Tuesday, June 18, 2013

Urbanation Comments on the Bank of Canada Financial System Review

In its recently released Financial System Review, the Bank of Canada once again flagged the Toronto condominium market as a key risk.
Given the high level of attention this has received in the media, Urbanation felt it necessary to provide responses to their messages:
 “Construction activity remains strong in [the Toronto condominium market] despite the slowdown in overall housing demand over the past year and the total number of housing units under construction remains significantly above its historical average relative to the population.”
Of course it does. Construction in the Toronto condo market adjusts to changes in demand with a 12-18 month lag because the majority of units that start construction are sold well in advance during pre-construction sales campaigns. That means the slowdown in sales activity over the past year will work down construction volumes in the year ahead. But don’t expect a dramatic slowdown as roughly 30,000 units were in pre-construction at the end of Q1-2013 and were collectively 60% sold.
The total number of units under construction will continue to remain above its long-term average because there has been a dramatic shift towards high-rise at the expense of low-rise development in recent years. Since high-rise projects stay under construction for a lot longer than low-rise homes, the total housing supply under construction is ultimately boosted relative to historical averages or the population.
“The number of unsold high-rise units in the pre-construction and under-construction stages has remained near the high levels observed since early 2012. If the upcoming supply of units is not absorbed by demand as they are completed over the next 12 to 30 months, … [it increases] the risk of an abrupt correction in prices…”
Unsold condo inventory numbers are the most misunderstood statistics about the market. It’s very important to understand that the majority of unsold units are in projects that are still in the pre-construction stage. If these projects haven’t sold enough units to meet their conditions for construction financing (typically 70% or more), they won’t begin construction until they do, or will perhaps be cancelled. So, most of the unsold inventory reported today will either never materialize or have several years to be absorbed prior to completion.
The projects that are under construction remain 89% sold —a figure that hasn’t changed over the past year. While the number of unsold units has risen with more projects under construction, this represents little risk to the market. The construction process is lengthy and by the time the average project arrives at the completion stage, it is 95% sold. Even if sales stall at the 85-90% mark, the developer will generally turn a profit by this point and can be more aggressive with its incentives or opt to hold onto the units after completion and rent them out. As of Q1-2013, there were about 600 unsold units at recently completed projects – a level that is virtually zero in comparison to the size of the market and one that can withstand increases without threatening prices.
“If the investor component of demand has boosted construction in the condominium market beyond demographic requirements, this market may be more susceptible to shifts in buyer sentiment.”
Tough to argue with that.  Investors have likely purchased about 60% of units that are under construction today. If they all came to completion in a short span, the majority decided to sell and demographic requirements declined, prices would no doubt fall. It’s possible, but not likely.
In the absence of an economic shock, household formation in the Toronto CMA is likely to continue averaging approximately 35,000 households per year (as it has over the past three census periods). With low-rise housing seemingly capped at 15,000 units per year going forward, a 20,000 unit gap is left for high-rise to fill. Based on historical trends, capacity constraints and construction progress to-date, it appears unlikely that many more than 20,000 condos per year will be completed over the next few years.
Furthermore, most investor-held units are likely to continue flowing into the rental market, where demand is currently running at a 20-year high, vacancy rates remain close to 1% and very few purpose-built rental apartments are being constructed. There is little reason to believe there will be a major shift towards investor flipping – if short-term speculators were the majority of buyers, there would have been a much stronger run-up in prices than 7% per year over the past five years (In the previous cycle, condo prices increased by 170% from 1985 to 1989).
It’s true higher investor involvement in the market raises risks to prices because they are more prone to shifts in sentiment, and there is no way of being certain that the economy and demographic demand will remain stable. While it’s important to continue closely monitoring the market, these risks appear to be well contained at this point. Actually, without higher investor involvement, the market today may have been facing a different – and perhaps more difficult – set of problems. Supply would be much more restrictive, causing prices (and perceived overvaluation) to be even higher and a severe shortage of rental properties.