Economic Shifts and Multi-Family Markets: Insights for Canadian Investors

In the dynamic realm of real estate private equity, institutional investors are continually seeking avenues to optimize their portfolios and enhance returns. The Canadian multi-family sector, as detailed in CoStar’s Multi-Family National Report from August 2023, presents a compelling case for investors looking to divest their privately held partnership interests through secondaries. In this post, we will dissect the report and elucidate how large capital groups can strategically navigate this market.

Overview of Canada’s Multi-Family Sector

Tight Market Dynamics

At the end of 2022, Canada’s national multi-family market was as robust as ever, with vacancy rates hovering near historic lows and year-over-year rent growth reaching double digits. Markets like Vancouver and Toronto, where owning a home is unaffordable for many, exhibit the most pronounced tightness, consistently recording apartment vacancy rates below the 2% threshold. This trend is common; across the country, rising mortgage rates and swift population growth are contributing to increasingly constricted market conditions.

Demand Drivers

The factors propelling the Canadian multi-family market to such constrained levels are manifold. On the demand side, Canada’s immigration policies stand out as exceptionally welcoming, with over 431,000 new permanent residents in 2022 alone, marking the highest annual increase in the country’s history. These new residents predominantly settle in key urban centers—Toronto, Vancouver, Montreal, and Calgary—where the housing markets are notably less accessible, pushing a majority towards renting. Additionally, the influx of non-permanent residents, including students, exerts further pressure on the already strained rental market.

Supply Shortfalls

On the supply side, the landscape has been challenging. For decades, the development of new purpose-built rental properties has been sparse. Rent control policies in major cities have dampened the economic incentives for developing rental apartments, leading many developers to pivot towards constructing condos intended for ownership. Toronto and Vancouver, in particular, have seen some of the highest rates of high-rise condo development in North America. A significant portion of these condos, as estimated by Canada Mortgage and Housing Corporation (CMHC), end up being purchased by investors and enter the shadow rental market, indirectly contributing to the rental supply.

A Shift in Development Trends

However, the recent escalation in rents, driven by the extremely low vacancy rates, has sparked a resurgence in the construction of purpose-built rental apartments. CMHC reports that over 100,000 such units are currently under construction—a peak not seen in decades. Concurrently, the development of new condos has not slowed, with approximately 80,000 units under construction at the end of 2022, many of which will likely join the shadow rental market.

Forecasting Supply and Demand

The expected influx of new housing supply should ease the tight vacancy rates. However, with high mortgage rates persisting and population growth set to maintain its strong pace, Canada’s multi-family rental market is forecasted to remain tight with robust occupancy rates. While the explosive rental growth seen in recent times may moderate, the potential for strong rental rates remains, particularly for new leases, as the average market rental rates still significantly undercut the average ownership costs for comparable units in the condo market. Until the gap between renting and owning narrows, we anticipate a sustained upward trajectory for rental rates, ownership costs, or a combination of both.

Investment Climate

Multi-family properties have become a darling of investors in recent years, buoyed by solid fundamentals, access to low-cost financing from government entities like CMHC, and the allure of portfolio diversification. Yet, the landscape is shifting. Higher financing costs, tightening capital flows, and a growing divide between buyer and seller price expectations have led to a reduction in multi-family transaction volumes in the latter half of 2022. While unit sale prices continue to climb, the evolving deal structures could exert upward pressure on multi-family cap rates. The traditional leverage levels that buyers have grown accustomed to are being challenged by higher debt service requirements, leading to the emergence of alternative financing methods such as assumable debt or vendor takeback (VTB) mortgages with significantly higher interest rates.

Closing Remarks

In conclusion, while the Canadian multi-family market faces headwinds in the form of higher financing costs and a shifting investment landscape, the fundamentals remain strong. Immigration, demographic shifts, and the comparative affordability of renting collectively drive the demand in the market. On the supply side, a significant increase in purpose-built rental construction is on the horizon. For investors, the current market dynamics may necessitate a recalibration of strategies, particularly in the realm of financing and deal structuring. Moving forward, the resilience of the multi-family sector will undergo testing, yet the underlying drivers indicate that this asset class will maintain its status as a cornerstone in real estate private equity portfolios.

Economic Context: A Closer Look at Canada’s Economic Landscape

As we reflect on the economic trajectory of Canada at the close of 2022, it is evident that the year concluded on a subdued note. The overall economic growth experienced a downturn in the final quarter, primarily attributed to inventory reductions. Nonetheless, the softening of domestic demand was also a significant factor, marked by a growing disparity between resilient consumer spending and a downturn in business and residential sector investments. This divergence is not merely a reflection of a robust job market but is also amplified by substantial government transfers that have elevated after-tax household incomes, outpacing inflation. This trend poses a challenge to the Bank of Canada’s efforts to temper the domestic inflationary momentum.

Deciphering Canada’s Labor Market: Strengths and Stresses in the Face of Economic Headwinds

The Canadian labor market has shown remarkable strength, mirroring trends observed in the United States. However, the economic puzzle presents pieces that need to be aligned. We anticipate a notable deceleration in job growth as businesses grapple with diminishing productivity and shrinking profits. Escalating borrowing costs will likely shape consumer behavior as the year unfolds, with a growing number of households facing mortgage renewals at higher interest rates. While extending amortization periods can soften the immediate budgetary impact for some, it is not a solution that applies to everyone. Moreover, those who do extend their debt servicing period are likely to adopt a more conservative stance on discretionary spending.

Interest Rate Uncertainty: Navigating Canada’s Housing Demand Amid Economic Volatility

The surge in mortgage rates directly affects housing demand within Canada. Following a period of moderation, there are signs of recovery in the housing data. However, significant risks loom on the horizon. Recent turbulence in the U.S. banking sector underscores that we have yet to reach a stable state regarding interest rate volatility. The Bank of Canada is likely to hold interest rates steady, yet the policy landscape continues to be uncertain. The Office of the Superintendent of Financial Institutions (OSFI) has hinted at new regulations to address household leverage risks, and there is a persistent possibility that the Bank of Canada may need to resume rate hikes. Conversely, suppose heavily leveraged consumers strain the economy into a more pronounced slowdown. In that case, the Bank of Canada might cut interest rates by the end of 2023—a possibility that futures financial markets are already beginning to price to some extent.

Transitory Relief or Trending Down? Examining Canada’s Inflation Cool-Down and the Path Ahead

Inflation in Canada has shown signs of easing more swiftly than anticipated, partly due to targeted government interventions, such as significantly reduced daycare expenses and energy rebates in certain provinces. These measures, however, are not rooted in cyclical economic forces and thus do not offer a permanent solution to inflationary pressures. While we have seen encouraging trends in price stabilization across various sectors, including household goods and shelter costs, reducing inflation from its current high levels to the target of 2% remains a considerable challenge. While adopting a cautious approach, the Bank of Canada must continue to demonstrate that it can effectively rein in inflation.

Implications for the Multi-Family Sector

The economic backdrop has direct implications for the multi-family real estate sector. The interplay between a strong labor market and the potential for increased household leverage due to policy changes could influence the demand for rental housing. As borrowing costs rise and consumer spending becomes more guarded, the propensity to rent rather than own may increase, thereby sustaining or even intensifying demand within the multi-family market.

Investors and strategic partners in the real estate private equity space must remain vigilant, monitoring these economic indicators closely. The potential for interest rate cuts could provide a more favorable borrowing environment, while rate hikes could further compress yields and necessitate a reevaluation of investment strategies. Understanding these economic nuances will be crucial for capital groups and investors as they navigate the complexities of the multi-family market and assess the timing and structuring of their secondary transactions.

Investment Performance

For capital groups, the performance metrics of any investment are paramount. The report details a historical average asking rent growth year-over-year of 4.3%, with effective rent growth mirroring this trajectory. Sales volume figures are equally telling, with a notable peak in Q1 2023. These figures are instrumental for investors considering the timing and pricing of entering or exiting investments.

Strategic Implications for Secondaries

The secondary market for real estate private equity offers a unique set of opportunities and challenges. Institutional investors can leverage the detailed analytics and trends from the CoStar report to identify the optimal timing for selling their interests. By understanding the macroeconomic factors and real estate trends, investors can position themselves as a strategic partner to capitalize on the market’s momentum.

The August 2023 Multi-Family National Report Canada by CoStar is a treasure trove of data for institutional investors. By leveraging these insights, capital groups can make informed decisions about when to enter or exit investments, particularly through secondaries. The current market conditions, underscored by strong economic indicators and a robust investment performance, present a strategic opportunity for those looking to optimize their private-equate real-equity portfolios.

As we continue to monitor the market and provide updates, we encourage our readers to consider the implications of these findings in their investment strategies. For those seeking a strategic partner to navigate the complexities of the secondary market, our expertise and insights can serve as a valuable resource.

Note: This blog post is based on the Multi-Family Canada National Report from August 2023, credited to CoStar, and aims to provide information only.