Foreign ownership and risk: Is complacency the biggest worry?

Foreign real estate ownership has been raising concerns among Canadians and Canadian governments alike in recent months. Foreign ownership is cited as a main driver of skyrocketing housing prices in key urban markets such as Vancouver and Toronto. Many see it as a factor that’s distorting market fundamentals, and others worry Canadian real estate is being used to launder funds for criminal ends — or worse.

Real estate and construction firms may feel these issues have little directly to do with them, but that’s not the case. The worry is the building boom, driven at least in part by years of foreign investment, may be making some companies complacent about the risks they face. And should those risks materialize, these companies could find themselves facing significant and serious business challenges.

Low dollar adding fuel to concerns

The low value of the Canadian dollar has only made Canadian real estate even more attractive to foreign investors. With the dollar hovering around US$0.75, domestic properties are 25 to 30 percent cheaper from a foreign investor’s perspective than they were not long ago. It’s prompted more foreign investors to look for value in residential, commercial, and industrial properties — even vacant land. Unfortunately, this trend has coincided, if not exacerbated, concerns about foreign ownership.

A rising tide that’s hard to measure

One of the major issues involved in trying to determine the extent and impact of foreign real estate ownership is a lack of data about the trend. But this “data gap” may soon be closing: in the spring of 2016, the Canadian Housing and Mortgage Corporation (CMHC) released figures on condo ownership that provided what might be the first reliable indicator of the increasing pace of foreign ownership.

According to the CMHC data, six percent of Vancouver condos built since 2010 were foreign-owned, compared to only two percent of those built before 1990. The CMHC also revealed that its data suggested 10 percent of Toronto condos are now going to foreign buyers. With the CMHC under government pressure to deliver more detailed data about foreign ownership and its impact on housing prices and market stability, it’s likely our understanding of this trend will only improve in the months and years to come.

The market distortion effect

One of the chief criticisms of foreign investment in Canadian real estate is that it has distorted the market, particularly in major centres such as Toronto and Vancouver. Prices are no longer being driven by the usual balance of supply and demand. Instead, market prices are increasingly driven by unconventional reasons, the most common of which is wealth preservation. Overseas investors often worry about domestic market insecurity, or losing their savings to corruption or government fiat; they see Canadian real estate as a safe investment in an orderly, well-regulated country where their money won’t be seized.

This influx of money has, however, severed the link between housing prices and economic fundamentals, especially in major markets, sparking a growing outcry over housing affordability and demands that governments take action to rein in rising house prices. In response, earlier this year the B.C. government announced a 15 percent tax of foreign homebuyers to a mix of praise and criticism. B.C. is certainly not alone in taking such a step: in other countries, such as Australia and England, similar public uproar has also led to concrete government action. Australia generally limits foreign buyers to newly built houses and apartments, and requires a minimum $5,000 fee simply to be able to make an offer on properties up to $1 million (the fee rises beyond that). The UK introduced a sizeable capital gains tax — up to 28 percent — on the sale of foreign-owned residential property.

How the new B.C. tax affected real estate markets was dramatic: the number of transactions involving foreign buyers dropped from 2,034 deals in seven weeks before the tax to 60 in the four weeks after, according to the provincial government data. Real estate and construction firms may find the good times they’ve come to rely on are coming to an end. However, falling sales are not the only risk involved in Canada’s foreign real estate investment trend — or the most serious.

Money laundering worries rise

Another major concern related to growing foreign ownership of Canadian real estate is some buyers may be using Canadian properties to launder funds or even provide financing for terrorism. The Department of Finance itself has identified Canada’s real estate industry as highly vulnerable to such activity.

It’s not hard to understand the concern. Real estate is an incredibly active sector, one in which large sums of money are regularly exchanged. Buyers determined to hide who they are and where their money comes from can do so relatively easily using third parties or complex corporate structures. And Canada’s comparatively lax attitude towards collecting data on foreign buyers provides an attractive path of least resistance for those with something to hide — or clean.

Not that there aren’t regulations in place. The Financial Transactions and Report Analysis Centre of Canada (FINTRAC) places certain requirements on Canadian real estate brokers, sales representatives, and developers under the Proceeds of Crime (Money Laundering) and Terrorist Financing Act. Along with various record-keeping and compliance requirements, companies are required to report suspicious transactions they suspect are related to a money laundering or terrorist activity financing offence, and any large cash transactions involving $10,000 or more received in cash.

Despite this, some real estate companies affected by FINTRAC have yet to fully implement a compliance regime, even though they face potential fines of up to $500,000. Many believe that there’s little risk, given that purchase funds flow through lawyers and financial institutions rather than their companies. Others feel there’s little reason to react, given the government’s apparent lackadaisical approach to foreign ownership.

Is complacency giving risk room to grow?

The influx of foreign investment in Canadian real estate in recent years has proved a boon for the real estate and construction sector. It’s fuelled not only rising prices, but sales activity, new developments, revenue growth, and healthy margins. Times are good for many companies, and despite widespread concerns over housing affordability and worries over the impact of B.C.’s new foreign buyer tax, few can imagine the trend coming to an end.

And therein lies the risk. Years of heady growth have made many companies complacent. They’re making projections and decisions based on past trends — reasoning, for example, that because prices rose 10 percent per year for the past three years, a project coming on stream in three years’ time will experience a 30-percent price increase. But what if it doesn’t?

Few, it seems, heed the investment warning that “past results are not indicative of future performance.” Companies are underestimating the risks involved in a shift in market dynamics or less-than-ideal sales. What if 10 percent of a company’s inventory under development didn’t sell? What if a highly leveraged property experiences a price drop? More daunting for many is the prospect Canada could, for reasons beyond its control, find its foreign real estate owners pulling out — or simply moving to a new, more attractive market. These situations could have a significant impact on companies’ balance sheets and even throw transactions or succession planning into disarray.

Real estate companies’ noncommittal attitude towards FINTRAC’s regulations represents another risk. Recent developments hint the government and FINTRAC may be ramping up efforts to enforce compliance (boosting efforts to educate real estate agents about their obligations, for example). Firms that don’t understand their obligations, haven’t developed a compliance regime, or planned or budgeted for any of it could find themselves at the wrong end of a significant fine.

Take action now to avoid surprises down the road

Real estate and construction companies should take steps to ensure today’s conditions aren’t making them complacent about tomorrow’s risks.

All companies should conduct some form of scenario planning that looks at current projections through a highly critical lens. Identify where they’re based on rose-tinted extrapolations of past trends, and then consider and prepare for scenarios where those dreams don’t come true. It’s far better to know how to deal with a sudden drop-off in sales or a foreign-owner exodus now, than try to respond in the midst of a crisis.

As well, real estate companies would do well to refresh their knowledge of their FINTRAC obligations and take steps to fulfill them. Companies should ensure staff understand what’s expected of them, and reinforce — or establish — compliance processes to forestall regulators’ criticism or penalties.

Complacency is the biggest risk

Foreign ownership has provided a welcome stimulus to Canada’s real estate and construction sector and the Canadian economy overall. But the trend is giving rise to very real risks companies need to address and plan for, especially when complacency may mask their importance. Overcoming that complacency and mitigating tomorrow’s challenges today can help real estate and construction companies steer through choppy waters when a storm hits — and seize opportunities along the way.

This is the fourth in a series of MNP perspectives on risk management aimed at Canada’s real estate and construction companies which explore subjects such as enterprise risk management, fraud risk, and restructuring and insolvency risk.

For more information, contact Glenn Willis, CPA, CA, CMA, at 416.596.1711 or [email protected] or your local MNP Real Estate and Construction Advisor.