Economists expecting “substantial declines over the next year or two”.

Feature Picture The recent Global Forecast Update (Scotia Bank, 2013) illustrates how deleveraging of the private and public sectors coupled with geopolitical unrest, an expanding income gap, and euro zone unemployment could still put the moderate global economic recovery into a tailspin. The Update supports central banks around the world continuing to maintain borrowing costs at “exceptionally low levels”. We can then expect the overnight rates to stay very low for the next while, or at least until 2015 claims the Update. As we will see, this is good news for consumers looking at borrowing for real estate investments.

With over night rates as low as they are, it’s a wonder why people are not cashing in on variable rate mortgages. There is a good reason not to lock in your mortgage if rates are projected to remain the same for a while. Utilizing the lower interest rate of a variable rate mortgage in the short run allows you to contribute more towards your debt now, in turn saving you a lot of money in the long run, possibly when you’re locked in and after the rates have increased.  Though variable rates aren’t as popular as they use to be, the inflated price of Toronto real estate still means big savings. Amortized over 15 years, the premium paid for a fixed rate $750 000 mortgage can be as high as $150 000. Yet people are still lured into fixed rate, and in some cases even locking in their mortgages, despite the fact that variable rates will save them money, now.

Of course inflation could also deal interest rates a major blow, this is an especially large concern given the amount of cash and frequency of Quantitative Easing that the Federal Reserve has been using to support the American economy. However American government bonds have been steady for at least a year and this supports the idea that we are not in for significant increase in inflation in the near term. Though American dollar inflation would not be good for its Canadian counterpart, the Canadian dollar could weather the storm as long as its not intentionally devalued.

The combined mix of record low mortgage rates and a vacillating housing market then begs the question of whether or not a consumer should buy now; and it looks like the answer is a firm no, do not buy for the next while. The Bank of Canada has recently warned that Toronto’s condo market is severely inflated, and the Economist (2013) has made the grave suggestion that a correction on Toronto real estate, specifically the condo market, could be as much as 78%. The Bank of Canada alerts, “A specific concern is that the total number of housing units under construction has been increasing and is now well above its historical average relative to the population”. The Bank cites their three main concerns: the escalating number of unsold units; a stall in condo demand relative to the supply and asking price; and, that the square footage of newer condos has been steadily decreasing, a trend largely driven by greedy investors.

A recent study by Capital Economics (2012) agrees, contending that the Toronto condo market is in fact in a bubble, and ready to burst. The report cites as their main concerns, the unwillingness of condo developers to drop prices, cancelations or delays of new condo projects, and a worrying demand in decrease. David Madani, an Economist with Capital Economics, says that “There is always a stand-off period at the end of a housing bubble when prospective buyers refuse to meet the price of sellers, who refuse to drop the asking price . . . eventually it begins to dawn on sellers that the market had shifted”. It would seem as though we are at the precipice of such a moment. David continues by saying he expects “substantial declines over the next year or two”.

This stagnation experienced by the condo market is largely driven by simple over supply. There are currently 147 high rises under varying states of land acquisition and construction in Toronto. When completed, these will add an additional 56 000 condos, to an already saturated market. Ohad Lederer, an analyst at Veritas Investment Research, shows that the demand for all these condos is driven 50% by investors and their “shoddy mathematics”, who are currently earning a risk adjusted dismal four percent return before inflation on their condo investments. Lederer continues by saying that if rental rates fall as current projects near completion there could be an excess of as many as 5 000 units, leading to a decrease in both rental rates and purchase price.

Toronto

However it would seem that the problem is largely restricted to the condo market. As evidenced by the graph, the deviation from what the bank calls “Historical average per person” is mostly, if not all, accounted for by the condo market. So, it looks as though semi, and detached house will remain as a safer or a less risky wager when buying. Though the bank warns that, if severe enough, a housing drop could spread beyond condos.

It is worth mentioning that despite the rhetoric, Torontonians, and Canadians on the whole are highly unlikely to experience a drop, which could be compared to the one experienced by Americans in recent years; our mortgages are backed by taxpayers through the Canadian Mortgage and Housing Corporation.

What does all this mean then? If you are an investor, I would propose a move to take advantage of current interest rates and borrow against your equity in Toronto real estate to hedge your bets in another distant and safer market such US sunbelt properties, which have recently bounced from these historic lows and are attractive to northern snow birds. If you’re looking to buy in Toronto, I would wait at least a year to enter the market. The more conservative estimates are that Toronto real estate will detract at least seven to eight percent, 2013 looks to be a critical year for Canadian real estate; one worth observing and not participating in. Hopefully by next year we will have a more concrete picture of where real estate is going in the future, and its place in the Canadian economy.