As high as Toronto and Vancouver rents may seem to local tenants, landlords often lose money there.
In recent years, many family real estate investors in both cities have quietly paid more in mortgages and other property costs than they receive in rent, hoping they’ll end up selling for a profit on the back of rapidly rising home values. , experts say.
But as interest rates soar and price growth slows, some highly indebted homeowners are starting to feel the pressure more acutely. This financial pain could eventually push rents even higher, some experts warn.
“It’s all about leverage,” said Ron Butler, a Toronto mortgage broker.
His company, Butler Mortgage, receives daily calls these days from real estate investors in Ontario who have used a home equity line of credit (HELOC) for all or part of the down payment on a second property. Home equity lines of credit have variable interest rates that lenders generally adjust up or down based on fluctuations in the Bank of Canada‘s benchmark interest rate.
Will a new Tax-Free Savings Account help homebuyers? Experts offer mixed reviews
Here’s the income you need to pay rent in major Canadian cities
Canada’s central bank has raised its key rate by 0.75 percentage points so far this year and analysts expect several more hikes in the coming months. Rate increases are rapidly increasing HELOC payments, a headache for some investors who bought expensive properties during the height of the pandemic housing boom.
“If you bought a rental property seven years ago, which was hugely cheaper – you may even have had positive cash flow – you’ve had time to pay off the HELOC,” Mr Butler said. .
But if you’re an investor who bought in the last 18 months at a much higher price using a HELOC for the down payment and with rent not fully covering your monthly costs, “you now have a problem,” a said Mr. Butler.
It’s not uncommon for homeowners who’ve seen the value of their first home skyrocket in recent years to borrow against their home’s equity with a HELOC to fund the down payment on an investment property, Mr. Butler, speaking of the Ontario market. Borrowers often do not disclose to their bank their intention to use the HELOC to acquire a second home, he added.
Once they’ve withdrawn the money for a HELOC down payment, borrowers typically apply for a mortgage to fund the rest of the home purchase, Butler said.
With HELOC rates rising, many of these highly leveraged investors are now scrambling to convert their line of credit balance into mortgage debt with fixed payments, Butler said. The risk is that some may not be able to do so.
This may be because the additional debt they have taken on the investment property means they are not meeting lenders’ requirements. Another hurdle is the fact that rising interest rates have raised the bar that borrowers must clear to pass the federal mortgage stress test, Butler said. Another problem is that mortgages, unlike HELOCs, require principal and interest payments, resulting in higher monthly expenses for borrowers, he added.
Although Mr Butler said he had yet to see this scenario play out in real life in the current environment, he did witness highly leveraged investors who ran into this sort of problem in 2008. and 2009, when house prices in Canada briefly fell after the financial crisis. crisis.
Most homeowners aren’t as vulnerable as those who used HELOCs to fund their down payments, said John Pasalis, president of Realosophy Realty. Many have fixed rate mortgages that won’t renew for a few years. And, up to certain thresholds, even those with variable rates benefit from fixed payments, with lenders simply applying a larger portion of monthly payments to interest rather than principal as rates rise.
But rising interest rates are nonetheless a concern for landlords who are already unable to fully cover their owning costs with rent, he added.
Data provided by Pasalis suggests that many investors who bought properties in the Greater Toronto Area in 2020 with the intention of renting them are not breaking even.
The average price of condos sold that year that were then rented out within 12 months of the owner taking possession was just over $600,000, with an average annual property tax bill of $2,235. $ and average condo fees of $514 per month, according to Mr. Pasalis’ figures. With a 20% down payment and what was then a competitive five-year fixed mortgage rate of 2.29%, the average monthly cost of ownership for a mid-priced property would be around $2,800, according to the calculations. from The Globe and Poster. But the average rent for properties in the group followed by Mr. Pasalis was less than $2,250, resulting in a monthly loss of more than $550.
It’s an even bleaker picture for investors who rent homes, who could face an average monthly cash crunch of nearly $1,160, according to data from Mr. Pasalis and calculations from The Globe and Mail.
In a March 2021 report, CIBC Deputy Chief Economist Benjamin Tal and Shaun Hildebrand, president of condo research firm Toronto Urbanation, found that 37% of GTA condo rental units registered in 2020 had negative cash flow, with home ownership costs exceeding rent by $492 per month on average for this group.
In Vancouver, anecdotal evidence suggests the share of recent homeowners losing money may be smaller, said Romana King, chief content officer at Zolo Real Estate Market and author of Poor House No More.
There are “deeper pockets” in the city’s real estate market, with foreign investors often choosing to buy investment properties with cash or being required by lenders to make large down payments because they have little financial history in Canada, said Ms. King. Still, negative cash flow for local family investors is not uncommon, she added.
For many real estate investors, the main reason for investing hundreds of thousands of dollars in properties that they won’t be able to rent out for a profit is the hope of being able to sell for a much higher price.
In the GTA, “people invest based on capital gains,” Pasalis said. “They don’t mind if they have negative cash flow every month because they assume the property will be worth $50,000 or $70,000 more by the end of the year.
For now, cash-flow-negative homeowners can take comfort in the fact that condominium price growth hasn’t slowed as much as that of low-rise residential buildings, Pasalis noted of the condominium market. Toronto.
Another group of investors willing to accept negative cash flow are those buying properties as future homes for their children, Mr. Tal said. The fear that offspring will be permanently excluded from the real estate market is common in Vancouver, Ms King said.
Still, rising interest rates could cause some owners with negative cash flow to shed their properties and deter some potential condo investors from buying, with knock-on effects for the broader rental market, Mr. Tal.
While the resulting rise in supply and slower demand could put some downward pressure on prices, it could have the opposite effect on rents, Tal said.
Indeed, a slightly weaker presence of investors in the condominium market will reduce the supply of units available for rent, even if tenant demand remains very strong, Mr. Tal said.
Canada is expected to welcome more than 430,000 new permanent residents in 2022 with even higher targets for 2023 and 2024. International students have also flocked to the country, adding to the number of newcomers looking for rental accommodation.
Cooling investor demand for condos “isn’t something that’s going to derail the market by any stretch of the imagination,” Tal said. But it will increase upward pressure on rents, he warned.
Larger mortgage payments could also increase landlords’ motivation to raise rents, he said. Although rent control regulations limit many landlords’ ability to charge existing tenants more, there are ways to get around the rules, he noted. For example, landlords often raise rents after a renovation that forces tenants to move out.
The end result could be rising tensions between real estate investors feeling the financial pressure and residents.
“There will be this showdown between tenants and landlords,” Mr. Tal said.
Are you a young Canadian with money on your mind? To set you up for success and avoid costly mistakes, listen to our award-winning Stress Test podcast.