Housing investors in Canada are heading for the exits as rates rise

At the tail end of a historicbull runin Canada’s housing market last year, investorscame to comprise afifthofthe country’s homebuyers. Now, they are some of the first scramblingto unload propertiesin what some are already saying could be the most severe housing market downturn in the country's recent history.

Rents could no longer cover interest payments

In early July, Toronto-based mortgage brokerRon Butler’s client called him with exactly thatdilemma: The financials on the suburban condo he purchased as an investment property just four months earlier no longer made sense. Rents could no longer cover interest payments on the mortgage after a six-fold jump in the central bank rate.

Butler advised his client to sell, instead of losing money on the property each month. The Bank of Canadaraisedits benchmark rate another percentage point to 2.5 per cent just a week later, so Butler is bracing himself for even more calls like that.

“It’s starting now,” Butler said. “Every quarter there’s more bad news. More renewals. More negative cash flow. More, ‘Does it make sense to hold onto this rental?’”

Weighing down home prices

As long as rates stay high, he predictsinvestors will turn into a steady stream of forced sellers andfurtherweigh down home prices.“The economics of this thing for the next two years just don’t make sense,” Butler said.

Over the last year, the central bank issued repeated warnings about the risk investorsposed to the market as they became a greater share of the country’s homebuyers. Not only are investors thoughtmore likely to sell in a downturn because they don’t live in the homes they own, thevolume and type of debt they were taking on —specifically loans with a floating rate — could make them more likely to experience a financial squeeze if rates rose and prices fell.Now it looks like that’s exactly what’shappening.

“Investors in residential real estate are typically what you would call ‘weak hands,’” said David Rosenberg, an economist, borrowing a term from poker. “The momentum could build on itself, where the lower prices beget even lower prices because of the forced selling by these leveraged weak hands.”

Even though rental prices have gone up, the annual increases aren’t keeping pace with the central bank’srate hikes.

Declines are so far moderate

Though the declines in Canada’s benchmark home price have so far been moderate, amounting to just 3.3 per cent in the three months to June, they’veaccelerated inthat time, and various private sector economists predict average home pricescould fall between 10 per centand20 per cent from the February peak. Rosenberg,however,says forced selling by investors could push prices down as much as 40 per cent.Robert Hogue, an economist at Royal Bank of Canada, says the country is on its way to a “historic”downturn that will be bigger than any in the last 40 years.

“Bubbles burst when interest rates go in the other direction,” Rosenberg said. “The question always is, when is the inflection point? And the inflection point has already arrived.”

By the end of last year, Canadian home prices were nearing theirpeak.More than halfof homebuyers of all kinds, investors included,turned to the record-low borrowing costs available throughvariable-rate loans—the catch being the rates on those mortgages move in lockstep with the central bank’s benchmark borrowing cost.

Borrowing against old properties

At the same time, nearly a fifth of investors were also borrowing against old properties to finance the purchase of new ones, other bank researchshows. That type of debt,known as a home equity line of credit,often carries a floating rate too.

Thismakes investors morehighly indebted overall, and central bankresearchshows they are far more likely to have a total debt load10 times their income.There may also be many more like Butler’s client, who borrowed thedown payment as well as the mortgage for a new property,and so owe 100 per cent of the purchase price. All of that debt has becomeconsiderably more expensive in just the last few months.

For someinvestors, the situation is even more dire because theywere losing money on their propertiesbefore the rise in rates.In Toronto and Vancouver investing circles, such negative cash flow was often justified because it wasin partgoing topay down the principalon the mortgage each month,increasing the investor’s equity in an appreciating asset.

Steve Saretsky, a real estate broker in Vancouver, said he’s now getting calls from investors who have seen their monthly losses go from $200 to $400 (US$155 to US$310)because of increased payments on their variable-rate debt. He says they won’t be able to bear that kind of negative cash flowmuch longer, particularly with prices falling.

“I definitely think there’s going to be a decent element of distress,” he said. “Those people are unfortunately going to have to hit the sell button at whatever the price is at the time.”

For all the growth in investor activity in recent years, homes occupied by owners still remain the largest part of the market, and those people have more reasons to stay put. Still, these regular buyerswere not immune to the market-wide turn to variable-rate mortgages in the last two years, and manywill already be seeing their monthly payments going up.

The protection of a fixed-payment plan

Even thosewho chose the protectionof a fixed-payment plan, which National Bank of Canada research suggests amount to about 40 per centof variable-rate mortgage holders,may not be spared for long.

Thosemortgages keep borrowers’ monthly payments the same by taking any extrainterestout of the share of the monthly feesthat would normally go to principalrepayment. Now rates have risen so far and so fast, there might not be much more principalrepayment left in those monthly fees.

“We’re getting very close to the point where even those fixed payments are going to have to start getting ratcheted up,” said Robert Kavcic, an economist with the Bank of Montreal. “It could very well just deepen the near-term downturn.”