How differing beliefs about the housing market between buyers and investors leads to very different market outcomes.
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A recent note from the CIBC argues that real estate investors cannot be blamed for high house prices. While this conclusion is technically valid, the real issues surrounding how investors impact the housing market are more nuanced.
When economists study housing markets, they first try to determine what factors are impacting house prices. If they observe a high share of investors in an area with rapidly rising house prices, they might assume that investors are causing the higher prices, in a relationship that looks like this:
For this reason, the CIBC conclusion that “it just isn’t clear that one can draw a cause and effect line from investor purchases to high housing costs for Canadians” is a reasonable one. But their statistical argument overlooks important issues when considering the role that investors play in the housing market.
In my April 2021 report, I argued that policy makers should consider macro-prudential policy measures that either make it harder or less lucrative for investors to invest in single family homes. I did not suggest this because I believe investors are the only cause for high house prices or because I think their effect on the housing market is inherently bad — investors have played an important role in adding rental supply to the GTA’s housing market.
My suggestion is instead aimed at mitigating the outsized negative impact investors can have on a market once it starts to see price declines — an issue that MIT economist Alp Simsek discusses here.
At the heart of Simsek’s argument is the idea that average home buyers and real estate investors have very different (heterogeneous) beliefs about the future direction of the housing market, which affects their behaviours and leads to very different market outcomes.
When prices are rising, real estate investors are more optimistic that prices will keep rising rapidly in the future which is why investors are typically willing to pay more for a property than an end user. Investors are often so optimistic they’ll buy a property with a negative cash flow (where the income isn’t high enough to cover expenses and debt payments) simply because they believe house prices will be higher tomorrow, something I’ve written about often.
From CIBC’s report:
"Our prior research found that Toronto area rents provide slim or even negative net cash flows to leveraged investors. Capital gains must therefore be their motivation, and climbing prices could be read by some as a sign of more to come."
But the optimistic real estate investors also tend to be the most leveraged - that is, they use a lot of borrowed money to make their investments, which means they feel the effects of a decline in prices far more than an end user. And it’s during a down market that beliefs about the future direction of the housing market suddenly flip. The optimistic investor suddenly becomes the pessimistic investor eager to exit the market to mitigate the risk of a further decline in home prices and hits to their balance sheet:
As Simsek notes:
"Now these guys will get disproportionately hit, because they were the ones loading up onto the risk in good times, so when the bad times come, their wealth share now will collapse disproportionately, and this means that now the swings on the downside will be much bigger because now a lot of the wealth is in the hands of the pessimists. So they will be the ones that are basically pricing risky assets like houses. So that's actually going to generate a downward swing the other direction. So this makes the asset boom bust cycle much bigger than it would otherwise be."
Toronto saw an investor driven boom in 2016/17 that saw a rapid acceleration in the price of suburban detached homes (which I identified in my report Freeholds on Fire). The decline in prices that followed was also largely limited to the segment of the market where investors dominated - suburban homes.
Today, optimistic investors are not fuelling the resale house market, but the market for pre-construction condominiums (pre-con condos), where units are now selling for nearly 40% more than the average resale condo in the central Toronto (old City of Toronto boundaries).
These elevated pre-construction prices are not a problem if resale prices and rents are rising by 10% per year, but if they’re not, will these investments pay off? If as CIBC notes, many investors have a negative cash flow on their investment condos in today’s market when resale condo prices are $1,000 psf - what will the finances on these pre-construction condos look like at $1,400 psf? What will their numbers look like if interest rates are higher? Will investors be rushing to hold on to those investments in a few years or eager to unload them?
The danger is that such hasty investor exits risk sudden increases in supply that may lead to downward pressures on prices, which can then affect regular buyers who have purchased units on the way up and have to manage a sudden loss in value. A large enough movement can then, as we’ve seen in past housing market downturns, affect the housing market — and even the economy — as a whole.
In short, one of the goals of curbing the share of properties bought and owned by investors is to mitigate the disproportionately negative effect they can have on a country’s economy should home prices fall in the future.
But in what appears to be an election year in Canada, the attractions of a debt fuelled housing boom is looking to prove more tempting than mitigating future downside risks.
Let’s just hope prices keep going up forever because the GTA’s housing market isn’t well-placed to handle a decline in prices at present.
The Move Smartly Monthly Toronto Area Market Report is powered Realosophy Realty Inc. Brokerage, a residential real estate brokerage serving Toronto and the GTA. A leader in real estate analytics, Realosophy educates consumers at Realosophy.com and MoveSmartly.com and helps clients make better decisions when buying and selling a home.
Email report author John Pasalis, Realosophy President