Watch for these 3 supply flood indicators in the real estate market.

 I had someone inquire about last week’s 3-pointer videos on Instagram (which I haven’t posted the follow-up article to, sorry). The inquiry was specifically about the meaning of a supply-flood, and how exactly that may take shape. A flood, or other type of supply-shock is probably the biggest vulnerability the real estate market faces right now, and potentially the only thing that could cause prices to decline in a meaningful fashion alongside the major indices. In order

Be mindful that economics assumes that consumers are rational. Rational people typically buy real estate for passive income (cash flow), whereas they invest in the stock market for growth. Canada has one of the worst-performing stock markets in the world, so apparently we had to place our detachment from fundamentals elsewhere.

Detaching from fundamentals has basically taken shape as people buying property for speculative value increase. Because that’s been such a consistent trend, people have come to rely on it, and that causes problems. I’m not implying it couldn’t have perpetuated forever, but a true black swan has arrived, and if that sentiment starts to erode, it’s going to be the most important metric for our economy to watch.

If you assume everyone wants to exit with an equal % IRR, you can see the exits each person would need to target to get out. Much like the stock market purging itself of toxic assets as they infect, there would be different erosions at different support points, during which speculators may supply the market in unison, causing a supply shock.

1. Watch the Low-hanging fruit:

Remember the idea that “one bad apple ruins the bunch?”… well, in this case, the low-hanging fruit has already fallen to the ground, and it should start rotting any day now. Following the flight to safety or flight to quality theories of finance, properties should appear on the market in order of:

1. their downside risk;
2. the impact of the virus on their income; and
3. the sunk-cost associated with the barrier to entry. You would quantify this as a sort of “willingness to sell” curve, or a price elasticity of supply. 

Current property use:

Basically, when analyzing the market’s vulnerability to a supply shock, you want to understand how many units exist of a certain risk profile, and then understand what price they’d need to sell to break-even. 

The most recognizable properties of this nature would be the ghost-hotel units in Toronto’s real estate market, specifically among Toronto condos. It would not be unreasonable to expect to see a flood of former Airbnb listings as the ghost-hotel concept is massively impacted by coronavirus. Ironically, the virus’ impact was just salt in the wound, as the City of Toronto was already in the middle of a regulatory change, which would have seen the majority of these units reach the rental housing stock – and therein lies the rub.

Converting to a long-term rental seems like a futile exercise given that tenants think they don’t have to pay rent this month because the media told them that lenders weren’t charging mortgage payments. Even beyond that cynicism, in the current economy, expecting a tenant to pay a few month’s rent is extremely optimistic, and probably relatively unfair.

So, ask yourself, do you hold the unit, or dump it at a profit before everyone else does the same? 

Entry price:

I’m assuming cash purchase rather than levered return, and using really rough numbers here to get the point across, I’ll try to substantiate with some real data.

Independent of all other factors in the market, the following would be true if each investor wanted to get an equal return since they purchased, and they should hypothetically list their properties in this order:

•  Investor who purchased at $700/SF in 2016 and wants a 10% annual return will sell at ± $980/SF, and can afford to stay in the market the longest.
•  Investor who purchased at $800/ SF in 2017 and wants a 10% annual return will sell at ± $1,040/SF and can afford to stay in the market longer than those who paid higher.
• Investor who purchased at $900/ SF in 2018 and wants a 10% annual return will sell at ± $1,080/SF and can afford to stay in the market longer than those who paid higher.
• Investor who purchased at $1,000/ SF in 2019 and wants a 10% annual return will sell at ± $1,100 SF, and is likely enter the market first.
• Investors who have paid >$1,000/ SF for units that have yet to complete may be incentivized to walk away from pre-construction units. 

I’m not saying this is what’s going to happen, but if it were going to, that’s what it would look like, assuming a rational consumer. If you want to investigate whether or not it might be happening, take a look at a ghost-hotel building in Toronto… Liberty Village, ICE, or CityPlace could make sense.

2. Competitive pricing

The easiest way to understand whether or not this is happening is how properties are pricing based on one another. In a typical seller’s market, we have properties that price comparatively, whereas in a supply-flood, you’d see properties pricing competitively 

This is a tiny, nuanced difference, but it’s an important one. If we begin to see sellers undercutting one another’s pricing to communicate their motivation to the market, this would be a primary leading indicator that we could see prices move down.

3. Long-term indicators

There are 3 long-term indicators that could lead to greater sell-offs of property. When evaluating these, be mindful of the challenge of real estate illiquidity prevents stock-market style sell-offs. So, we could already see investor sentiment in decline, but it’s being propped-up by marginalized purchasers re-entering the market to try to capitalize on the “virus that will just go away”. Remember how polar bull vs. bear investment theses are right now.

1.    Q1 earnings: if we start to see Covid’s impact quantified in domestic companies, this trickles down into real estate, and into investor sentiment. Remember these big companies are also end users of Canadian real estate, just like residential tenants are.

2.    Unemployment: if we start to see unemployment jump, especially by 20%+ estimates we’re seeing in the market right now, this would cause a serious impact on tenants’ ability to pay rent, and eventually, that translates to the bottom line of the people that rent to them. This translates a lot faster 1-to-1 on individual units than it does 100-to-1 on institutional ownership. Also, higher-priced units will suffer more. The closer to the price floor established by the welfare system, the safer the asset right now.

3.    GDP contraction: Similar to Q1 earnings, but a more long-term metric that alludes to further contraction in Q2 earnings, and an even further dip.

4.    Insolvencies: This one may take some time, given that nobody knows what to do right now, but eventually, well see insolvency climb, and assets have to clear out with that. 

^ Hoyes Michalos / HMA ^ (click to view article)