The K-Shaped Recovery (or the Perfect Storm that Missed)

January 27th, 2021 by Potato

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.

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