Some buyers who purchased pre-construction homes as an investment could be at risk of having to sell at a loss if interest rates keep rising, which could affect prices in the wider real estate market, according to experts.
In a practice called assignment sales, some buyers buy homes with the expectation of reselling their contract with the builder before the unit is ready for occupancy. It’s a common investment practice that allows buyers to profit on the rising real estate value of new developments.
“You’re getting the benefit of a real estate market that is rising without having to take out a mortgage or to put down assets beyond the 15- to 20-per-cent deposit that’s required, so it’s a really good deal,” said Mark Morris, a lawyer at legalclosing.ca.
But he said falling home values are wiping out the potential for assignment sales. That will force those pre-construction buyers to close at a time when rising interest rates make the carrying costs of the homes prohibitive. In some cases, assignment sellers have agreed to buy multiple units, making it all the more difficult to close on their purchase agreements.
If it’s a matter of forfeiting a 20-percent deposit, Morris expects those who aren’t able to sell on assignment will simply walk away when it comes time to close on the unit they agreed to purchase.
“It is a growing problem and it is something that is on the horizon,” he said.
Pre-construction values set the price floor for the entire category of homes, including resale condos, so if those who bought to sell on assignment experience widespread financial distress, the pain will be contagious, Morris said.
Despite four consecutive month-over-month drops in the average price of a GTA home, prices still remained 5.3 percent above June 2021 levels last month, the Toronto Regional Real Estate Board reported on Wednesday. But it was condos that led the annual gain, rising 9.3 percent year over year compared to detached houses, which rose only 3.5 percent in that period.
Sales of houses and condos both plummeted about 40 percent last month compared to June last year.
Houses as well as condos hit the assignment market, but there are more of the latter type of homes being built in the GTA, said Ian Serota, co-broker of record and manager of Keller Williams Legacies Realty.
Because houses sold at higher prices than condos in the last two years, those are the deals he suspects will be less likely to close. Like a $2 million assignment listing he spotted recently in Burlington, those houses are more likely to sell for the original price rather than selling for a profit by the original purchaser.
“Those people are also having a hard time qualifying because they’re taking on a higher leverage mortgage, or at least they would have been but now they don’t necessarily qualify for that,” said Serota. “They never really probably did at the beginning.”
But the level of assignment seller distress depends on when the home was purchased. Many of the homes coming up for occupancy now were purchased in 2016 and 2017.
“While people might not necessarily be happy with the interest rate that they’re getting for closing, they’re still able to close and qualify (for a mortgage),” he said.
Serota said he’s already hearing whispers of developments that will be canceled given falling prices and rising rates.
Shaun Hildebrand, president of Urbanation, a development market research firm, said he has not seen any official cancellations.
But in the first quarter of the year his company identified more than 5,000 new housing units that launched for pre-sales over a year ago and sold for $1,000 a sq. ft. or less, which he says, makes them economically unfeasible to build.
“There’s a very large pool here of potential projects that could be canceled and there’s likely others that might have been delayed in terms of starting construction and risk canceling given the cost environment,” he said.
Labor and material costs have risen dramatically in the pandemic, along with supply chain issues.
Hildebrand said the current situation with new developments is similar to what happened in 2018 when 4,687 units were cancelled, following the last major price run-up that peaked in early 2017.
“We’re kind of getting close to the same sort of situation,” he said.
“We were expecting over 30,000 units to launch this year but because of what’s happening we won’t end up anywhere at that level.”
Because rents have risen dramatically in the last year, those who purchased condos two years ago or more can probably still achieve their carrying costs by renting them, said Hildebrand.
But projects that sold over the last two years were bought at record prices. That may have made sense when interest rates were at two percent, but are harder to argue economically when rates are at five percent.
“It’s those buyers who were likely buying on capital appreciation, price speculation rather than long-term rental income,” he said.
But he expects that the real distress won’t be evident until 2024 when projects in the early stages of development are now ready to close.
Although people who buy expecting to sell on assignment comprise a relatively small group, mortgage broker and real estate watcher Ron Butler expects half of them will run into difficulty when it comes time to close.
“You might have gone the last five years selling these condos by assignment and never having to get a mortgage and you weren’t even connected with the need to get a mortgage,” he said. “And it’s not going to be pretty.”
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