By: Denis Borisenko
Recent changes have been made to Toronto’s residential market regulations, but what do they mean in terms of future prices and rent dynamics? This is of interest not only for tenants, but also for investors, both domestic and international. Will the prices continue to grow? Will rents increase further? How will market liquidity be affected?
In different countries around the world, regulation differs widely – from very relaxed to very strict – and there are some people who believe that moderate government regulation helps smooth out market shocks.
There are three key government measures adopted in Toronto:
- tax on foreign buyers (15%);
- vacant homes tax (rate under discussion);
- rent increase cap (2.5% p.a.).
Tax on Foreign Buyers
A tax diverts at least some foreign buyers away from markets, or stimulates them to find ways in which to circumvent the measure, meaning a reduction in demand and a depression of prices. Some people argue that the measure is inefficient since the share of foreign buyers is not so significant. However, there are no clear statistics on this. If a measure is affecting the market in right direction it’s better to stick to it, regardless of the extent to which it influences the market.
This can be said for the vacant homes tax: it leads to some owners placing their properties on the rental market, increasing rental supply and making renting more affordable. The only question is the size of the impact such a measure provokes.
Rent Increase Cap
This measure is most the controversial. Not only may the reasons for introducing it include a political context, as voters obviously prefer lower rents, but hard-limit regulation can have a two-pronged effect: limiting rate increases ensures affordability of rental housing, but it may lead to a decrease in supply as developers are less willing to build rental homes. As such, the negatives associated with the implementation of the measure may outweigh the positives. However, there are a number of places throughout the world (e.g. Berlin) where they have managed to successfully implement such a policy.
When trying to understand this measure’s overall effect, there are several points worth making.
As stated above, the key argument some experts allude to regarding this measure is that it may in fact increase rental prices where developers abruptly cease pursuing rental projects. However, while in theory this statement is true, in practice there is not enough evidence to support the assertion that developers are ready to abandon many projects and even if they do, it does not affect the market in the mid-term.
We should note that a financial model with a stable rent roll increase that outpaces inflation is an optimistic one, however, a cap on rent increases is likely to lower a developer’s forecasted margins, meaning that developers are willing to pay less for the land plots they are acquiring. They will abandon projects only if landowners refuse to lower the prices of the land. A landowner’s willingness to sell will depend on the following:
if a decrease in demand from rental project developers leads to a change in the “best use” of the land – meaning there is more economic value in developing another asset class (from rental residential, to the second-best use) – then indeed, the landowner will refuse to lower the price and will sell the land to the developers of the second best use (e.g. condo or commercial), with the residential developer abandoning the project; but, if even at a reduced price, residential properties set for the rental market still remain the most profitable use for such land, the landowner will have to “bite the bullet” and accept a lower price if they want to close the deal. As such, the landowner suffers, while the developers’ attitude to new projects remains unchanged.
Therefore, this measure may have a negative impact where it leads to a massive change in the best use for properties, i.e. from residential to another asset class. Given that there is no severe deficit of any other asset class: retail, office and industrial in Toronto, and also due to the fact that changes are not always possible, a complete change of use for land is unlikely.
What is more likely, however, is that such developers may consider switching their rental residential projects to condos. Some people may argue that, as caps on rental increases force many developers to switch their projects from rental to condo, the supply of residential properties for rent lowers, thus increasing rental prices. However, even if this does take place, it is only over the short-term. So, if the supply of rental properties temporarily decreases and the supply of condos increases then, since the supply has increased, but demand has remained at the same level, condo prices go down, making developing them less profitable and so developers have less of a reason to switch the development from rental in the first place. As a result, the condo supply decreases and the supply of rental properties increases back to its initial level, meaning rental prices return to their initial level; even if we imagine that all of the additional supply of condos is met by increased private investor demand from those looking to buy-to-let and the prices don’t go down, these condos will head for the rental market. Therefore, we will have an increase in the supply of rental properties with only difference being that they are now owned by many individual owners, instead of a single property developer, so rental prices return to their initial level.
Some people may argue that previous rises in residential property prices made major redevelopment projects economically viable (e.g. the Toronto waterfront), while any decrease in prices may make them unviable. However, most of those projects began at least two-three years ago, when prices for residential properties were more than 30% lower than they are now, so they should easily withstand an equal decrease in price levels.
Some are also of the opinion that capping rent increases at a level that may be lower than inflation makes investing in such projects unviable, and certain buyers, such as pension funds, only invest in properties where the rent will subsequently experience an increase in real terms. However, there are two prerequisites for making this investment unviable: an inability to increase the rent to cover capital expenditure or repairs and renovations; and an inability to increase rent when leasing to new tenants.
Both conditions are not applicable to Toronto’s regulations. If we compare the situation with that of Europe, investment funds extensively purchase properties with fixed lease contracts with only partial inflation offset, and sometimes even without any inflation adjustment. Then we can look at differently regulated markets and see that, for example, Germany has had a rental cap for many years and this has not destroyed the market. Moreover, rental agreements are often signed for properties, stipulating rises capped at 60% of actual inflation.
Regulation to control abnormal and excessive price increases – 10-20% annual increases over the course of several years is abnormal on a developed markets, where disposable incomes do not grow at such a pace, has benefits for the market, but it is important not to be overdo it with too much regulation. Furthermore, while, in theory, limitations on rental rate increases may sometimes lead to the opposite effect on rental rates, in particular cases such as that of Toronto, it is unlikely to lead to abrupt and long-term rental price increases.
Denis Borisenko is Partner, Head of Capital Markets at Tranio.com an overseas property broker.