Friday, November 29, 2013

Urbanation Response Part 2: Do Condo Rents Look Poised to Fall?

This is the second part of a Blogpost that responds to research findings reported through a recent Globe and Mail article that states condo rents are declining.
This post will address the validity of the claim made that “the Toronto rental market may no longer absorb supply as it comes on-stream, resulting in lower rents and increasing cash outflows for landlords…”
The first part to this blog post addressed the more glaring issues related to the quality of the research conducted that found condo rents are declining.

Condo rents are not falling
As mentioned in Part 1 of the blog post on this topic, Urbanation tracks condo rental activity through the MLS system, which we estimate covers at least two-thirds of the market.  We marry transaction data with our own proprietary database of square footage measurements for condo units, first taken from developer plans and then verified post-registration from surveys submitted to the land registry.

Our data shows that on a per square foot basis, average rents in the third quarter grew by 4.2% from last year. While a rising inflow of newly completed units with above average rents per sq ft are helping to push this level higher, our same-sample analysis (using only buildings common to Q3-2012) still shows rents are growing, albeit at a slightly slower pace of 3.5% year-over-year. This reflects a market that is starting to balance out following three years of exceptional growth in rents. But note that the rentals-to-listings ratio remains elevated at above 70%, which still supports further growth in rents.

Demand will be able to absorb new supply

We expect that the emerging trend towards more balance in the rental market will gradually continue over the next couple years. As more units come to completion, more investor-held units will be listed for rent. But it’s important to recognize that rental demand is currently running at a 20-year high, driven by such factors as reduced ownership affordability for first-time buyers, strong growth in the population aged 25 to 34 and migration into the core. This, combined with the lack of growth in conventional rental supply, is why vacancy rates remain near historic lows despite the growing supply of condos — which made up 85% of the growth in rentals over the past 10 years.

Assuming a flat profile for household formation and ownership rates, the number of net new renter households will average around 10,000 per year out to 2016. Over the same period, condo completions are expected to average 20,000 units per year. Assuming 60% of these units are owned by investors and 3/4 will list their units for rent, we will see an average of roughly 9,000 condo listings per year from new completions. While supply can also be added from older condos (as owners hold onto their units after moving out) and some new purpose-built units, the point is that demand and supply should remain at similar levels.  

This isn’t to suggest that the market won’t change — we firmly believe that more balance is on its way. Realistically, there are likely to be short-term periods of weakness experienced in selected areas of the market over the next few years. But on the whole, the market should not experience a pervasive decline in rents. However, this may not be enough to keep some investors from looking to sell their units. It’s no secret that cash flow margins on rental units have become squeezed, and they will remain that way as higher priced units enter the market and rent growth slows. But with vacancy rates expected to remain low, the equity accumulation inherent in having a steady stream of rental income go towards mortgage costs and principal repayment will continue to encourage most investors to hold.

Condo investors recognize the advantages that leveraging a low-cost mortgage brings, as well as the sense of security in owning a piece of property, which is particularly shared among new immigrants who tend to be big purchasers in the market. So it’s difficult to assume that because unlevered cap rates are below financial market dividends that investors will begin to suddenly change course.

History has taught us that supply tends to direct itself towards where demand is strongest. The exceptions being when owners are forced to sell because they can’t close on their homes or can no longer afford their mortgages — neither scenario should have enough prevalence to impact the market. Should the economy remain stable and interest rates remain low, mortgage arrears will remain near historic lows (0.31% in Ontario as of August 2013). As a greater volume of units come to completion, there will naturally be more reports of buyers struggling to close on their units, but they will continue to represent a very small minority. The vast majority of units set to complete have deposits paid of at least 15% (equal to around $60,000 on a $400,000 unit) — buyers will do whatever they can not to lose their investment. They have also been pre-qualified to close – something banks require before advancing construction loans (despite reports of the contrary).  

The market will be challenged by resisting forces for price and rent growth over the next few years, but should remain stable in the absence of any strong deterioration in confidence. The media can help to prevent this by, at minimum, offering readers a more balanced selection of informed opinions on the market. 

Part 1 - Do Condo Rents Look Poised to Fall?:

Urbanation Response Part 1: Do Condo Rents Look Poised to Fall?

This is the first part of a Blogpost that responds to research findings reported through a recent Globe and Mail article that states condo rents are declining.

A recent report by an equity research firm came to the conclusion that condo rents are on the decline, which, in turn, could trigger a sell-off of investor units that would cause condo prices to “drop dramatically.” They found that on a per square foot basis, rents declined by 1.6% from last year. The basis of their analysis came from researching ‘for rent’ postings on Craigslist in 47 projects, and comparing them to the results from last year’s exercise. They added that mortgage pre-approvals are not needed to buy new condos and buyers may have trouble closing, which could lead to “significant losses” for developers and lenders.

Urbanation does not have access to the actual report, so we are basing our response on the information published in the Globe and Mail.

The first part to this Blogpost will address the more glaring issues related to the quality of this research. The second to follow will address claims of impending rent and price declines and closing risk.

Using Craigslist as the basis for determining changes in market rents poses at least a few major problems.
Craigslist doesn’t report transacted rents
It’s important to recognize that Craigslist is a listings website – it shows how much owners are asking for their rentals, not what they are getting. While it may be true that listing values can generally be used as a close approximation for transaction values, it is less likely to be the case on Craigslist. These listings can often be posted by individuals with very little knowledge of the market, and are more likely to under- or over-price their units, relative to units on the MLS system, which are posted by realtors who work in the market every day. If there is a difference in the degree of over- or under-pricing units between two periods, the change in average rents calculated becomes unreliable.

The sample size is too small
The listings vs. transaction value issue may not be that problematic if one were using a large enough sample that could mask differences in the degree of over or under pricing units between two periods. But 47 buildings isn’t enough. It represents only 3% of the total number of condo buildings in the Toronto CMA.  It’s also unclear if the same buildings were monitored at both points in time. Given that they report, 553 postings in October of this year versus 148 last year – this isn’t likely the case. Rents can be very project-specific, and even slight changes in the sample can impact results.

Inconsistent reporting of unit sizes
It was stated in the article that the research ‘controlled for unit sizes where possible’ to measure changes in rents per square foot. When measuring changes on a per square foot basis in a small sample, precision is paramount – you can’t look at rents per square foot for some units and not for others. And the unit sizes must be accurate, or at least consistently reported across sample periods. Is it a stretch to think that some people posting on Craigslist may exaggerate? Again, this may not be that big of a problem if everyone exaggerated by the same degree. But if one person posts a 650 square foot unit for $1,600 in 2012 and the same unit gets posted in 2013 for the same rent but it’s now advertised as 675 feet  – it reduces the rent per square foot by almost 4%. Similar issues may arise using unit size information taking from MLS listings, which is why Urbanation goes through the arduous process of maintaining a complete database on unit sizes taken from survey measurements on record at the land registry.

Who's research should be taken with a “grain of salt”?
We recognize that transactions through the MLS system don’t represent all activity in the condo rental market, but we do believe it represents the strong majority.  Rentals through MLS will reach 20,000 units this year, which equals an annual turnover rate of roughly 8% of the entire stock. Adding in units sold yields a total annual turnover rate of about 15%. The ‘true’ annual turnover rate of all condos is likely closer to 20%, which means total rental transactions through other means such as Craigslist probably add about 1/3 to the total.

This means Urbanation captures about 2/3 of the entire condo rental market. The activity within the 47 buildings monitored through Craigslist would capture no more than 5%. Nonetheless, the authors of this research cautioned that claims such as Urbanation’s that rents per square foot are rising by 4% year over year should be taken “with a grain of salt”. We wonder, what would be appropriate to take with their claims?