The next housing crash

The next housing crash

The next housing crash

“A change has been proposed for this site.” Sound familiar? It should if you live in Toronto. Signs with that phrase are posted at what feels like every parking lot, church, factory and corner of the city. At this point, every Torontonian knows what change has been proposed: a condo.

But before developers can start digging, they need to sell around 75% of the units to get bank financing, depending on the site and the developer’s capital.

Purchasing pre-construction condos was popular in the early days of Toronto’s condo boom, and it certainly made many buyers a considerable amount of money back when appreciation was not ‘baked in’ – that is, not already built into the price. In 2011, Brian Persaud even wrote a book on how to capitalize on it. Units sold for far less than a comparable resale unit, and buyers could occupy, rent or sell them after a few years. And thanks to Toronto’s red-hot real estate market, the units almost always increased in value during that time.

One of the biggest concerns I have for this segment seems to be all but a casual conversation, but it’s one that I think people need to spend more time with. Many preconstruction condos will close at rates over 40% higher than they were at the time of purchase, and simply put, the buyer won’t qualify for a mortgage at today’s standards. In addition, they won’t have sufficient cash flow to carry the investment.

It’s time to wake up, real estate speculators, because this is going to hurt. In recent years, pre-construction condos have only faced stagnant or declining interest rates; now that rates are climbing, protecting yourself is more important than ever.

For much of 2015, 2016 and 2017, we had the lowest mortgage rates in history. These are not realistic rates to price into closings that, in many cases, are years out. Those buying pre-construction properties must ensure that they can secure a rate-capped mortgage from the bank on site – or have the cash flow and/or liquidity to endure higher rates. Otherwise, these clients might find themselves with a legal commitment to close on a pre-construction deal they can no longer afford. Or, heaven forbid, real estate prices could be even lower – yes, this can happen.

Currently, a big bank will partner with a developer to offer a special deal to purchasers. The bank agrees to lock the buyer in at a five-year fixed rate and even allow them to capture a lower interest rate, should rates have declined by closing. Amazing, right?

The problem is that this type of financing hasn’t been tested when interest rates are on the upswing. It’s easy for a bank to agree to lock in an interest rate when it will likely be lower at closing, because it’s to their advantage. But how can – and why would – a bank guarantee a rate today when it’s extremely likely that rates will be higher tomorrow?

My second major concern is that the timeframe until completion for these pre-construction condos is so long that either the client’s financial situation or the lending criteria could change in the interim. Purchasing a unit without guaranteed financing could leave a would-be purchaser with serious cash-flow issues.

Here’s what that could look like: A client buys a 600-square-foot pre-construction condo in 2017 for $620,000 (about the average price in Toronto at the time) and puts down 20% ($124,000) at a rate of 3% and an amortization of 25 years. The total monthly mortgage in this scenario is $2,347, not including maintenance fees, utilities, etc.

In four years, the unit is finally ready – except now mortgage rates are 5% and the monthly mortgage is $2,885, or $538 more than budgeted for.

This scenario is based on a 2% rise in interest rates. Is that a likely scenario? The truth is, we don’t know – no one does. And that’s the problem.

The take-away? Planning for four years in the future based on today’s financial circumstances is risky. For an owneroccupied purchase or an investor with a strong balance sheet, this may not be big deal, but as with any other investment or financial risk, if you can’t afford to lose, don’t play the game. While numerous preconstruction condos might make for great places to live or be very appealing investments in the long run, erring on the side of caution to avoid overexposure is always prudent financial advice.

Calum Ross has spent 15 years in mortgages and wealth management; during that time, he has funded more than $2.5 billion in mortgages. He is also an Amazon bestselling author and an alumnus of Harvard Business School.