Mark Carney thinks Canadian real estate is a bubble. When asked about it, the former governor of the Bank of Canada (BoC) once said “real wealth is built through innovation, it’s gained through hard work. It’s not through some magical asset inflation.” That was in 2013, when he was still the BoC Governor, and before Carney took his low-inflation circus over to the Bank of England. Since he’s said that, prices in Canada didn’t cool – they actually capitulated higher. How do prices continued to rise, especially in the new construction segment? It looks like smart real estate developers are using a very interesting trick that’s widely used in the apparel industry – massification.
Don’t Alienate Buyers
This may come as a surprise to many, but people have a finite amount of money. I know, shocking, right? The higher the price point of the product, means fewer buyers will be able to afford that product. As prices increase, volume drops, but ideally the seller gets to make up the total dollar volume with even higher prices. The problem is, eventually prices get so high you can’t find enough people to maintain your dollar volume.
You can slash the price, and try to stimulate more buyers with a discount. Unfortunately, this alienates existing buyers of the product. Afterall, you feel pretty crappy if the next round of buyers are paying less money than you, for the same product. Instead, smart brands adopt a strategy that luxury companies have been using for decades – massification.
Oh Yeah, We All Know What Massification Is… But Tell Us Again
No. Not that thing your priest told you would make you go blind.
Massification is a strategy that companies use to attain maximum growth, while maintaining brand image. The strategy is relatively simple, you create another product line, that creates primary revenue at a lower price point. Now you have two lines, something cheap and attainable, and one that people strive for. Together they add up to even more profits than you would get using a single line. You know have two distinct marketplaces.
Buyers of the two seemingly distinct brands have a very different opinion of the product. The high end consumer believes the lower priced products are inferior. You know, because the stuff they buy never gets discounted. The buyer of the lower priced product can’t justify (or afford) the high end consumer’s product. However, they can be convinced to pay a premium on a cheaper product with similar branding. Sometimes the lower priced product is of equal quality, sometimes it’s not even related.
Examples of Massification In The Wild
There’s a couple of examples that illustrate this point to people in the business. Most notably, designer perfumes and department stores. Perfumes are one of the first applications of this. Have you ever seen one of those fashion shows, where apparel companies show completely unwearable clothes that are more art than fashion? Those outfits run in the tens to hundreds of thousands of dollars. Dressing like a butterfly covered in sequins isn’t for everyone though, so the market is pretty small. They mostly are only sold to people going to galas or award shows… if sold at all.
The market is fairly limited, and some companies don’t even make enough sales of these pieces to cover the cost of the show. The solution? Purfumes. You may never buy a $100,000 ballgown, but there’s a chance you’ll pay $150 for $5 worth of smelly oils in a bottle to feel like you’re the kind of consumer that pays for that ballgown. Now you know why high margin perfumes are the first floor at every department stores. Speaking of department stores…
Department stores elevated this concept even further, by segmenting the discount apparel into another store. Fancy department stores might have a sale, but once the markdown gets to a certain point, they don’t want consumers ready to pay the premium to see these discounted stock. Instead, they move it to a clearance centre, an “Off Fifth” location. The same product, just in a less premium or visible location. Ew, visiting a discount store? How gauche.
Canadian Developers Are Pioneers In Massification of Real Estate
If you’re from Toronto and Vancouver, you may have noticed that prices are way beyond typical incomes. Despite this, towers keep getting taller, and the units appear to be selling at an ever increasing price point. Some clever Canadian developers took the concept of massification, and applied it to real estate development. We’re seeing two distinct forms of massification to maintain price points, level phasing and overseas sales.
Many people don’t realize that buildings are sold strategically to get financing for the project, and the last few units are the developer profit. Early buyers get a “discount” for the project, and it gets more expensive as the project reaches release. They used to be similar finishes, and about a decade ago you would get dinged an extra $2,000 on each floor higher. Now, many projects treat lower levels almost like a completely different building. They’re often tiny boxes, with mass market finishes.
Many of these units are only available through bulk pre-sale buyers, that sell them as “investor grade” to rent out. As the first few phases close, you enter different configurations with higher end products. Once the building registers, you more closely follow the “price per square foot” model for resales, but everyone in that building paid a very different price to get in. That means the mass units bought at a discount on lower floors, often end up getting the price per square foot averaged higher to more luxurious floors.
More interesting is the overseas model we’ve been seeing pop up. An increasing trend is selling units overseas to investors in bulk. Typically at a deep discount, with various middle people taking a cut until it gets sold back in Canada at a similar rate to what the developer was offering here. Recently I came across a great example of this. One developer assigned a few dozen units to a marketing firm, knowing they would sell them overseas. Once the units were sold, they had attained enough for financing. They then rolled out a “locals first” campaign, where locals would get first dibs on… well, the rest of the “profit” units. Yes, they will probably claim ignorance on the bulk sale. Afterall, they sold it to a local, who just happens to specialize in overseas sales.
Basically, if you’re buying a condo in Canada – you’re shopping at Saks. If you’re an investor and you buy it through a domestic or international reseller, you’re shopping at Off-Fifth – a discount store. You both get similar products, and naive consumers buying won’t know the difference. They’ll still pay a premium, because the alternative was never seen.
Gap Between Household Formations
Many of you will probably never be offered a home at a discount, but how can you observe if there’s premium scalping? Look towards household formation, and completions. If investor demand exceeds actual housing demand, there’s a good chance investors are nabbing extra inventory to control the release. When that number gets in the tens of thousands, you have a lot of investors holding properties. When this happens, you’re likely seeing large blocks of units being bulk liquidated.
In Toronto, Bloomberg has noted, there is an “excess” supply in contrast to the number of households formed. Census 2016 showed an increase of 146,200 households formed from 2011. CMHC data shows that 175,825 homes were completed in the same area, during the same period. The author noted “supply exceeded demand by almost 30,000 units.” To give a sense of scale, if Toronto had no completions next year – it would be enough housing to fit another couple of years of net population increase. To sell that much excess inventory requires pretty big discounts.
No, This Means S**t For Pricing
Many people are saying that prices are rising due to a shortage of inventory, which we can see isn’t exactly true. When that was determined, the narrative shifted to “it’s the wrong type of housing.” Agents scrambled to explain single-family homes are in short demand… so I need to pay a premium for a condo? That doesn’t make sense, even if you’re willing to be very generous with logic here.
We did receive a valuable lesson in consumer surplus, however. People are willing to pay what they have access to, regardless of whether they know what the true market value is. Consumers don’t know people are paying lower prices, so they’ll pay what they see other people paying. There’s no negotiation, because most of you don’t even know that’s possible. When you show up with a professional negotiator like an agent, the agent’s fee also becomes a part of the pre-sale price. Supply and demand isn’t as important, as the perception of demand for the supply.
Some brands are super chic for decades, some just fade out of style. How long can massification continue? As long as there’s buyers that think premium branding is worth more, than the discount goods being hawked down the street.
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