Blessed by the Potato

This spring looks like real estate prices are coming off the boil. People seem to be wondering if prices could possibly go down despite years of bulls and the FOMO crowd saying that it only ever goes up.

There have also been more people wondering about housing bears. “Remember housing bears? Didn’t they once say that housing could possibly go down in the future? Is this what ‘down’ is?” And of course the big one “So how bad could this get?” As us long-time housing bears come out of hibernation this spring, perhaps it’s worth a long (and snarky) review of the thesis.

A Low Growl

There are lots of ways to determine what a house is “worth” or what it “should” be priced at. You can look at historical relationships between incomes and debt and house prices, but that’s all very high-level stuff, and hard to apply to one specific house that you want to live in. The argument that has always resonated best for me is that a house is primarily a place to live, and shelter is also one of life’s greatest expenses, so it’s worth looking at all your options. Renting your shelter or buying it are the alternatives available.

So we can examine the relative costs between renting and buying, and I made a spreadsheet and a whole series of posts to do that and others made rules-of-thumb and YouTube videos. And basically house prices had gotten so expensive relative to rents that it looked like you were better off renting, and the only way buying would possibly come out ahead is if already-expensive housing became even more expensive at a very high clip and even then you needed cheap leverage.

Well, we got skyrocketing prices and cheap leverage, so people who bought anyway look like they came out ahead (for now). But it didn’t have to turn out that way, and the question is always how much further can those trends go before something breaks? The bigger the price:rent ratio gets, the harder it is to fix it through anything other than a housing crash (assuming of course, that these fundamentals matter at all).

But if doing a price-to-rent comparison is so easy anyone with a physics degree and insomnia can do it, why did prices get so detached from fundamentals in the first place?

Models of the World

The market is far from monolithic: there are many players in it. Not just buyers, sellers, and agents, but buyers with different pricing models at work – people are playing the game with different rules. We can build a thought experiment with different agents (agents in the sense of actors in a model, not the people whose job it is to sling houses) using different strategies and approaches, and how prices might change.

A decade ago we talked about supply and demand, and how speculative demand works: in a textbook economics market, as the price increases, fewer buyers demand the thing the textbook is discussing. Even if they disagree on the assumptions and arrive at different estimates of fair value, people who use a rent-vs-buy framework will, all else being equal, start to drop out of the market as the price gets too high, and choose to rent instead. But with speculative demand, you don’t get that: high prices beget high price expectations, which helps bring in new buyers to replace (or even exceed) those who got priced out.

So that’s one of our groups of buyers and their pricing models: prices going up is good, because they’ll continue to go up, so pay whatever you need to today as you’ll only be richer in the future. This group is what we’ll call the FOMO-MOMO group: fear of missing out/momentum. They expect that as prices go up, they will continue to go up. And the faster they go up and the closer housing gets to completely unaffordable, the more they will pull demand forward and buy more because they are more and more afraid of missing out or getting priced out (e.g., those stories of people buying places for their children). Their pricing model is basically to look at the last comparable price, see how many people show up for the bidding war, and add $10k for every nose on top of the last price.

It can have big positive-feedback cycles, as prices going up makes them feel wealthier, and feel more certain in their worldview, and gives them easier access to credit. A subset of them buy more and more properties: as the first purchase works out and goes up, they build equity, which they can drain with a refinance to buy another place, and another, helping to propel the market upward while adding leverage and fragility to the structure.

The bear case is of course that this is insanity, but we’ll get to that.

The next class of buyers are the ones who just want a place to live, but who skip step zero (i.e., the rent-vs-buy analysis). So they are only looking to buy, and they’re just simply going to go into the market at some pre-determined time point (say on their 30th birthdays for the sake of modelling) and buy as much as they possibly can (AMAP). They don’t care too much about what the price of housing is doing – up, down, or sideways – they just borrow as much as they are able and buy as much house as possible. Their only limit is their ability to service the debt used to finance the purchase and things like a stress test that affect their buying power.

Then you have the “rational” buyers (R): those who may want to buy a house, but want to do so at a “fair” price, and will go rent or GTFO if the prices get too extreme. They may use a price:rent or price:income basis, like dinosaurs, but they’re looking to buy without becoming house poor.

So if we have a group of price-insensitive buyers, and even a small supply/demand imbalance, the FOMO-MOMO and AMAP crowd can rapidly drive prices to crazy levels, and drive the R’s completely out of the market – the demand is strongly inelastic from those buyers. In addition to all the speculation about how this was working in Toronto and Vancouver’s run-ups, we saw more natural experiments with this in the pandemic: prices in many small exurb towns doubled with very small increases in the number of price-insensitive buyers hitting the region.

These pricing models used by the currently dominant agents lead to a powerful positive-feedback loop. But what happens when the market finally changes?

Eschatology

As soon as prices stop going up, the momentum buyers may hit pause, creating a reinforcing cycle in the other direction: fewer buyers, putting fear into others, as fewer and fewer believe it’s a dip and start to fear prices won’t be up so much in five years’ time that any price today can be justified. Plus, how do you even set a price if your model is to multiply X by the number of noses in the bidding war and nobody else shows up to bid?

If the FOMO-MOMO crowd disappears, the next marginal buyer is the AMAP, who simply will borrow as much as they can for a house and pay that. With interest rates rising, their ability to borrow is more limited, so prices will have to come down a bit to match their maximum affordability.

So our mental model suggests that the first new equilibrium point would be wherever the new constraint on buying power puts prices.

Take a house that’s currently selling for say $1.5M in Toronto. An AMAP buyer that could afford that place at 2.5% (a mortgage payment of ~$5400/mo) may only be able to pay $1.3M at 4%, or $1.2M at 5%. Not a huge difference, which is what a lot of people are saying now – a slowdown or correction is in the works from interest rate increases, but far from the crash the bears have been crying about that would be needed to restore actual affordability. We’re still in the post-pandemic bump there, and not even negative year-over-year thanks to that massive run-up at the end of 2021/start of 2022.

The true bear case is if the fomo momo crowd steps back, and there aren’t enough price-insensitive AMAP buyers (or their purchasing power is significantly impaired, which may happen for example if they need a down payment from the bank of mom and dad, which is also facing higher financing costs on their HELOC, or interest rates rise even more, or inflation hits all the other line items in the GDS calculation at the same time that interest rates rise) to move the needle. The next marginal buyer is then the “rational” buyer.

And the problem is that the price that the “rational” buyer or investor buyer steps in is far, far below the current prices. That $1.5M (peak) house might rent for $3200/mo, a price:rent of 469X. To get back to say 250X, the price has to come down to $800k – a big air gap below current prices.

So that’s how a crash could play out from too-high prices and a shock that breaks the momentum and psychology. It’s certainly plausible, but is it at all likely?

And that’s the problem with this mental model: it produces some narratives to help explain how we got here, and some potential future paths, and where some reasonable stopping points for bottoms might be (when the monthly payment for AMAPs balances out, when the price:rent gets back to historic norms, etc.). But it doesn’t make any actual predictions about what will happen – there isn’t survey data out there about how many AMAPs are left, for example.

The Turn

Though the market does seems to be turning now, with rising interest rates putting fear into the hearts of the fomo momo crowd, and reducing how much “as much as possible” is for the AMAP crowd – the “every 50 bp reduces the maximum amount you can borrow by X,” etc. articles that you’ve no doubt seen all over.

But wait, there’s more! In the calculation for the debt service ratios is also a line for heating costs. And natural gas has roughly tripled in price over the last few months, which will take another decent chunk ($100/mo or so?) out of the maximum borrowing capacity of buyers.

So in that example of a $1.5M house that an AMAP could reach for at 2.5% going to $1.2M at 5%, add in an extra $100/mo hit on heating costs and now their maximum serviceable price is hit by another $20k.

I see lots of people still saying that there’s no way it could crash though, and there’s a lot of good reason to think that way. The government explicitly said they wouldn’t allow even a 10% correction to happen, and they’ve made plenty of (deliberate?) policy errors to get us into this over-priced mess in the first place. And the market has gone straight up in the face of bear logic for so long that people believe that there must have been a mistake in the logic somewhere. Every time we’ve had a good reason to think a correction was at hand (2012, 2017, 2020), the market has given bears a thrashing and gone right back to resuming its lunar trajectory.

And maybe they’re right. The fundamentals have gotten worse (better if you want high prices): we do also have a supply problem now on top of the demand surge, and we can see it in rents that have gone up above the rate of inflation (esp. for product that makes for a good [illegal] AirBnB). However, the increase in rents isn’t even in the same solar system as the increase in prices. So the floor has been raised… but it’s still a long way down.

And the demand is still high: for all the demand that has been pulled forward, there are plenty of Canadians and newcomers who want to own, they’re simply priced out. Maybe there are hordes of would-be buyers on the sidelines who will come rushing in to buy on any weakness, and this will only be a gully, not a crash. But at what price can those priced-out hordes come in? If they are themselves AMAPs who were priced out, then prices need to drop enough that even with higher rates and heating costs that they can service the debt again (I am very carefully avoiding the word “afford”), so we’d need to see prices fall by at least 25-30%.

Six Impossible Things Before Breakfast

Through the years, many people have acknowledged how expensive Canada’s housing markets have become, but say that a crash is impossible for reasons.

Back in the day when Alberta was even bubblier than Toronto, people said Toronto could crash, but no way Calgary would because its house prices were supported by the oil industry, and demand for oil wasn’t going anywhere. Just a few years later, the price of oil crashed, though miraculously Alberta experienced a soft landing rather than a crash. Record-low interest rates (which drove Vancouver and Toronto to new heights as they stabilized Alberta) likely helped a lot with that feat.

In Toronto, interest rates have been one of the key impossible things supporting the market: people can afford the payments to keep the market elevated as long as interest rates stay low. And far past the crisis days of 2008, emergency rates stayed with us, and even went lower and lower. It didn’t seem like the BoC was ever going to raise rates, and there are only so many years financial pundits can warn people that rates will eventually go back up before buyers tune the warning out and just go hog wild on debt. Even as inflation started to rage at the end of 2021 and beginning of 2022, the BoC stood its cowardly ground, and bulls became even more emboldened in their call that rates would never go up.

And besides, the argument went, “they” couldn’t raise rates: we’re too indebted as a society, higher rates would crash prices and cause a recession, and they would never do anything to endanger house prices.

Well, it looks like we’re in for some rising rates. [Ed. note: since the first draft of this post and the enormous amount of time it took me to hit publish, the BoC has raised rates 100 bp in two 50-bp steps after the first cowardly 25 bp hike in March] And if the argument was that rates couldn’t rise because house prices would fall… I guess house prices are going to fall then?

When markets get badly distorted, but the most obvious corrective force is “impossible”, well, impossible things seem to happen all the time to break theses in nasty ways. Many people seem to be learning the hard way that real estate prices can go down, and rates can go up.

The Big Misunderstanding

One other common sentiment out there is that “bears were wrong and so will always be wrong. Even with rising rates and a correction, house prices will never go back to 2011 levels so bears have lost! Don’t listen to bears!” And this sentiment is either an attempt to show a brave face as a bull, or a deep misunderstanding of the rent-vs-buy math that we’ve been talking about for that decade.

If you were in Toronto in 2011 and decided to rent when the price:rent was 300X, the bulls were (so far), right post hoc and had a faster increase in net worth… if they were sufficiently levered (and sell and go rent now to lock in that gain). But check that spreadsheet again: the base case for renting was that you would be ~$100k ahead (back then six figures was a lot of money and not just a kicker to win a bidding war) assuming historical ~3% increases in real estate. Bears don’t need prices to go back down to nominally what they were (though we do need a correction to pull ahead < a href="http://www.holypotato.net/?p=2516">post-hoc), as the difference in monthly cashflows and investments can close the gap. Indeed, at various points along the way the price:rent got so disjointed that you needed a 6%/yr increase in house prices forever just to keep pace with the renter. The last decade saw closer to 7%/yr in Toronto, so those who bought have done well for themselves… but how much longer can that rate of appreciation keep up?

Someone who passed on a $700k house in Toronto to rent and invest the difference does not need house prices to crash below $700k to come out ahead – they just need prices to come back to ~$1.2M by 2024 to win in the post hoc comparison. Yes, that will still require a correction from here, but the delta is not nearly as big as those who just want to say being early is the same as being wrong want to paint it as. If you did make the “disastrous” choice to rent, you’re not nearly as far behind as all that.

How Far Down?

A common question I see directed at bears now that people remember that we exist is how far would it have to drop before you’d buy? I’ve been quite happy renting here, and the LL doesn’t seem to be in any hurry to throw us out. Even though it would only take a ~30% correction from the peak to end up ahead (and prices are already down ~10%), I’m not sure that I would be buying there – the price:rent would still be pretty elevated at that point, and we have to be forward-looking with our decisions.

There is a kernel of truth to all that stuff people say about not perfectly timing the market and all that, so I wouldn’t be trying to pick the bottom once we get back into range of some semblance of a fair value. But even at 30% off, unless rents also spike, we’re still talking about very elevated price:rent levels around here. There’s no way to know if the R’s in our mental model will ever become the marginal buyer again, but for doomcasting, that would mean prices dropping something like 45% from the spring 2022 peak.

Adam Vaughan made himself the face of government callousness and inaction earlier this year[0]. It started with an appearance on TVO’s the Agenda, where when talking about what the government should do about housing, he said “We’re in a safe market for foreign investment but we’re not in a great market for Canadians looking for choices around housing.” Which wasn’t news to a lot of people, but it was news that the government knew and was choosing to do nothing rather than just being incompetent and unaware.

He then continued to say (and followed it up and in various Twitter battles) that the government would not do anything if it meant risking even a 10% decline in house prices — which in the context of the time (over 20%/yr increases, and not just in the big cities) would have been rolling prices back just a few months. But even that was too much for them.

In other words, he said the quiet part loud. And now we all know that they know, and that they don’t care.

He’s tried to make the case that housing prices falling is bad, as have others throughout this decade+ run-up in house prices. People don’t like seeing their biggest asset fall in value, and recent buyers could be underwater and financially stressed. If it gets rolling, it might lead to a recession.

And sure, it’s pretty obvious that if we have a housing crash, it would have many negative effects. The problem is, high prices also have negative effects, and there’s a chance prices will fall anyway in the future, and inaction just delays and exacerbates that.

Why Housing Bubbles are Bad

A housing crash and its associated harms is hard to miss, but the harms of a bubble are more subtle and insidious, but just as bad for society.

Bad? The wealth effect? Our cities becoming “world-class”? These are bad things? Well, those aren’t the only side effects of a housing bubble.

There are much more serious effects on people’s lives. There’s rising inequality, though that’s just part of it.

Housing is the biggest cost in most family’s budgets, and for young people that can be by a huge amount[1]. When housing gets more expensive, they feel the squeeze: literally, if they have to settle for being under-housed to make ends meet. That has real-world consequences.

I can write about the rent-vs-buy decision and raising a kid in a rental all I want, many people out there still want to put off starting families until they can buy sufficient housing for a family. The frenzied speculation makes rentals less secure even if rents themselves have lagged price appreciation. With higher prices (and rapidly rising prices), buying is harder — much harder — and young families have to settle for less space, and delay their purchases to save up. That means they put off having kids longer, and having fewer when they do. Toronto’s fertility rate dropped 16% in the last decade[2]. If anything else had caused our fertility rate to drop that much in just a decade (in the face of millennial demographics that we might have expected an increased fertility rate from) we would be rioting in the streets for the government to do something, holding up signs about the missing 10,000 babies. We’d be banning chemicals, exterminating mosquito vectors, or adding fertility treatments to OHIP coverage. But when it’s economic: crickets. Housing insecurity and microcondos are just the way of life here in a world-class city, and a few thousand unconceived babies are acceptable collateral damage for muh price growth.

Mike Moffat has also pointed out Toronto’s troublesome population movement patterns: the largest cohort of people leaving the city are newborns (followed by other young children and those in the parents of young children age bracket) — so even when a kid is born here, there’s a good chance its family promptly leaves.

Lots of people leaving Toronto and Peel. And who are they? People in the 30s and small children. Why? Priced out of the market. pic.twitter.com/oH8r5oGLhO

— Dr. Mike P. Moffatt (@MikePMoffatt) August 17, 2021

Lower interest rates (that somehow keep going lower) have helped support housing prices: mortgage payments have not increased as much as prices. But they have gone up quite a bit, and even if more and more of that payment goes toward principal, the principal still has to be paid back. 10 years ago, a $775k average detached house required that, at some point, you paid back $775k. Spread evenly over 25 years, that’s $31k/yr. A big chunk of a couple’s after-tax income, but doable if you were pulling in $100-120k combined (and a monthly payment including interest of $3.1k). At $1.7M, that’s $68k/yr to pay it off in 25 years, which doesn’t leave much else for having kids or supporting the economy (and the monthly is up to $5.4k at lower interest rates).

This is a big black hole for the velocity of money: more and more of our salaries are going to paying for our houses. That’s money that isn’t circulating back through the economy, or investing in something productive. Wouldn’t we be better off with lower house prices, and more of our disposable income going to services, innovation, transitioning to a low-carbon economy, charities, etc., instead of having housing sucking up all the cash flow?

In conclusion, while a crash can be harmful, high (and rapidly rising) house prices also have harms. So far the government has made it clear which set of harms they see and care about.

Election Time

A federal election has been called, and more and more people are saying that housing is a big issue for them. Each party has come out with an ineffectual do-nothing housing plan, and not one has acknowledged the elephant in the room: that a solution must allow at least the risk that house prices will drop. The cure to affordability is not to create more loan programs and tax breaks to help people pay higher and higher prices for housing[3] — it’s to get prices lower.

The first step is admitting that there is a problem[4]. I’m a left-leaning voter — often ABC — and while there are a lot of issues I care about (science funding, the environment, electoral reform, etc.), man, at this point I would vote PC if they actually came out with a housing plan that was willing to actually address prices and affordability.

[0] And stealing that crown from DoFo in a pandemic was quite the achievement.

[1] Though for the wealthy who haven’t read my book, investment fees may edge out housing.

[2] And that’s before the effect of the pandemic and lockdowns, which looks to have created its own “baby bust”. Also, other cities did have birth rate declines over the last decade too, though they were lagging Toronto’s — Calgary and Halifax had held steady through to 2016 (which would be about 9 months after Alberta’s oil bust started) and then a step down; London had a small decline in 2016, which was then exacerbated in 2018, while Toronto just heads down and down the whole decade.

[4] Update: Rob Carrick had a similar take here (and he got around to hitting publish first while I was dicking around in MS Paint). “Only a major price reversal can restore mass affordability and the federal parties won’t touch policies that would make this happen.”

It was 10 years ago that I finished my PhD and started looking for a new place to live. I went deep, deep down the analysis rabbit hole, eventually emerging with my rent-vs-buy spreadsheet. At the time, we decided to rent: the housing market in Toronto was already at a price-to-rent ratio of over 300X, and using a bunch of very reasonable assumptions, renting looked like the much smarter move.

Well, now it’s 10 years later. How’d that all work out?

The housing market (esp. in Toronto) performed very well over the last decade. That was unexpected: the market was already expensive on a price:rent and price:income basis in 2011, and it just simply got more expensive — incomes have not surged ahead in the city, nor have rents. Yet prices have been on an absolute tear, roughly doubling in that decade.

Back then interest rates were at “emergency” lows, and nearly everyone was warning buyers that they would have to be prepared to renew at higher rates. Reality is stranger than we can imagine though, and instead we find ourselves a decade later with rates even lower. If you predicted that, congratulations, you already have your prize. If you used the best information available at the time and decided to rent instead, then you likely have a constant stream of people looking to dunk on you. “How’d that renting thing work out for you anyway?”

While housing is the national obsession, investments had a hell of a decade, too. Remember in the rent-vs-buy analysis we assumed a 7% rate of return for investments? Well in actuality an aggressive diversified portfolio got over 9% because the stock market also blew the lights out.

So how did those two choices shake out with all things considered then? The answer comes down to leverage: if you had a big pile of money and were looking to buy a place outright, you were better off investing it. A $775k (the price of an average detached house back then) investment in a TD e-series portfolio would grow to become $1.9M, while a house of the same value grew to $1.7M. Without leverage, renting and investing was a toss-up versus buying.

If you use the more realistic scenario of starting with a smaller amount to invest and using that as a downpayment (and getting a mortgage for the rest), then buying a house came out better — thanks, leverage!

To look back we can use the same rent-vs-buy calculator and just adjust a few numbers based on how things played out — higher realized returns for both investing and house price appreciation, lower mortgage rates, lower property taxes, as well as lower rent inflation [1].

Saving the extra cashflow from renting plus investing the downpayment would leave the renter with a portfolio of $820k (remember how expensive housing was compared to rents — it took a lot of cashflow to buy!). But that house appreciation (to $1.7M!) leaves the owner with even more equity. Once you sell both (hit the renter’s portfolio with some capital gains taxes, the owner with some sales commission), the owner is better off by $367k.

That’s… not a small difference.

Findependence Proximity

Here’s the strange thing: in reality I chose to rent, so I can see how much more houses in my neighbourhood are than my portfolio. Yet I don’t feel bad about missing the boat. Part of it is not wanting to engage in resulting. I knew what information I had at the time, I know that I put a tonne of effort into my decision-making and analysis, and made the best decision I could with it at the time. Some people were indeed calling for those high growth rates to continue, and we would do the math and laugh.

“You can’t be serious. At that rate, in a decade an already-expensive bog-standard 3-bedroom detached house would be $1.7M! Who would possibly be able to buy that!” Well, here we are, the Darkest Timeline.

With the incredible stock market returns, the renters now have enough to be able to buy in cash — mortgage-free — the house they were previously renting… if it had only appreciated in-line with inflation. But it didn’t, and instead they’re priced out forever (…ever-ever-ever…).

Yet in a way, they’re better off.

I tend to try to put big numbers into context by thinking about FIRE — how much closer to retirement would $367k [2] put me? On the surface, that much money should be a very meaningful difference in outcomes — years knocked off the time in the science mines. But it’s all locked up in real estate equity in the counterfactual. That’s the funny thing: though they can’t buy a house, that stock market performance means that the renter’s investment portfolio is now roughly large enough to pay their rent indefinitely. A few more years of saving and investing to cover their other needs and they’re on track to retire in their 50’s.

The owner still has 15 years of mortgage payments to make, and then still has to save up enough to be able to pay the other costs of the property (tax, insurance, maintenance) and then find a way to pay for food and all the other necessities of life. Their net wealth is significantly higher, and yet their life goals are much further away.

Unless, of course, they’re willing to sell and realize those gains. But at what point do you do that? If you looked at the market in 2011 and decided to buy anyway, when do you switch tracks and get out? What do you do with all that housing wealth if you don’t sell?

The market has seriously warped the notion of wealth. Ten years ago I was aiming for an early retirement (not extreme FIRE, something like early-to-mid 50’s). Round numbers, $1.5M invested would have been in the ballpark for me to comfortably quit my job and either fully retire or go freelance part-time. Yet these days, that doesn’t even buy a house here.

Resulting and the Next Timestep of the Simulation

Was it a “bad decision” to rent 10 years ago? I don’t think so — based on the information available at the time, it was the right move under most expected future scenarios. The future as it turned out happened to be the darkest timeline: rather than correcting the 300X price:rent, it simply went to an even crazier 470X through massive appreciation. If in 2011 you told me the high rate of growth would continue for another decade, I’d say that seemed laughable, and do the math for you — wouldn’t the average house becoming $1.7M in 2021 seem like a ridiculous outcome? …yet here we are. So no, I don’t think it was a bad decision, just a bad outcome.

Likewise, continuing to rent from here: there is nothing in the short-term data that suggests this market is about to crash. The bulls are firmly in control and the government has explicitly said it’s not going to do anything that might bring prices down. But it doesn’t have to crash for renting to come out ahead — it just has to stop growing at such a ridiculous rate. The price:rent is even more insane, so even with lowered expectations about future stock returns, renting looks like it should come out ahead if the housing market also settles down to inflation-plus-a-bit returns. And maybe in 10 years we’ll laugh at how people thought a two-and-a-half decade bull market would continue into a third and fourth decade, and that an average house would somehow be trading at $4M by 2031. Or maybe we’ll see that become the price and the class divide will be complete.

Now, if you gave me a time machine and said what would be the best move to make in 2011, then sure, buying might be the way to go… but that would be a terrible waste of a time machine. As Ben Felix said it would be even better to use that time machine to go back and rent and then invest the difference + downpayment into Bitcoin.

1. There’s a big suburbia/downtown split here — AirBNB really threw a wrench in the rental market. If your condo approximately resembled a hotel room, the rent went up by more than the 2% assumed inflation, then crashed in 2020, while rents out here in commuterville have gone up less than 2%/yr yet held up through the pandemic.
2. Or whatever scaled but not so very different amount for my actual situation vs. the average house retrospective/counterfactual numbers here.

In the clouds of the pandemic, a perfect storm was brewing for Toronto real estate. The units stolen from the residential market by AirBNB were coming back online, at the same time that immigration was suspended and a massive wave of unemployment and economic uncertainty swamped the economy, oh and the city was warning that the lost TTC revenue and extra costs might lead to a huge property tax hike (spoiler: they got a bailout and chose to cut services rather than increase taxes if it gets worse). In a sane world those should have been a handful of pins popping an already frothy real estate market, with an epic, sharp crash to bring us back to sensible price:rent and price:income levels — or at the very least an Alberta-style soft landing that takes the froth out.

But we don’t live in a sane world, and instead we have a K-shaped recovery. Except unlike the K-shaped recovery people talk about for people and the jobs market, where one group is having a really bad year with no light at the end of the tunnel yet (e.g., anyone whose livelihood revolves around music festivals, conventions, or personal services), while another has virtually uninterrupted income and lower expenses (e.g., many people who work primarily on a computer and who only had to go into the office in the first place because of a lack of imagination and will from their corporate overlords), in the real estate market it can be the same property with two divergent outcomes.

The rental market has taken a big hit in the downtown core, especially the microcondo segment that was most ghost hotel-y and the least fun to quarantine yourself in. Yet prices to buy those units have barely budged. In the burbs, rents are flat-ish, while prices have exploded higher.

And hold on to your butts, because the early indicators are making it look like the first half of 2021 is going to be an absolute ripper. Whether its low rates, or spending so much time at home that makes people want a house, or the freedom to look a little further afield if daily commutes may be off the table for a while, demand is surging, while the deferral cliff (that was one of the elements of the perfect storm that missed) turned out to not be such a big deal.

Now, if you’re just looking for a long-term place to live, then this likely doesn’t concern you — one more blip up on the chart of craziness, while renting continues to be a predictable expense. But if you’re in the FOMO game, or are looking to take a big risk on flipping a place this year, this is a big deal. It’s also so confusing and so hard to see coming, especially if the pandemic has left your own financials in shambles.

Where are people getting the money? How do they even have the energy to go rage-buying houses when things are so terrible?

Well, the upper leg of the “K” is doing just fine, if not even better than before, and they’re the only ones who buy houses anyway. So of course the market would be ripping, why didn’t I see it before?

Buuuuuut, immigration is still down. Tourisim is still down. Employment is still down. The perfect storm may have passed us by for now, with the upper leg of the K doing fine and dandy and as focused on real estate as ever, yet the storm clouds still look to be brewing out there, and are even weighing on the rental sector. If rents are down, why isn’t it affecting the purchase prices of the same units? Will this so-called fundamental stuff eventually matter?

Though rents are a big factor in the value of housing, a part of that to consider is the gearing involved: as rents race ahead, the added rent is essentially pure profit for the landlord (the beauty of a fixed-cost business), allowing a disproportionate increase in the price of the unit. As rents fall, the same should hold true in reverse: the price should fall by more than the decline in rents. However, investors can also speculate on future rents, while the rental market is basically a spot price. So if you believe that all the factors currently holding rent down are temporary, it may be rational to not cut your price by much, or even to down a big ol cup of FOMO FlavorAid. Conversely, if all the demand factors are down for the foreseeable future, and rent inflation may be muted for a long time, then prices should drop a lot — first to catch up with the lowered rent, and then to reverse the expectation for rapidly rising rent that had already been baked into prices.

As always, I look around and renting looks to be the smart move. The price:rent is IMHO more likely to be fixed in the long term by prices coming down than rents going up. But the market can stay irrational for a long, long time, and based on how the spring is setting up, a while longer still.

There’s a parallel in the Gamestop (GME) mania: with a long-term view, you may see a mostly bricks-and-mortar retailer with limited profit potential, worth nowhere near the current price. But short-term supply-demand imbalances (a mania combined with short covering, and options fuckery*) can drive the price up far beyond that, and it’s impossible to know the precise moment it will turn.

* – I believe the technical term is gamma squeeze but I don’t want to have to try to explain it.

Rents are dropping in Toronto, particularly for downtown condos (the market that had been driven up the most by the AirBnB crime syndicate phenomenon in the first place).

That raises an important question: what should owners of a vacant condo do? Advice is all over the map, from those who say to sell it while valuations are still high¹, to those who say to rent it out tout suite to avoid cash burn, to those who say to do the opposite and hold off because rents will go back up one day but renting at a low price now will lock you in to covid rents until the tenant leaves.

Not so long ago when prices were increasing all the time, real estate bulls had the logic that the best predictor of the near future is the present, so better buy now before it gets even more expensive. Well, that argument can work in reverse too: better take the rent you can get now before rents drop even more — or to bleed money with a vacancy if they don’t go back up. On the other hand, Toronto real estate has always been a story of hope and bullishness over all comers, and unrelenting bullishness and irresponsible leverage has won every time so far, so why not one more victory for that unstoppable pair?

How do you even approach such an important decision with such uncertainty and completely opposing advice? Congratulations to the regular readers who said spreadsheets. Save us math, you’re our only hope!

First off, consider the two choices for renting the place out: early, or late. That will help frame the third choice of selling the place (or possibly buying more while prices are “low” because you can make multiple millions but only go bankrupt once so the risk-reward is clear).

Renting now is more-or-less certain what you’re going to get. The main uncertainty is how long your new tenant will stay in place (which is only a concern if rents to go back up substantially faster than rent control guideline increases). But you can pull a number out of a hat and likely not be too far off. These are downtown condos we’re talking about, even at a discount to market rent it’s quite unlikely a tenant will stay for more than 5 years (or that your intended holding period is that long).

So you’ll have just 3 factors for how much money you’ll make: R, the current market rent; E, your expenses², and T_r, the amount of time the renter stays, which is unknown but we’ll pin at 60 months.

So renting right away will give you: (R – E)*T_r.

So far so good. Now if you decide to wait, you’ll still have expenses, E, to pay to carry the place. You may have additional expenses that the tenant would normally pay for, such as utilities, but we’ll assume E stays the same for now. So you’ll be losing E for a period of time, let’s say T_v, the length of time until there’s a vaccine or widespread normalcy or what have you, and you get your once and future rent again. Let’s call that A. You’ll then get that for the remainder of T_r after T_v has passed.

Waiting then will give you: (A – E)*( T_r – T_v) – E*T_v

There’s a lot more uncertainty here: how high will A get, and how fast? All the way back to pre-covid highs by the spring? Maaaybe, but IMHO that’s unlikely because that was in part driven up by AirBnB, and pandemic aside, the city has finally moved to restrict AirBnB rentals. But maybe you laugh at my foolish hope in the rule of law and say that it will never be enforced, so that’s fine. Maybe you should consider the scenario where A isn’t all that much higher than today’s rent, R. And you also don’t know what T_v is going to be. It could be a few months, as some on the real estate blogs are saying, it could be a few years to get back up to pre-covid rents.

One approach to make the decision is to compare something mostly known today to an expected value of a bunch of possible outcomes. But before we do that, you have to stop and examine the risks. You could be “totally sure” of an outcome, but if being wrong would ruin you then you maybe shouldn’t take the risk anyway.

So some real estate investors are deep-pocketed with massive unrealized capital gains, so a year or three of vacancy doesn’t really phase them. Their advice to wait may mean little to the start-up specuvestor who expected the condo they stretched to buy to make money, not demand it while they are also financially strained from the pandemic. If 3, 6, or 12 months of that negative E term starts to look like bankruptcy, then you may need cashflow now even if it caps future potential gains (or you may want to look at selling while the selling is still pretty decent).

If you’re able to survive different outcomes, then you can do some math on expected value. How likely is the scenario where rent goes all the way back up in 3 months? How about the one where it takes a year? How about the one where you wait 18 months and settle for rent that’s the same or even lower than today? An expected value is just a weighted average of each of the outcomes, where the weighting is your guess on the probability.

You can plug all those in to a spreadsheet, and give yourself some information to work from.

Here’s an example of how that might work:

Pre-covid rent: $2250. Expenses: $1600/mo. Current rent: $1860.

Renting now would earn $15,600 over 5 years (at which point we assume the tenant with the cheap rent leaves and it’s ceteris paribus).

Rent later might have four equally weighted scenarios, say you wait a year for things to settle out and see where rent is at, and maybe it’s fully recovered, maybe partly recovered, or maybe you decide to wait a bit longer if things are on the upswing but still a bit below the peak, or maybe you get lucky and rent goes through a huge whip-saw and gets back to where it was in just 6 months.
1: Rent for $2250 after 1 year, vacant until then = -$19,200 + $31,200 = $12,000
2: Rent for $2000 after 1 year, vacant until then = -$19,200 + $19,200 = 0
3: Rent for $2250 after 18 months, vacant until then = -$28,800 + $27,300 = -$1,500
4: Rent for $2250 after 6 months, vacant until then = -$9,600 + $35,100 = $25,500
Average/expected value: $9,000

So here’s a spreadsheet, play with your own numbers and assumptions… but three of the scenarios above lost out to renting right away, even at a 17% discount. You have to have either very low expenses or very high hopes for a speedy rental recovery to make the case for waiting for the market to recover. Or fear a rent-controlled tenant will stay substantially longer than 5 years.

Psst!

Hmm?

Psst, Potato!

Oh hey, it’s Italics Man, paying a visit from Nelson’s blog.

Yeah hey, expenses don’t matter.

And indeed, if you’re paying the same expenses whether you rent the place out or not, then you can drop that term in all the math: the only thing that changes between the scenarios is the revenue (though if your expenses change, such as having to pay utilities that a tenant would otherwise pay during a vacancy, that’s a different story). So we could simplify it down even further: look at the difference in rents and how long it takes to go from one level to the other. Taking $400/mo less means you lose ~2 months of rent every year. So if you figure a tenant might stay for 5 years at the lower rent if you rent right now, then your breakeven point would be to wait for 10 months for a full recovery. If that sounds unlikely, then you may as well rent now. Given that renting now means you don’t have to endure 10 months of highly negative cashflow, I’m inclined to think that renting now really should be the preference given these numbers, but I also think getting all the way back up to pre-pandemic rents in a matter of single-digit months is quite unlikely.

However, including a version with the expenses may be important when framing the decision. After all, in the case where you wait a very long time (#3 above), you not only made less money, you had a loss on the condo. Even in the other cases, waiting starts with a loss, which you need to be prepared for and see when making that choice — do you have that first $20k on hand to survive to the high-rent near future you predict? People are sometimes much more motivated to avoid losses than increase gains. When all the numbers are positive, the decision looks very different.

More importantly, remember that there was a third choice: selling and bailing. Here’s where it makes all the difference to look at the amounts with expenses versus just the difference in revenues. If your expenses are high enough, then either the choice of lower current rents or waiting for higher rents may have you staring at a big loss and an even bigger cashflow hole. That may mean selling into a slightly weaker-than-last-year market may be the way to go for you, to take your lumps now rather than bleed cash over the next year or two.

And of course, all of these numbers have more uncertainty than I’ve indicated. For the most part, I think I’m being generous to the owner considering delaying — I didn’t include any scenarios where they wait only to find rent has gone down further. It depends on your view of the market, but I have a hard time believing that after the year that 2020 has been that rents will be sharply recovering for downtown condos any day now.

On the flip side, some people are worried about rent control and a tenant paying less than market rent for even more than my arbitrary 5 years. If you think you may get stuck for a decade or more you can try to convince yourself that it’s worth it to hold a vacant unit for an extended period of time. If you’re worried about being stuck with a below-future-market tenant for 12 years then you might be able to talk yourself into two whole years of vacancy (depending on the difference in rents, etc.). Of course, by that same logic you should have never rented over the past few years anyway, when downtown rent inflation was out of control — getting 10% less than you could get next year was a bad move if you were worried about the tenant sticking around for infinity years with rent control. As the magnitude of the gap between current and future rents widens then you may have an argument for tenants having more of an incentive to stick around – being just 10% below market may not have been enough to get them to forestall their life plan of moving from your 1 bdrm to a 3 bdrm in the burbs, but maybe a 17% would get them to hang around just to spite you? Still, I think there’s an underlying current of fear around rent control that leads people to make these suggestions to keep a place empty rather than make some money and house someone at the same time, rather than a serious economic analysis.

Anyway, feel free to check your own assumptions and situation, but I suspect that the best strategy is going to be to accept that the market sucks right now and rent anyway rather than prolonging a vacancy on hope, or to sell if your view on the long-term market has been changed.

1. While the downtown condo market has cooled a bit from the peak, valuations are still historically high, and astronomically high on a cap rate basis thanks to lower rent, as rents have dropped more than prices.

2. We’re not going to worry about inflation or time value of money to keep things simple, but yes, the costs would be expected to increase over time, with an additional big bolus of uncertainty from what property taxes will do after the sledgehammer that covid was to the city’s finances.