Appraisals Too Low! Which Toronto Real Estate Markets At Highest Risk & Where To Invest Instead 2022
Introduction
As we approach a buyers’ market, remember that the lower demand is not just from buyers holding off because they feel that prices will drop, but also from those who are forced to back out because they can’t afford to buy it anymore. The latter part typically happens when buyers get their offers accepted at the peak and then appraisals come in lower than expected before closing, and we’re hearing this start to happen again.
In many of these cases, buyers end up not being able to close on their properties because they either don’t have enough capital or they can’t secure financing because their property isn’t worth as much as they bought it for. This will cause a quicker downward spiral to motivate fearful sellers to sell more quickly with bigger discounts in order to actually close on their sale.
Note that even though this is definitely possible in all markets as prices head south, we’re not seeing this in our clients’ freehold purchases in Toronto so far, and our mortgage agents are telling us a similar thing from their experience as well. Right now, properties at the highest risk are those that saw the biggest swings upwards when interest rates dropped and now have to adjust back downwards for the overshoot as interest rates hike pretty aggressively.
So in this video, let’s dive in to it to see what specific real estate markets in the Greater Toronto Area (GTA) are at the highest risk, and then which markets might see the best risk-adjusted returns moving forward.
Toronto Real Estate Volatility Comparison 2015 - 2020
When we dug into where specifically our mortgage contacts see the biggest issues with appraisals, their answer was simple: the suburbs.
So, let’s take a look at the price fluctuations during the last full real estate cycle from 2015 to 2020 in the GTA. Once we look at this, it becomes pretty clear that the GTA saw the biggest standard deviations, which is an indicator of how much a market fluctuates. In the GTA, where most properties are detached homes, they saw a standard deviation of 0.095. Out of all the whole GTA, this market had the highest level of price swings, even more than detached homes in Torotno, which also saw a pretty high standard deviation of 0.09.
The main reason for the higher price swings is that these markets tend to have more end users, who typically buy more with emotions than with logic. This is the main reason why so many people buy at market tops and sell at market bottoms. I recently came across some back of the napkin sketches done by finance blogger, Carl Richards, who illustrates what you shouldn’t do pretty nicely.
As we move further from end-user markets and add more investors to the mix, you’ll notice much lower market volatility in investor-centric properties like condos and or the even less volatile semi-detached homes, which make safer investments in our current rising interest rate environment.
In the past videos, you might have heard me say that the higher fluctuations in real estate nowadays mean that there are deals to be had. But I actually want to be clear that you still have to be smart about it. Not all markets are the same, and I’m not saying you should invest in those markets that are typically more volatile. In fact, in times like this, it becomes increasingly important to invest in stable markets.
The thing is, even in more stable markets, there are short periods where there are spikes in volatility, and this usually happens in the beginning when things start to change. So what I mean is that when you catch these short-term volatility spikes to buy, that’s when you’ll get a better chance to pick up great deals before the market stabilises again.
Toronto Real Estate Investment Returns Comparison 2015 - 2020
Besides choosing opportunities with lower volatility, at the end of the day, returns still matter most, so let’s look at that next. It turns out there’s an inverse relationship between market volatility and how prices move when interest rates rise.
Once you dive into historical data, you’ll find that markets with lower price fluctuations are usually the ones that perform better with rate hikes. In the last cycle, 416 condos saw the best average annual returns, followed by 416 semis, then 416 detached homes, and then the 905.
Differences During This Toronto Real Estate Cycle
Now, that’s what happened in the last cycle, and it can give us general trends to look out for. But of course, there are differences this time around, and these varying factors are what it takes to change things up slightly this time around. I think the biggest difference today is that our governments are really focusing their housing supply growth on affordable units, which condos are not.
So if we expect them to follow through with their direction, then Toronto condos might continue to be hit with higher development fees, which get passed onto the purchase price and reduce condo profit margins. On the other hand, individual investors taking on the task of creating more affordable housing units might end up getting more incentives, which could lower their capital requirements or increase their profit margins.
And then we have rent yields. It’s well known that houses have better rent yields compared to condos, but you might not know that these rent yields are expected to widen. In the last cycle, it was still possible to find condos that could cash flow neutrally or even slightly positive.
But in today’s market, all condo purchases can flow negative, so from a holding power perspective, condos are just a lot less attractive compared to before, and the rent yield gaps might continue to widen because there are active ways to bump up rent yields on freeholds if you take on secondary suites, or laneway and garden suites built in the backyard. So, from a holding power standpoint, there’s a lot more drive to invest in houses today.
If you look just at returns, condos did the best in the last cycle. From a stability standpoint, semis had the lowest risk. And then if you look at the complete picture by taking into account returns and risk, semis in the 416 actually had the best risk-adjusted returns. This time around, after simplifying looking at investor preferences from our end and everything that’s going better for houses in Toronto, I’d say semis might have a good chance to do better this time around and that will make an even stronger case for investing in freeholds in Toronto.
How We Can Help
We’re big believers in investing in freehold houses in Toronto, and if you want to chat more about this, we’re ready for you! We can look at your requirements and preferences and then match you up with the best investment property that fits your needs.
After we help you buy it, our team also provides renovation guidance, leasing and property management if you need it. Just connect with us if you want to learn more about our services!
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