Small-time real estate investors have formed the backbone of Canada’s housing rental market. Despite data indicating that individual investors have been a growing share of the housing market, I don’t believe these figures tell a story that mom-and-pop investors are crowding out home buyers.
Overall home buying activity has fallen significantly with the rise in interest rates. This decline is especially apparent among first-time home buyers. Furthermore, investors have been primary purchasers of preconstruction condominiums, and the mortgage funding for newly constructed condos reflects purchase agreements that were signed several years ago. With the rise in rates, these deals are beginning to look like money losers. Even with the rapid increase in rental rates, rents are not covering expenses.
(As a side note, the significant rise of condos as a primary source of new rental supply over the last two decades wasn’t part of CMHC’s planning. Investor financing, backed by mortgage insurance companies such as CMHC, Canada Guaranty, and Sagen, emerged due to competition for market share rather than from an explicit policy aimed at promoting rentals.)
Condos have been generating negative cash flow for some time, but investors have been willing to carry these units on the belief that there is sufficient upside to this investment. Now that is not so certain. According to a recent presentation by Teranet, a leading provider of land registry and real estate services, investors with larger property portfolios are downsizing their holdings in Ontario. Bloomberg has been reporting of investors deciding to walk away from their purchase agreements with builders. This could make future condo building even more challenging, as construction funding heavily relies on presales. If this trend persists, it could pose a more prolonged issue, resulting in reduced construction activity for condos in the long term.
If investors begin withdrawing from the rental market, especially in the condo sector, how will the resulting gap in rental housing be addressed?
CMHC has been examining past federal programs from the 1970s aimed at encouraging rental construction. Specifically, they reviewed the Multiple Unit Residential Building (MURB) tax incentive that operated between 1974 and 1982. This program allowed investors constructing new residential buildings to offset losses from allowable depreciation and other construction-related costs against their other income. Around 195,000 units were built through this program.
While the MURB program was successful in driving more housing development, it was not without problems. Many investors heavily relied on debt to maximize their investment tax advantage and prioritized immediate tax benefits over long-term investment returns. When the real estate market crashed due to prime rates reaching a high of 22.75%, most of these investments lost their value. For instance, Abacus Cities, a major builder funded by MURB, declared bankruptcy in 1981. At that time, the company had approximately 6,000 creditors, mainly small investors engaged in construction projects linked to the MURB program. Abacus Cities found itself burdened with roughly $350 million in debts compared to $365 million in assets.
As this scenario suggests, the Department of Finance does not like tax shelter programs. What is not widely appreciated is the Rental Housing Finance Initiative (RCFI), announced in advance of the National Housing Strategy in the 2016 Budget, was designed to stimulate construction of rental housing without relying on tax policy changes. The recent GST rental rebate to encourage more apartment construction is likely as far as the federal government is going to go on major tax policy changes to support housing finance.
During my high school summers, I worked on a number of Abacus construction sites doing engineering survey work. Many of these projects were 2 to 3 storey “stick” construction townhouse units, where each part of the building was constructed on-site. These units went up quickly. Right now, we need programs that deliver immediate relief to our supply constraints. Apartments buildings that take nearly a decade to complete are not an immediate solution.
If a new MURB tax incentive is unlikely to be a solution, what other options exist to address the urgent housing need through small investors?
Next week, we’ll look at government housing finance policies and programs that can be designed to support small investors in expanding rental housing.
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