Today's Main Story is Not the Suburbs, it's the Condo Sector
Overview of important developments in the Toronto Metro housing market and macro reported in May 2022
Price declines in the suburbs are dominating headlines, which is understandable due to the magnitude.
However, those declines are partially caused by temporary factors (explained in Apr 2022 newsletter) and are not fully supported by the market balance. Market balance1 reveals that the condo sector is weaker today than the overall GTA market and it’s actually weakened faster in May. The condo sector is the main story today in my view and it is behaving similarly both on the Toronto Metro and city levels.
Before diving deeper into details I’ll start with an overview of the whole Toronto Metro market and then return to condos later on.
Resale Market
Important note: CREA changed the methodology of benchmark price2 calculation (link) which requires re-calculation of all historical data. Until it’s done I will be adjusting benchmark price data based on the old methodology and as a result benchmark prices presented in this newsletter will differ from the latest officially published data. It’s the necessary step to retain the link to the historical data. After historical data is re-calculated latest readings will start matching the new official TRREB reports.
Toronto Metro market continues to weaken. Market balance indicators differ but overall the market should be balanced. Keep in mind that the market balance indicators provide just a guideline based on historical correlations, the actual price changes define what kind of market we are in. Based on the price changes and Sales-to-New listing indicator it’s a Buyer’s market already.
Here is also a historical context for those metrics. Sales-to-New deserves attention, it’s very low based on historical data but so far it’s not unprecedented.
All price metrics continue declining
Overall Toronto Metro prices are down by about 10% compared to the peak.
Active inventory is growing rapidly but still remains historically low
Sales are below the 10-year average and continue to decline on a seasonally adjusted basis.
especially in the luxury segment
Despite the weakening, there are already some signs of the forces which could lead to the stabilization of the prices. For example, the pace of active inventory growth is slowing down.
It tells me that the sellers are not panicking but rather getting increasingly convinced that it’s a bad time to sell so it’s better to wait it out.
Rental Market
Toronto Metro rental market remains tight and maintains pretty much the same level of tightness.
Rent prices are growing and are expected to continue doing so in the short term.
Condo Sector
I highlighted the importance of the condo sector in my previous newsletter (link). The fact that it continues weakening faster than the overall market convinced me to put it directly in the headline of today’s newsletter.
I’d like to elaborate on why I believe it’s important. First of all, I don’t see any signs of relative overvaluation of the condo sector compared to single-family which could’ve justified relative weakness.
When mortgage rates are rising, impacting affordability, demand should shift to more affordable options with condos being “the last shoe to drop”. The fact that the opposite is happening today is abnormal and deserves attention.
What could explain it?
I was following Toronto Metro condo investment math very closely in 2021 and selected it for one of my top 5 charts of the year (link). Investment math made sense in 2021 but that situation drastically changed in 2022 as a result of rising bond yields and mortgage rates. I was laser-focused on this topic and provided regular updates in my newsletters (link1, link2, link3, link4). Cash flows for new investors deteriorated to the point where it’s challenging to have a positive cash flow with a 20% down payment and a discounted 5-year fixed mortgage rate even after principal payments recapture. Here is the latest estimate.
Unlike in 2017, investment math doesn’t make sense today and it may explain why condos are weakening faster - the market could be losing interest from investors.
To understand if it’s the buyers or sellers behind condos’ underperformance let’s break it down by sales and new listings to see how those two are changing individually.
If we compare the change in sales since March 2022 between Toronto Metro condos, Toronto (416) condos, and the overall Toronto Metro market we can see that the demand is declining faster for condos, and also more new listings are added.
Both weaker sales and stronger new listings contribute to the relative weakness of the condo sector with sales decline responsible for 67% of that weakness since March 2022.
Another discovery is that the sales decline for Toronto (416) condos is not much different from the one for the overall Toronto Metro condos. To me, it is an indication that segment-wide (rather than location-specific) changes are happening which could be explained by a decline in the demand from investors who were very active in condo sectors in recent years. Another possible explanation could be related to the permanent nature of the partial work from home setup which would make smaller condos less attractive as an asset class.
Condo prices are holding up better than the overall market but are declining as well.
To check longer-term condo investors’ sentiment, high-rise new construction sales were inspected. That’s where investors traditionally dominate with 70-80% share of sales. Here is a great study by CIBC & Urbanation from 2018 focused on condo investors and their importance to the market.
“If you want to understand the GTA housing market, you have to get into the heads of condo investors. While the focus is often on foreign investors, the key to the future of the region’s real estate market may be held by domestic investors. Never before has the role of these investors been so great in generating demand for and influencing future supply of condo units. With tougher qualification criteria, rent control and rising interest rates potentially working to change the economics of that investment, how will these investors react? What’s their prime motivation? Cash flow or capital appreciation? Any change in their behaviour might have implications for the condo market — which last year accounted for a record-high of no less than 80% of all new home sales in the GTA.” (link)
It turned out that new condo sales declined only slightly in April.
Data is being released with a lag so this is the latest available one. As of April, new construction investors remained pretty confident.
That strength can be justified. The rental market is tight and rents are rising, mortgage rates are high today but they may decline by the time units are completed. The price declines we are seeing today could be viewed as a temporary weakness. Instead of investing in today’s bad resale environment, the new construction segment is providing investors an opportunity to bet on the positive future outlook. All those are speculative assumptions but that’s how futures markets work, including the new construction segment. For some investors, it’s not a choice, they simply can’t afford to invest in today’s resale so new construction is the only option. Based on the proxy data price premium for new condos is not terrible today.
To sum it all up, it’s not undeniably clear that condo investors are capitulating. I believe that it’s likely happening in the resale segment but at least longer-term views on the condo sector remain strong among investors (as of Apr).
Going forward, continued strength in new condo sales could be explained by the justification provided earlier and a significant decline in new condo sales would be a sign of longer-term (4-5 years out) expectations collapse by condo investors.
To obtain an insight into the latest state of new-construction condo sales, I approached one of the Real Estate industry experts - Jordon Scrinko (@ScrinkoCa) and he characterized the latest new construction sales in the following way:
“Absorption has dropped precipitously on new launches since Feb/March”
Please keep in mind that it’s based on a very narrow subset of data, official data for the whole market will be released later.
Another 0.5% increase by the Bank of Canada
Bank of Canada raised interest rates by another 0.5% on June 1st. This is the third consecutive increase and the second 0.5% one. The Bank of Canada is trying to catch up with inflationary pressures and keep long-term expectations around 2%. Based on the current market pricing, another 0.5% increase in July is a certainty for the US (assuming a 0.5% hike in June), and likely for Canada.
A variable mortgage rate is catching up with the fixed one but is still significantly below it.
I was in the inflationary camp since 2020 (link) but given how much pressure both inflation and the current interest rates create I don’t think we are going to see both fixed and variable discounted mortgage rates(as presented on the chart above) exceeding 4% during this business cycle. I could be wrong, time will tell. Meanwhile, I put my money where my mouth is. (link)
Just to clarify, structurally I believe inflationary forces will persist so 5% mortgage rates could be a worry during the next business cycle, but unlikely during the current one.
Conclusions
Toronto Metro real estate market continues to weaken. So far the market performance is somewhat similar to 2017 which was a mild correction.
It is reasonable to expect the correction to continue and exceed the 2017 level but I see no evidence of the market confidence collapse. Active inventory, which is an important “fuel” for price corrections, is still way below the historical average and 2017 level, and the pace of inventory growth is starting to slow down already which is a stabilizing factor.
At the same time market is fully anticipating another 0.5% rate hike in July by the Bank of Canada so it’s reasonable to expect demand to continue declining. That should help price correction to progress in the coming months.
The condo sector is weakening faster than the overall market which is the main story today. It is driven by the bigger sales decline and also the higher number of new listings. I believe investors are the main force behind both of those developments since investment attractiveness deteriorated to unprecedented levels for the first time in many years. New construction condo investors with units completed this year are facing cash flow issues they likely weren’t expecting.
New construction sales declined slightly in April but remain elevated indicating investors’ confidence about the condo market 4-5 years down the road. Based on some anecdotes the latest new condo sales are much weaker but there is no official data available yet.
Taking into account challenges for investors and unprecedented housing unaffordability for homebuyers it’s reasonable to expect sales to decline further. The question is what sellers are going to do: will they stop listing and stabilize the market, will they panic-sell or will we see a slow addition of excess listings due to forced sales? Within a couple of months, I believe we should get an idea.
Months of Inventory shows how many months are required to absorb current active inventory at a current level of monthly sales. The lower the value, the stronger the market.
Sales-to-New Listings measures market balance by comparing the number of sales within the last month to the number of new listings during the same period. The higher the value, the stronger the market.