Macro Perspective
Housing is one of the main topics debating among authorities and investors in Canada. Prolonged period of low interest rate encouraged Canadian adding to their assets by borrowing, and now that the central banks and Bank of Canada started to hike interest rate, the question is how vulnerable are Canadians to the higher cost of debt? Whether the real estate is still rational investment? How different are cities across Canada regarding the degree of vulnerability? To answer these questions, we tried to review the fundamental macro drivers of Canadian real estate market, and by emphasizing on Uptimo’s core area of competency, Sherbrooke city, depict a clear view about the Canadian housing market.
What is the Real Estate Track Record as an Asset Class?
The tile chart below shows how 8 different asset classes performed in the last 18 years. We think it can give good comprehension as it composes 2008 financial crises as well. As you can see in the last two columns, average annual real estate return in the last 18 years was 11% beating all the other assets classes and this reading can get even more interesting when you consider assets’ volatilities too. Volatility is a statistical barometer to gauge the risk of investment, and a rational investor should only consider an asset if its expected return can compensate its risks. Having said that, the real estate is the third asset after Corporate Bond and Government Bond from Risk-Return perspective, better than equities in the last 18 years. We don’t suggest bond for investors, specially long duration ones, as they are most susceptible to rising interest rate.
[1] We have used REIT as a proxy for real estate asset. REIT is a security trading on stock exchanges representing real estate company value. Although it usually affected by stock market overall environment in short-term, in the long run it is a good reflection of its real underlying property which it represents.
There are couple of factors explaining this meaningful return in the Canadian real estate market:
Secular decline in interest rate: Aging population, improved efficiency, elevated level of price competition among goods and service providers along with more awareness by consumer thanks to online purchases, lower price of oil and less portion of energy in the households’ expenses vs ten years ago, dragged the developed world’s inflation to a secular depressed level which resulted their interest rates lower. Lower interest rate means cheaper money to borrow and accumulation of wealth. We at Uptimo believe that this regime is not going to be changed because none of the aforesaid factors will be different in the foreseeable future.
Since 2016 market started to price in hiking interest rate by central banks, including Bank of Canada. Higher interest rate means higher cost of borrowing, but investors should not confuse higher rate with high rate environment. The market is expecting max 2 rate hikes from bank of Canada which means 0.5%. If you have invested in pricy markets like Toronto or Vancouver, even this very small increase can trigger market reaction. (please read the Housing Overview section for more detailed info about cities), but other cities which their housing market have not been distorted by speculation bets will sustain with higher rates as long as unemployment rate is at a healthy level.
To illustrate this concept, let’s look at the relation between 10-Year Canadian Government Bond yield (as the proxy for interest rate level) and average Canadian Cap rate. as you see the interest rate level, light green line, has been increased from 1.7% to 2.26% in the last 24 months, however the cap rate depressed slightly. Strong demand for Multifamily buildings and industrial real estate keep Canadian cap rate at the low level, although the interest rate showed increase in the past 24 months. We think this pattern going to persist. Based on our analysis, to see the cap rate starts moving upwards, 10-y gov bond yield should be trading around 3%. This will need additional 4 rate hikes from BoC which we don’t see in foreseeable future; there are even some debates that may be BoC will forced to cut rate at the end of 2019 if the oil crisis in Alberta continues.
[2] The capitalization rate or, Cap Rate, is used in the world of real estate to indicate the expected rate of return. This measure is computed based on the net income which the property is expected to generate. The higher rate usually means lower purchasing price. Therefore, compressed cap rate is a sign of high demand in real estate market.
[3] Overheating= when sale overpace the new listing. Price Acceleration= Rapid increase in the price of houses; Overvaluation= a situation when relation between house prices and personal disposable income, population, interest rate, and unemployment rate become distorted; Overbuilding= when rental apartment vacancy rate and inventory of newly built and unsold units are higher than normal .
Overview of Housing Market Assessment in Canada:
CMHC released its latest observation from Canadian housing market based on four metrics: Overheating, price acceleration, overvaluation, and overbuilding. The analysis shows high degree of overall vulnerability at the national level but with disparities among different cities. Vancouver, Victoria, Toronto, and Hamilton had high degree of vulnerabilities while, Montreal, Ottawa, and Quebec City enjoyed the low level.
Rental Market
Demand for rental housing across Canada is at record levels. The latest numbers represent strong fundamentals and limited supply of multifamily assets which is lifting properties’ valuations all around the country. The national average cap rate decreased ~19 bps to 4.9%, across all categories of multifamily properties during 3Q18, specially for low rise class B products. Montreal’s multifamily segment had the highest tightening of 62 bps in its cap rate among all Canadian cities during the quarter. When we look at different Canadian markets, we prefer QC province the most, because its economy is more diversified as opposed to western energy dependent provinces, and its housing market has not been inflated by speculators, like Ontario. In the following section, we review the fundamentals which we believe is supporting rental market in Canada.
Lower affordability:
The ownership costs of a home during 2018 lifted up around 55% of a typical household’s income. This is meaningfully higher than 43.5% three years ago. Mortgage rate increase, and implementing stress test for the mortgage applications in the past quarters were the main reasons of this fact.
The situation is more severe in Toronto and Vancouver where the share of income a household would need to cover ownership is around 95% and 120% respectively. In Montreal, the market continues to look affordable against the backdrop of relatively expensive prices in other cities, including Vancouver and Toronto, but it may start to face similar concerns as supply tightens. Therefore, as affordability deteriorates, multi-family rental is getting into a better position as more people entering to rental market.
Record and growing number of immigrants:
Canada’s population is expected to grow at an annual rate of 2.2% to 43.8 million in 2036 from 35.2 million in 2016. The federal government targeted an intake of 330,800 new immigrants for 2019 up from 310,000 in 2018. Having said these, housing density is also adding to the demand side of equation, as ~70% of total housing starts in Canada are multifamily and less than 30% single-detached houses.
Strong job growth:
In the third quarter, both the number of job vacancies and the job vacancy rate rose in every province on a year-over-year basis, a first since the beginning of the series in 2015. The average offered hourly wage for the vacancies was $41.75 for job vacancies that required a university certificate or diploma above the bachelor’s degree, compared with $16.10 for vacancies for which there was no minimum level of education. Quebec, Ontario and British Columbia reported the largest increases in the number of job vacancies. There were 31,000 (+35.5%) more job vacancies in Quebec than in the same quarter one year earlier. The rise was widespread across most sectors, with health care and social assistance; accommodation and food services; and manufacturing accounting for close to half of the provincial increase.
According to the latest result published by CMHC, the vacancy rate for rental apartments across Canada decreased overall for the second straight year to 2.4% versus 3.0% in 2017. In Quebec, the rental market experienced a tightening year, as its vacancy rate decreased from 3.4% in 2017 to 2.3% in 2018. (Vacancy rate in Montreal and Sherbrooke were 1.9% and 2.6% in 2018 vs 2.8% and 5.3% in 2017 respectively).
Rental market tightening was the highest in Sherbrooke among the other cities of the province. Higher than average migration rate, record student enrollment in the city’s universities, and ageing population were the main drivers of this fact. Neighborhoods next to the students’ communities, Lennoxville and Mont-Bellevue experienced a large decline in vacancy rate from 6.3% and 5.6% to 2.5% and 2.4% respectively. Speaking of Sherbrooke market, it worth mentioning that rental market conditions are much tighter in the case of newly built apartment.
Another key factor for rental properties’ investors, is the turnover rate, which is the proportion of units where new tenants moved in during the past fiscal year. Canada rental turnover rate was 19% in 2018 down slightly from 20% in previous year. Turnover ratio in Sherbrooke area fell from 25.7% to 23% in 2018. Tightening rental market limit tenant ability to find better alternatives.
Change in average rent for all apartments combines in 2018 was +2% in Sherbrooke which is lagging the overall Quebec province rate of +3.4%, and we think the gap is about to get narrower as the vacancy and turnover rate decline.
Final Word:
As the volatility in stock markets increases and return in fixed income are not sufficient enough to secure against inflation, investors need an asset class with foreseeable cash flow and less sensitive to change in the interest rate. We suggest investing in low rise B multifamily properties, as the source of wealth accumulation and income generation in this environment. However, investors should be worried about overvalued cities where the generated income is not enough to support monthly cost of properties. We overweight Quebec province in our real estate portfolio with emphasis on Sherbrooke city.
References of data:
Bloomberg, CMHC, RBC Capital, GMP Securities, CBRE Research, National Bank Research, The economist
[4] Net immigration to the city was 2,141 people in 2017, 31% higher than previous year.
Final Word:
As the volatility in stock markets increases and return in fixed income are not sufficient enough to secure against inflation, investors need an asset class with foreseeable cash flow and less sensitive to change in the interest rate. We suggest investing in low rise B multifamily properties, as the source of wealth accumulation and income generation in this environment. However, investors should be worried about overvalued cities where the generated income is not enough to support monthly cost of properties. We overweight Quebec province in our real estate portfolio with emphasis on Sherbrooke city.
