Strategy

Real estate: Is this a buying opportunity?

Prices are low. Money is cheap. But real estate investors still need to be mindful of where they are putting their money in this climate of uncertainty as we wait for the housing market to rebound.

Trust a real estate agent to put a positive spin on an otherwise incredible string of bad news about Canada’s housing industry since last June. That’s when the first year-over-year dip in average home prices in nine years appeared. It was a tiny dip, at 0.4%, but it signalled that the real estate boom was officially over after a decade. By January 2009, prices were reportedly down 14.2% compared with a year earlier.

But on the bright side: homes are more affordable now, says Michael Polzler, executive vice-president and regional director at Re/Max Ontario — Atlantic Canada in Mississauga, Ont. “There’s no question the high-end homes over $1 million are very slow right now,” he concedes. But “the opportunity lies everywhere right now — no different than many businesses, really. Now’s the time to organize yourself and get in.”

Before your eyes roll back into your head, Polzler may have a point. Historically, home prices have rebounded and then some about a year or two after a decline, and some major markets that had incredible runs — such as Vancouver, Calgary and Toronto — are now all of a sudden relatively affordable for first-time homebuyers. Have we hit bottom? Not likely. But the unsatisfying truth is that nobody truly knows when the market will rebound. For that matter, few can agree on what’s happening now.

For instance, the Canadian Real Estate Association reported that Toronto resale housing prices in December 2008 dropped by 8.5% compared with a year ago. But the Teranet — National Bank House Price Index (HPI), which relies on resale data provided to provincial governments, reports that prices dropped by just 0.62%. In Vancouver, CREA says housing prices dropped 0.9%, while the HPI indicates a drop of 1.54%. In Halifax, the average price is actually up by 11.9% and by 4.61%, respectively. Go figure.

Meanwhile, National Bank’s housing forward market is trading at about 20% below the current prices over the next few years, and indicates that customers who are trading on it anticipate the recovery will be a slow, painful uphill climb for the next seven years. The media have breathlessly jumped on the number, arguing that these investors are putting their money where their mouths are. Would these be the same investors who overbid stock markets worldwide and got swamped? They’re hardly a reliable source for direction.

But their bet does raise a salient point: it’s important to compare the value of a real estate portfolio with other investments. Make no mistake — buying a home is an investment, and probably the biggest one most Canadians will ever make. The numbers are revealing. On March 30, the S&P/TSX composite index had dropped 42.8% (8,673 points) from its 52-week high of 15,155 on June 6. Across Canada, average housing prices have dropped 11% to $281,972 since hitting a record $316,896 last May, according to CREA. “Real estate has nothing like the volatility in the stock market,” says Polzler. “For the average Canadian — and I don’t mean the big shooters down on Bay Street — a house still has been the safest place to put your money.” Polzler adds that sinking money into a house is like a forced savings account.

No wonder, then, that 48% of Canadians under 35 plan to buy a home within two years, compared with 36% last year, according to a March survey by Royal Bank of Canada. It’s a buyer’s market in just about every major city in the country — and a balanced market in the few that aren’t.

It’s also an opportunistic time to be a real estate investor — if you can stomach a couple of non-trivial risks. One, anything you buy today will likely be worth less in the next few months, so a quick, profitable flip is likely out of the question. Two, it might be quite a while before you do get enough of a price bump to make selling worthwhile. Prices of resale homes from 1997 to 2007 increased 98.7% for a 7.1% compounded annual rate of return, according to Re/Max. Typically, you get a 5% rate of return on residential real estate, or about 2% once inflation is factored in. But if you bought at the height of the market, now is not the time to be selling.

Home builders have been backing off new projects since November 2007. In February, only the Atlantic region is bucking the trend of double-digit drops in housing starts — Quebec, by contrast, saw a 15.7% decline, according to Canadian Mortgage and Housing Corp.’s latest numbers. “In the near term, it seems likely that residential construction activity will continue to undershoot longer-term demographic demand (roughly 180,000 units), while the Canadian economy is in the midst of a severe recession,” reported Pascal Gauthier of TD Economics. Gauthier expects the existing home market to pick up sometime in 2010, followed by new homes a few quarters after the resale market stabilizes.

But if you already own income-producing real estate, now is probably not the time to unload it. Prices are lower and the rental market remains strong, because roughly 250,000 people move to Canada every year and they generally rent before they buy. “We haven’t seen the rental market soften,” says Polzler. “I think the reason is that we don’t build apartment buildings anymore. People used to buy a fourplex or six-plex; now they buy a floor in a new condo building and rent it out.”

Paul Anand, the broker of record at Plex Realty Corp. in Toronto, says 8% — 10% of available inventory at any given time are income properties — and good properties are still scarce. Capitalization rates (the ratio of net operating income to the home’s original price or current market value) have been lower than 7% for quite awhile, and in many cases 5% and 6% are the norm. “Some people feel there is an opportunity because it’s cheap, but to me the opportunity is that we don’t have to compete for properties now,” says Anand, who adds he is always looking for more income-producing properties.

His advice? Always look at cap rates, which give an indirect measure of how fast an investment will pay off, and don’t get emotional about the properties you’re buying. “This is not glamorous work,” he says.

Rents in the commercial market have also remained stable because vacancy rates are low. “Across Canada, we’ve been at around 5% or 6% vacancy in both industrial and office, which is extremely low,” says Milton Lamb, a senior vice-president at Colliers International in Canada and a member of Colliers National Investment Team & Global Investment Services Team in Toronto. “That’s moved up, but compared to anywhere else in the world, that’s a very low vacancy rate. Just because you see the signs, it certainly exaggerates the reality a bit.”

Ah, yes, the signs. Walk down some of the most popular streets in Canada and you’ll see For Rent signs popping up with alarming regularity. Worrisome? Not really, says David Bowden, president of Colliers International in Canada. “The fear is far, far greater than the actual pain,” he says. “The downturn to this point has had only a limited impact on vacancy rates and a little bit more of an impact on rental rates, but it’s still negligible compared to the downturn we saw in the early ’90s or early ’80s.” In this cycle, despite its length and depth, there was much less speculative development than in the past three cycles (in the ’80s, ’90s and 2001). Apparently, builders and bankers learned a thing or two about building when tenants are not in place.

Not everything is rosy, though. Two areas of prime concern are downtown Calgary and Toronto, which for most of the decade were crying out for new office space. Now that new buildings are on the cusp of opening, there is a real fear that nobody will replace the new tenants in their old buildings. To fill those spots, Bowden believes, landlords will offer more incentives such as periods of free rent and leasehold improvements.

There’s no doubt the commercial market is more challenging for landlords than it was a year ago, but Bowden believes it will also turn around much quicker because there wasn’t a big overbuild. Typically, the commercial real estate market takes three or four years to rebound once the recovery starts, but Bowden thinks that time will be cut in half this time around. Commercial real estate investors are certainly quiet now, and have been for about six months, says Lamb. “The number of transactions since October is down 80% or 90% — the market just stalled,” he explains. “It’s taking a breath to figure out what the new loan-to-values for mortgages will be, what the new cost of equity is going to be.” In other words, real estate players are doing exactly what everybody else is.

Comparatively, Canada remains fairly stable, but that relative stability might actually slow down the recovery. That’s because while there is more risk in other markets, such as New York and London, which have been hammered far worse than Canada, the potential reward is that much higher, too. “Some international investors won’t even find Canada interesting, because we will not offer the high yields a New York or London could possibly achieve if there is a rebound,” says Lamb. “Other groups are more focused on strong income and will very much like Canada.”

In that sense, commercial and residential property investments are quite similar. Canadian real estate overall just hasn’tplummeted like it has in the U.S. or the U.K., and it may never hit those depths. The banks are comparatively strong, there were far fewer sub-prime mortgages dealt out (though certainly some), and reasonable financing for loans in the $5-million-and-under range can still be had.

The key to success for those thinking of selling now is to “hold the line, if you can,” says Polzler. “Rent the properties out and the prices will come back. They always have.”