Juggling Dynamite

In December 2017, the Bank of International Settlements (BIS) reported that Canada’s highest population areas were home to the most over-valued realty prices, relative to rents and income, of anywhere in the world.

According to a recent CIBC and Urbanation study, 48% of all newly completed condominiums in the greater Toronto area since 2017 were purchased for the purpose of renting out. Still, nearly half in 2019 were negative carry—not making enough rent to cover their holding costs.  Thirty percent of those studied were paying an interest rate greater than 6%, and one in six were paying a rate of more than 9%.

Now a perfect storm of rent-depressing factors is hitting many of the most expensive urban areas in 2020 as fewer short-renters are travelling, immigration pauses, post-secondary schools move online for the fall, new work-at-home employees seek space out of city centers, and millions look to lower expenses by consolidating with extended family and other roommates.

In just April, the Greater Toronto Area (GTA) saw a 91% increase in new listings of furnished condos from a year earlier.  In early May, the median monthly rent for a condo leased in the GTA was $2,200, down 4.3% from the same period a year ago while the number of signed leases fell 42.5% (source: Urbanation).

Capital Economics projects that rents are likely to decline by at least 5 to 10 percent in Toronto and Vancouver this year.  An additional 60,000 new condo units are presently under construction in Toronto, and 20,000 more are expected to be completed annually over the next two years.

This is a bad time to be a highly leveraged owner of Canadian real estate. As John Pasalis, president of brokerage Realosophy Realty, notes many people “overextended themselves” to buy multiple properties in recent years.  See Pandemic puts downward pressure on residential real estate:

These were investors who, a year ago, couldn’t care less if they were cash-flow negative [by] $500, $600, $700 a month on their condo investment, because in their mind that was going up 10 per cent a year, so it didn’t really matter,” Mr. Pasalis said. “Well, in a recession, you can’t be cash-flow negative on two or three or four rental properties. That’s going to destroy you.”

In turn, some investors could be forced to liquidate their units, which could weigh on resale prices, Mr. Brown of Capital Economics said.

“With property investors basing their price expectations on the assumption that rents would instead keep rising strongly, this represents a big risk to house prices,” he wrote.

As Canadian banks begin reporting their second-quarter earnings this week (for Feb thru April), Bank of Nova Scotia was first on deck with a 39% drop in profits and a 111% increase in loan loss provisions. Since business lockdowns and layoffs only surged in the latter half of March, half of this quarter was still pre-COVID-19.

It is important to note that the millions in loan payment deferrals presently in place are not yet counted as defaults.  We will have a better sense of how many deferred loans will be defaults and ‘bad debts’ for lenders after the emergency deferral period ends.  Presently, that is to happen in September, but there could be a further extension granted.

The segment below offers a good overview of the issues unfolding for the Canadian banks.

Nigel D’Souza, financial services investment analyst Veritas Investment Research, joins BNN Bloomberg to discuss what the Canadian banks will likely report as the quarter is set to reveal the beginning damage of COVID-19 to the financial sector. Here is a direct video link.

The problem is that many Canadians are missing large chunks of their income even with massive government support, so debt payment deferrals have slowed but not helped the insolvency crisis spreading through many households and businesses today.  Moreover, lost income is not bouncing back soon for many as spending remains subdued and companies look for ways to keep costs down.  Some of the millions of jobs lost will not be coming back at all; others, as in past cycles, will take years to recover.

After falling 40% between February 20 and March 23, Canadian financial sector shares (XFN) are today still 27% below the February peak.  We will have a better sense of where loan losses and financial profits lie as we head into the 4th quarter, as well as how all-important home prices are impacting the balance sheets of households and their lenders.

The push for aging owners to downsize expensive-to-maintain real estate was underway in Canada well before 2020.  Now, losses in investment portfolios and the present recession are likely to motivate more sellers to list.

The latest survey from Point2Homes finds that the percentage of Canadians saying they intend to buy a home in the next six months decreased to 24% in April from 31% in March, and 37% of those looking to buy say they are interested in a less expensive home, compared with 27% at the end of March.

If they wait a while, buyers, who are able, may well find the cheaper offers they seek.

“It’s going to take years – maybe three, four, five years to even get back to normal, and that’s assuming we get a vaccine,” Economist David Rosenberg explained in an interview with BNN Bloomberg Monday. Here is a direct video link.