Toronto. The theory was speculative investors had bought on the expectation of earning a profit based on the exponential growth in the short-term rental business. (In just 11 years, Airbnb, alone went from nothing to a company worth $31-billion USD.)
What wasn’t factored in was how damaging this short-term rental business had been on urban rental supply. In a report released in mid-January, Jordan S. Nanowksi, economist and senior analyst at the Canada Mortgage and Housing Corporation (CMHC) wrote, “despite increased purpose-built rental completions, demand for rental units still significantly outweighs the available supply [in the GTA], which creates tight rental market conditions where landlords can charge new tenants higher rents.”
According to a recent Rentals.ca report, the prevalence of short-term rentals in Toronto removed as many as 5,000 rental units from the market for long-term renters.
When Covid-19 containment measures were introduced, they essentially eliminated all short-term rental transactions. Many landlords responded by listing their units in the long-term tenant market.
This sudden increase in supply, prompted a drop in rental rates. In Toronto, the average rental price dropped 5 per cent (both from March to April and year-over-year from April 2019 to April 2020), according to a report released by Torontorentals.com and Bullpen Research and Consulting Inc.
Cleaning House
Recently, the Bank of Canada stated that the nation’s financial recovery from the impact of this pandemic will be long and bumpy. But even as the economy starts to return to some kind of normalcy, the housing market will continue to feel downward price pressure.
While current low mortgage rates will stimulate some activity and fewer units built and released should prevent a glut in supply, investors will still hesitate to take the plunge amid a softer labour market.
As CIBC economists, Benjamin Tal and Katherine Judge, wrote in an April economic report, “we expect to see average prices [drop by] 5% to 10%, relative to 2019 levels, with high-cost units in the high-rise segment of the market seeing the most notable price declines.”
Appraisal Rates Tag Along
Appraisers, particularly those working for big banks and mortgage lenders, rely on recent sales data to have comparable properties for their reports. As sales fall, this will likely translate into falling appraisal values along with a drop in approved loan values.
Falling appraisal rates are also a concern for potential real estate investors. In general, investments are measured based on their return on equity (ROE). This measures how effective the investor (or manager) is at using the assets to create profits. However, for real estate, a simple formula known as the ‘cap rate’ is used. The ‘cap rate’ (or capitalization rate) divides the net operating income (the rent a landlord collects, minus any expenses) by the property’s appraised current market value. This rate estimates an investor’s potential return. Higher cap rates indicate a potentially lower return on the investment and, therefore, a higher degree of investment risk.
Offsetting the declining net operating income (rents) and property values is a lower borrowing cost. The current ultra-low mortgage rate environment makes it easier to finance and use leverage when investing in real estate—for those with the experience and financial resources to do so.
Over the long run, rental rates and property values trend up, just like stock market prices. However, that doesn’t mean that real estate investing is fail-safe—a common misunderstanding. Many people lose money on real estate investments in good times and in bad. To be smart, the real estate investment needs to be cash-flow positive both in the present and five years from now. For those who think real estate investing is “easy money”, it’s important to ensure the numbers make sense before diving in. If making a profit from real estate investing were truly that easy, everyone could do it successfully and, sadly, many don’t.
