What Happens To Toronto Real Estate Investments If We Enter A Recession In Canada?
Introduction
We’re seeing recession creep into the news more so lately, which nobody likes to see. Right now, 59% of Canadian economists are predicting that we will see a recession by the first half of 2024. So in this video, let’s take a look at where our Canadian economy is at, what we might expect to come, and how a recession might impact Toronto real estate if it happens.
Canada's Economic Situation Now
I’m going to defer to the Bank of Canada (BoC) to talk about where we are right now. In a speech by BoC’s deputy governor in mid May, they tell us that we’re not in the same situation as where we were in the 70’s. We’re not in a stagflation situation because we’re not in a recession but rather seeing very strong economic growth, with our GDP is growing year over year and month over month.
The other sign that we are in a strong economic environment is that our unemployment is at all-time lows. Canadians are still pretty rich, have more savings than normal, and this is why our spending continues to increase. When you combine this with supply chain issues from COVID and the extra commodity shock caused by the war in Ukraine, the Bank of Canada refers to our current situation as “the perfect storm,” which is why we’re facing a major inflation problem.
Honestly, the Bank of Canada has a very tough job in front of them. They are trying to aim for a super targeted landing. They want to cut the excess COVID demand so that we can reduce wages, prices, and corporate growth to drop inflation. But they can’t cut demand by so much that normal output gets slashed and our GDP tanks.
I know a lot of people think the Bank of Canada acted too slowly, and they were too naive to think that inflation was transient. Honestly, it’s way more clear with hindsight. The important part is that the Bank of Canada agrees that inflation is a big issue and has been adjusting inflation projections every quarter, as you can see from this chart. Right now, we’re seeing more realistic expectations for larger levels of inflation over a longer period of time, hopefully peaking, but it is much harder to tame.
Similarities & Differences Compared To the 1970s
Now, it would be very detrimental if we ended up going back to where we were in the 70’s and 80’s, so let’s see how we compare. As you can see, we are seeing the highest level of inflation since 1981, and we are seeing our CPI exceed the GDP, which is similar to what happened in the 70’s and 80’s.
But let’s look at the differences. Our unemployment rate is a key indicator that our economy is indeed much stronger as I already mentioned. Right now, it’s an an at all-time low, which is very different from the 70’s and 80’s, where unemployment was much higher.
The second difference is our GDP trend. During the peak of inflation in the late 70’s and early 80’s, the economy was slowing down, as indicated by a dropping GDP. If you think that our inflation is peaking, we are in a different situation because our GDP is still growing.
The third difference might be the unwinding of the COVID effects, which naturally helps to balance out supply and demand and lower inflation on top of raising rates. We’re seeing workers come back as they recover from COVID, factories opening up again, and people naturally shifting from goods to services as COVID comes to an end. All of this will help cut that excess demand from the past two years.
What Happens To Real Estate If We Enter A Recession
Real estate will definitely crash if we end up seeing double digit interest rates, but the Bank of Canada already came out to say that they’ve made that mistake before and that’s not going to happen. What’s more likely is that overnight rates are going to stay between 2 and 3% in the long run, but might edge a bit higher than 3% if needed.
That gives us confidence that if we do see a recession, it would be more like the newer recessions starting in the 90s, where real estate stayed pretty strong and stable throughout-which is a much better case scenario. Over the next year, we do expect overnight rates to reach close to the upper bound of neutral rates at 3%, and that is a big jump from our starting point of 0.25%.
Variable rates have around a 1.5% premium over overnight rates, so variable rates might get to 4.5%. And when that happens, based on our analysis, there will be very different effects on the end-user real estate market compared to the investment property market in Toronto.
Let’s take a look at end-user homes first. On a $1.5M home, when variable rates were at 1.75%, the monthly mortgage was $4300. Once variable rates get to 4.5%, the monthly mortgage will increase to $6100, which is a $1800 hike in monthly expenses and not workable. So real estate prices will have to come back down closer to $4300 per month, which would mean prices have to drop to $1.05M, or a 30% drop on the end-user side.
On the investment side, we can use the same $1.5M purchase price at a 4.2% cap rate, which is typical of triplexes at around this price. That translates to $1,400 of positive cash flows, which act as a buffer when rates rise. But even so, it will be cash flow negative at -$350 once variable rates go to 4.5%. Most real estate investors aren’t comfortable with negative cash flows on a freehold, so that means the price of investment properties will also have to drop but not by as much. Actually, prices would only need to drop to $1.4M for cash flows to be slightly positive, and that would be equivalent to an 7% drop.
Rising rates have a much bigger impact for end users, and what we might also see is end users deferring their purchases and staying renters for a longer period of time, which benefits the rental market. If we end up going into a recession, rates might come down a bit, which also benefits investor cash flows.
The last thing to remember is that real estate investors tend to invest for the long run. Even if an investor bought at the peak in February, their cash flows are likely still stable. What happens is the interest portion increases and the principal portion decreases, so the monthly mortgage payment is constant and they have decent holding power.
This means that if someone is selling in our current market, they are probably pretty motivated. It might be because they bought another home somewhere else, so they need to sell their current one, or they inherited the home and they just want to cash out, or the seller might have other financial or personal issues, or they might have a strong view of the market and want to take profit before they think the market will crash.
What this means is that if you find a motivated seller who sells for less than what the investment market actually drops by, then you end up getting a very good deal.
How We Can Help
Our last tip is that it’s probably safer to focus on the better cash-flowing investments right now, the freeholds, simply because interest rates are coming up very quickly. But of course, what you choose to invest in might differ depending on your personal situation.
So, if you want help exploring Toronto real estate investment options, let’s chat! We can look at your requirements and preferences and then match you up with the best investment property that fits your needs. After we help you buy it, our team also provides renovation guidance, leasing and property management if you need it. Just connect with us if you want to learn more about our services!
Want To Get Started With Real Estate Investing In Toronto?
We’d be happy to learn more about your situation and help you find the best investment opportunities for you.
