Blessed by the Potato

Rents are dropping in Toronto, particularly for downtown condos (the market that had been driven up the most by the AirBnB crime syndicate phenomenon in the first place).

That raises an important question: what should owners of a vacant condo do? Advice is all over the map, from those who say to sell it while valuations are still high¹, to those who say to rent it out tout suite to avoid cash burn, to those who say to do the opposite and hold off because rents will go back up one day but renting at a low price now will lock you in to covid rents until the tenant leaves.

Not so long ago when prices were increasing all the time, real estate bulls had the logic that the best predictor of the near future is the present, so better buy now before it gets even more expensive. Well, that argument can work in reverse too: better take the rent you can get now before rents drop even more — or to bleed money with a vacancy if they don’t go back up. On the other hand, Toronto real estate has always been a story of hope and bullishness over all comers, and unrelenting bullishness and irresponsible leverage has won every time so far, so why not one more victory for that unstoppable pair?

How do you even approach such an important decision with such uncertainty and completely opposing advice? Congratulations to the regular readers who said spreadsheets. Save us math, you’re our only hope!

First off, consider the two choices for renting the place out: early, or late. That will help frame the third choice of selling the place (or possibly buying more while prices are “low” because you can make multiple millions but only go bankrupt once so the risk-reward is clear).

Renting now is more-or-less certain what you’re going to get. The main uncertainty is how long your new tenant will stay in place (which is only a concern if rents to go back up substantially faster than rent control guideline increases). But you can pull a number out of a hat and likely not be too far off. These are downtown condos we’re talking about, even at a discount to market rent it’s quite unlikely a tenant will stay for more than 5 years (or that your intended holding period is that long).

So you’ll have just 3 factors for how much money you’ll make: R, the current market rent; E, your expenses², and T_r, the amount of time the renter stays, which is unknown but we’ll pin at 60 months.

So renting right away will give you: (R – E)*T_r.

So far so good. Now if you decide to wait, you’ll still have expenses, E, to pay to carry the place. You may have additional expenses that the tenant would normally pay for, such as utilities, but we’ll assume E stays the same for now. So you’ll be losing E for a period of time, let’s say T_v, the length of time until there’s a vaccine or widespread normalcy or what have you, and you get your once and future rent again. Let’s call that A. You’ll then get that for the remainder of T_r after T_v has passed.

Waiting then will give you: (A – E)*( T_r – T_v) – E*T_v

There’s a lot more uncertainty here: how high will A get, and how fast? All the way back to pre-covid highs by the spring? Maaaybe, but IMHO that’s unlikely because that was in part driven up by AirBnB, and pandemic aside, the city has finally moved to restrict AirBnB rentals. But maybe you laugh at my foolish hope in the rule of law and say that it will never be enforced, so that’s fine. Maybe you should consider the scenario where A isn’t all that much higher than today’s rent, R. And you also don’t know what T_v is going to be. It could be a few months, as some on the real estate blogs are saying, it could be a few years to get back up to pre-covid rents.

One approach to make the decision is to compare something mostly known today to an expected value of a bunch of possible outcomes. But before we do that, you have to stop and examine the risks. You could be “totally sure” of an outcome, but if being wrong would ruin you then you maybe shouldn’t take the risk anyway.

So some real estate investors are deep-pocketed with massive unrealized capital gains, so a year or three of vacancy doesn’t really phase them. Their advice to wait may mean little to the start-up specuvestor who expected the condo they stretched to buy to make money, not demand it while they are also financially strained from the pandemic. If 3, 6, or 12 months of that negative E term starts to look like bankruptcy, then you may need cashflow now even if it caps future potential gains (or you may want to look at selling while the selling is still pretty decent).

If you’re able to survive different outcomes, then you can do some math on expected value. How likely is the scenario where rent goes all the way back up in 3 months? How about the one where it takes a year? How about the one where you wait 18 months and settle for rent that’s the same or even lower than today? An expected value is just a weighted average of each of the outcomes, where the weighting is your guess on the probability.

You can plug all those in to a spreadsheet, and give yourself some information to work from.

Here’s an example of how that might work:

Pre-covid rent: $2250. Expenses: $1600/mo. Current rent: $1860.

Renting now would earn $15,600 over 5 years (at which point we assume the tenant with the cheap rent leaves and it’s ceteris paribus).

Rent later might have four equally weighted scenarios, say you wait a year for things to settle out and see where rent is at, and maybe it’s fully recovered, maybe partly recovered, or maybe you decide to wait a bit longer if things are on the upswing but still a bit below the peak, or maybe you get lucky and rent goes through a huge whip-saw and gets back to where it was in just 6 months.
1: Rent for $2250 after 1 year, vacant until then = -$19,200 + $31,200 = $12,000
2: Rent for $2000 after 1 year, vacant until then = -$19,200 + $19,200 = 0
3: Rent for $2250 after 18 months, vacant until then = -$28,800 + $27,300 = -$1,500
4: Rent for $2250 after 6 months, vacant until then = -$9,600 + $35,100 = $25,500
Average/expected value: $9,000

So here’s a spreadsheet, play with your own numbers and assumptions… but three of the scenarios above lost out to renting right away, even at a 17% discount. You have to have either very low expenses or very high hopes for a speedy rental recovery to make the case for waiting for the market to recover. Or fear a rent-controlled tenant will stay substantially longer than 5 years.

Psst!

Hmm?

Psst, Potato!

Oh hey, it’s Italics Man, paying a visit from Nelson’s blog.

Yeah hey, expenses don’t matter.

And indeed, if you’re paying the same expenses whether you rent the place out or not, then you can drop that term in all the math: the only thing that changes between the scenarios is the revenue (though if your expenses change, such as having to pay utilities that a tenant would otherwise pay during a vacancy, that’s a different story). So we could simplify it down even further: look at the difference in rents and how long it takes to go from one level to the other. Taking $400/mo less means you lose ~2 months of rent every year. So if you figure a tenant might stay for 5 years at the lower rent if you rent right now, then your breakeven point would be to wait for 10 months for a full recovery. If that sounds unlikely, then you may as well rent now. Given that renting now means you don’t have to endure 10 months of highly negative cashflow, I’m inclined to think that renting now really should be the preference given these numbers, but I also think getting all the way back up to pre-pandemic rents in a matter of single-digit months is quite unlikely.

However, including a version with the expenses may be important when framing the decision. After all, in the case where you wait a very long time (#3 above), you not only made less money, you had a loss on the condo. Even in the other cases, waiting starts with a loss, which you need to be prepared for and see when making that choice — do you have that first $20k on hand to survive to the high-rent near future you predict? People are sometimes much more motivated to avoid losses than increase gains. When all the numbers are positive, the decision looks very different.

More importantly, remember that there was a third choice: selling and bailing. Here’s where it makes all the difference to look at the amounts with expenses versus just the difference in revenues. If your expenses are high enough, then either the choice of lower current rents or waiting for higher rents may have you staring at a big loss and an even bigger cashflow hole. That may mean selling into a slightly weaker-than-last-year market may be the way to go for you, to take your lumps now rather than bleed cash over the next year or two.

And of course, all of these numbers have more uncertainty than I’ve indicated. For the most part, I think I’m being generous to the owner considering delaying — I didn’t include any scenarios where they wait only to find rent has gone down further. It depends on your view of the market, but I have a hard time believing that after the year that 2020 has been that rents will be sharply recovering for downtown condos any day now.

On the flip side, some people are worried about rent control and a tenant paying less than market rent for even more than my arbitrary 5 years. If you think you may get stuck for a decade or more you can try to convince yourself that it’s worth it to hold a vacant unit for an extended period of time. If you’re worried about being stuck with a below-future-market tenant for 12 years then you might be able to talk yourself into two whole years of vacancy (depending on the difference in rents, etc.). Of course, by that same logic you should have never rented over the past few years anyway, when downtown rent inflation was out of control — getting 10% less than you could get next year was a bad move if you were worried about the tenant sticking around for infinity years with rent control. As the magnitude of the gap between current and future rents widens then you may have an argument for tenants having more of an incentive to stick around – being just 10% below market may not have been enough to get them to forestall their life plan of moving from your 1 bdrm to a 3 bdrm in the burbs, but maybe a 17% would get them to hang around just to spite you? Still, I think there’s an underlying current of fear around rent control that leads people to make these suggestions to keep a place empty rather than make some money and house someone at the same time, rather than a serious economic analysis.

Anyway, feel free to check your own assumptions and situation, but I suspect that the best strategy is going to be to accept that the market sucks right now and rent anyway rather than prolonging a vacancy on hope, or to sell if your view on the long-term market has been changed.

1. While the downtown condo market has cooled a bit from the peak, valuations are still historically high, and astronomically high on a cap rate basis thanks to lower rent, as rents have dropped more than prices.

2. We’re not going to worry about inflation or time value of money to keep things simple, but yes, the costs would be expected to increase over time, with an additional big bolus of uncertainty from what property taxes will do after the sledgehammer that covid was to the city’s finances.