Welcome to my blog on design, culture and housing in Toronto, Ontario, Canada.
For many, it’s hard to envision Toronto – a city that has experienced near consistent market appreciation for a quarter of a century with nary a dip outside of the occasional value flatline – experienced a calamitous housing crash. But it did. In 1989 when, over the course of 6 years, real estate prices steadily dropped as much as 35%.
Do you own property? If you knocked off 35% off what you believe your place is realistically worth, would you be in negative equity, a break-even position, or still ahead of the game? Would you hand your keys to the bank and say “See Ya” or would you slog on making mortgage payments for a debt that surpassed the value of your property? It’s a sobering thought. And to think it happened only 3 decades ago which isn’t that far in the past.
And yet, it was a different time.
In 1989, the World Wide Web had just been invented, and cell phones were still analog. They were also the size of a brick. I remember the time a customer came into the restaurant I worked in and while dining alone, sat proudly opposite his brick with a big status smirk on his face waiting for a call that never came. Meanwhile, my co-workers and I were in the back cackling “What is he: Get Smart? He should just talk into his shoe!”
Can Negative Carry Become Negative Equity?
While the risk-averse give plausibility to a Toronto real estate market correction, few can fathom a substantial decline. People tend to frame a correction at most within the context of the stock market, where a reasonable range of volatility dips somewhere between 10% and 20%.
Furthermore, the 35% decline in prices wasn’t unique to Toronto either. According to the Washington Post “10 Years Later: How The Housing Market Has Changed Since The Crash” the 2008 recession in the United States saw real estate prices fall an average of 33%. And how many people saw that coming, besides John Paulson?
In 2017, “CIBC found that Over 44% Of Toronto Condo Investors Don’t Get Enough Rent To Cover The Mortgage” meaning they were in Negative Carry which is when you make up the shortfall between the income you’re earning and your out of pocket expenses. Many investors who do this claim depreciation – called capital cost allowance – to bring their net rental income down to zero, knowing that upon sale of the property, the CCA is brought into income and taxed, typically at a high tax rate.
For investors who run their rental property at a loss, it does not make it a bad investment, as one’s return is not based on cash flow alone. After all, one’s ROI is = to the total of the initial investment + the increased net equity annually + the cash flow. But it does have more risk, which is why anyone who engages in the market this way is defined to be a speculator rather than an investor because carrying at a loss implies the owner of the property is speculating on future price gains.
Given how significant the percentage of Toronto condo investors fall under this definition, it does make me wonder how many of them could weather a storm, in terms of ensuring they can personally meet their cash flow requirements, an increase in interest rates, or an unexpected special assessment.
I also have one beef with many Toronto realtors, because there has been a devolution in the provision of detailed comprehensive Income & Expense statements for investment rental properties and, a byproduct is a tendency for property investors to overlook or sidestep what was considered 15+ years ago essential criteria to assess whether an income property was a sound investment.
Which is why today I want to bring to your attention what USED to be essential to provide buyers in terms of documentation, and compare that to what is offered today – as well as some commentary on the accompanying market conditions, the interest rate environments, and the compounding effect of the pandemic!
Then & Now Investment Fundamentals
When I began selling real estate 30 years ago, property investors were looking for capitalization rates – the rate of return on a real estate investment property based on the income that the property is generating – of around 10% to 12%, instead of the 3.8% to 4.8% returns that are typical in downtown Toronto now. Although both of these returns were slightly higher than the mortgage interest rates during these times, the criteria by which a Cap Rate is promoted on a MLS listing today comprises an extremely limited Income & Expense Statement – one that rarely includes the true costs associated with owning and operating an Income Property.
At one time the economics were both much more detailed and comprehensive, and included the following:
- a vacancy allowance (of course when a tenant vacates the subject suite may be empty for a period of time. Back in the day it was expected your Income & Expense Statement accounted for any lost income)
- advertising costs or realtor expenses to rent the subject property
- property management fees + service costs like lawn care or snow removal
- a summary of annual maintenance and repair expenses since the property last sold, etc.
- annual property taxes
- all utility bills
- building insurance fees
Very rarely is any of that information included in a property listing today, despite the indisputable fact that these are serious costs to consider!
And understanding true costs is essential to really understanding viability of an investment- and whether or not it makes sense for your goals and timeline. I talked about the importance of anticipating costs- including taxes in my recent post Dear Urbaneer: How Might CRA Taxation Affect The ROI Of An Investment Property?
Let’s talk about rental income, first. Back in Oldie Times, a listing would include a detailed summary of the current monthly rents being paid by the existing tenants, with details like whether the tenants were month-to-month or on a lease, their original occupancy date, a summary of all the rent increases each tenant has received and when, and confirmation the tenants had paid both first and last month’s rent (of which the last month’s rent is subject by law to earn interest throughout the duration of the tenancy). Copies of the original tenancy agreements were provided as standard practice.
Where’s The Accurate Credible Due Diligence Package?
Today, very little of this information is available as part of a listing realtor’s due diligence package and, much to the disdain of many co-operating brokers, it may take several emails corresponding with the listing realtor to get all this information. More likely what one will see on an investment property listing today is a brief mention of the current rents being paid (as a line item) with much more focus paid to what the dwelling’s market rents would really be if the existing tenant vacated and the suite was ‘refreshed’. These proposed market rental sums are often egregiously inflated, and accompanied without any detailed summary of what the costs and timeless would be to upgrade the unit in order to generate the proposed returns. Often this proposed Annual Income is dramatically higher than the amount the existing tenants are paying – especially long-term occupants who have made these dwellings their homes for a decade-plus – and in my opinion wildly unrealistic.
This current scenario is not only maddening but it goes against the tried and true fundamentals of making an intelligent income property real estate investment and illustrates that the playing field is very different than it has been in generations past.
I’m not entirely sure why this has occurred, but I can attest from the real estate trenches that the investor pool has definitely changed over the years. I discuss this in my post, The Growing Trend Of Financial Landlords In Toronto Real Estate. Pension Funds and REITs have a different set of rules, as well as greater access to capital and a different level of risk tolerance than the small ‘Mom & Pop’ investor. But as stated in my recent ‘multiple property’ bog – The Number Of Owners With Multiple Properties Is Increasing In Toronto – the profile of investors has changed as well, with a growing proportion of homeowners with multiple properties increasing. So even Mom & Pop investors, by and large, have deeper pockets than they once did, so if taking a loss in the short term to cash in on a rise of real estate prices is well within the risk tolerance, it’s part of doing business.
However, it doesn’t mean potential Property Investors should be fed unrealistic cap rates, nor a watering down of the real costs associated with owning bricks and mortar. All realtors should be obliged to provide a comprehensive due diligence package that outlines any information that may increase or impact cash flow and potential profits. After all, it’s fundamental to knowing what kind of return on investment the Buyer can anticipate with that specific income property investment purchase.
Property Investors Today Are Banking On Tomorrow’s Future Value
It’s unfortunate Property Investors now buy multi-unit dwellings based less on the fundamentals of the dwelling’s existing income, or even realistic market rents the property will garner, but predominantly on the potential future value or capital gain they will net. Income-producing real estate investment properties are no longer considered places that, in order to invest your money and get a return annually, you have a civic duty and personal obligation to provide its residents quiet enjoyment, the security of tenure, and a home to foster health and well-being. The humanity of the shelter industry has been lost to the capitalistic drive and obsession for greater profits, even if it means evicting a long term resident and denying basic human right to shelter during tough times. I’m focused here on- but am not limited to- REITs and Pension Funds.
This Bloomberg article from March 2021 “Condo Investors ‘Stealing Activity’ From Future Amid Low Rates: Tal” talks about how investors, lured in part by low-interest rates and a dip in prices after the early months of the pandemic, were snapping up condos. However, a CIBC study referenced in this report showed that 40 percent of those investors were operating at a negative cash flow, banking instead on accelerated price appreciation to create wealth. Wowsers!
In the past, generating a positive cash flow was considered an integral part of an investment property portfolio. It was also about mitigating risk. If you are running your investment today at a loss, you run the risk your margins will inevitably get squeezed, especially given the Canada Revenue Agency typically grants you about five years of negative returns before they red flag you and delve a little deeper with an audit. And it becomes even riskier if the property in question requires significant capital investment to make it safe and sustainable – and you as the Property Investor have neither the interest nor the resources to ensure the dwelling meets Building or Fire Code.
The Interest Rate Environment & Property Investors
Yes, many property investors leverage their purchase through mortgage debt and lines of credit – and for some investors those debts are quite high. Although the Bank Of Canada (BOC) held interest rates in their most recent announcement on January 26th, 2022, the consensus is that rates will need to rise soon – and almost certainly multiple times, given inflation has spiked to a 31-year high! which, incidentally, aligns with the first and only time Toronto was experiencing a real estate bubble that burst.
Here’s a valuable Globe & Mail article, called, “Don’t Misread The Bank Of Canada’s Decision As Inaction. Interest Rates Will Rise, And Quickly.”
While there have been warnings from people for ages now around about the housing bubble bursting, without coming to pass, there is a different context around these new alarm bells. Namely, we are potentially facing incredibly high inflation, so interest rates will rise soon. Will the market pull back or pause, or is there so much capital available globally our market will just keep steaming ahead?
As this Bloomberg story, “This Red-Hot Housing Market Is Betting Interest Rates Will Never Rise” points out, the concern around affordability and rates rising isn’t as much based on the worry that homeowners won’t be able to afford their mortgages and start defaulting en masse, as happened during the 2008 sub-prime mortgage crisis in the United States, that blew out their housing market.
Rather, analysts are concerned about a softening of the market around property investors, who according to stats referenced in this article, own a fifth of properties in Canada. They also would be most likely to sell in the event of a market downturn, as the view these properties as investments more than shelter.
Just given the sheer numbers of investor-owned properties, this seems plausible. And given that most investors are leveraged – sometimes heavily and with multiple properties – they would be even more sensitive to interest rate hikes in terms of juggling debt.
And – when many people sell at the same time prices fall – sometimes substantially. We actually saw this happen real-time early in the pandemic in the Toronto condominium when the pandemic began on the heels of the City of Toronto implementing a policy prohibiting Airbnb rentals unless it was occupied by the owner or tenant (here’s my post called Airbnb Regulations And Toronto Real Estate).
The Example Of The Pandemic & The Condo Market
Now – few anticipated the pandemic coming when it did, nor the widespread and long-lasting restrictions that effectively dried up demand for condos, what with schooling moving online, borders closing and a new Airbnb regulations removing ‘ghost hotels’. As the demand disappeared many investors (particularly those in hi-rise buildings in specific locations) started to shed their units, with prices dropping around 10% in high-rise point towers that were heavily weighted with investor-owners. It goes to show there can be unanticipated elements of any market that extend beyond one’s control that can impact the returns on your investment.
This Financial Post article, “Toronto’s Languishing Condos Deliver ‘Reality Check’ For Small-Time Real Estate Investors” talks about some of the buyers’ remorse during that window experienced by investors hoping to cash in on rising property prices. For a full understanding of what the condo market experienced in the early days of the pandemic, check out my posts from 2020: An Overview Of The 2020 Toronto Condo Market And What Lies Ahead: Part One and An Overview Of The 2020 Toronto Condo Market And What Lies Ahead: Part Two
It’s noteworthy to mention that, now that those price declines and restrictions eased, the condo market has rebounded in a big way; demand is once again outpacing supply (“Toronto Star Condo Market Conditions Tightest In 20 years, Says Toronto Real Estate Board”), which means prices have again soared as well.
From the Toronto Star article: “there has been… a dramatic reversal of the early part of the pandemic when condo prices flattened while the number of available units spiked as investor owners looked to dispense with properties they couldn’t rent because of the outflux of tenants from the downtown.”
What this does demonstrate is that real estate is cyclical. And if, as an investor, you create an environment that hinders profitability through over-leveraging or having extra costs without cash flow to offset, you could be forced to sell. That’s great if you are selling when the market is up. But if you are having to sell when the market is the downturn of the cycle – which is when many that have to sell will – you could be selling at a lower price point than you had anticipated – possibly even at a loss.
The Risks Of Running At A Loss
Don’t forget there are costs to sustain while holding your property investment, which means you are running at a loss if properties are untenanted (which many of them were in the early days of the pandemic).
As a property investor who is breaking even or running at a loss, you are completely dependent on the price of your real estate growing to realize a return on your investment. One of the basic tenants of investing – in real estate, stocks or any type of investment is diversification. In addition to diversification, you need to have time on your side- which is why strategy is paramount. I talk about this concept in this post, Dear Urbaneer: Is It Better To Invest In Stocks Or Toronto Real Estate?
Never put all your eggs in one basket. Again, it goes back to mitigating risk.
This article “Risks to Avoid When Using Leverage in Real Estate” outlines mistakes that real estate investors make around leverage – including counting too heavily on price appreciation, ignoring the importance of cash flow and ending up with too high a payment, all of which erode profitability.
Similarly, this Forbes article “The 8 Things You Need To Know To Avoid Losing Money In Real Estate” warns prospective investors on high leverage, relying too much on price appreciation, negative cash flow, not having enough in the bank on reserve to maintain the property and sustain an untenanted property and interestingly- underestimating rehab costs for a property (which we will explore below).
Being a property investor can be very profitable, but it requires a sound strategy, a business plan, extensive due diligence and a patient timeline to weather investment cycles.
From my Dear Urbaneer series: I counsel a prospective property investor about –> Buyer Beware: The Pitfalls Of Owning Older Dwellings
Here’s some further reading for you!
Are you looking for a property with income potential? Decades of experience in the Toronto real estate market allow me to scrutinize and examine potential opportunities to help guide you to the right match. Sometimes that means having the patience and knowledge to walk away, keeping on eye on meeting your overall goals. We’re here to help!
May we assist you or someone you love?
Thanks for reading!
-The Urbaneer Team
Steven Fudge, Sales Representative
& The Innovative Urbaneer Team
Bosley Real Estate Ltd., Brokerage – (416) 322-8000
– we’re here to earn your trust, then your business –
*Did you know we were recently listed as one of The Top 25 Toronto Real Estate Agents To Follow On Twitter! – The Top 50 Blogs On Toronto – and The Top 100 Real Estate Blogs In Canada? Consider signing up in the box below to receive our FREE monthly e-newsletter on housing, culture and design including our love for unique urban homes and other Toronto real estate!
*Love Canadian Housing? Check out Steve’s University Student Mentorship site called Houseporn.ca which focuses on architecture, landscape, design, products and real estate in Canada.