Compressing Rent Yields: Do Real Estate Investments Still Make Sense In Toronto?
You’ve heard about it. Freehold prices are on fire! But rents are still down. So do freehold real estate investments still make sense in Toronto?
So let’s be upfront and address the elephant in the room. Yes, if rents are down and prices are up, the reality is that rent yields are down from the highs in early 2020. But rent yields are actually just part of the picture.
To be fair, we should actually compare how investment returns are now versus how they were like right before COVID.
Toronto Freehold Prices
Toronto freeholds have seen a 15-20% gain year on year, with lower priced freeholds being closer to the 20% mark:
- Toronto real estate was trending upwards right before the pandemic. We had a warmer than normal January, the economy was picking up so there was a few month of good run at the start of 2020.
- COVID came so that stalled prices for a couple of months during the first lockdown but that didn’t last long. Prices shot back up quickly in the summer – there was a lot more demand from buyers and sellers after a two month stall, plus more buyers were out there because interest rates were so low.
- At the end of 2020, second wave fears started mounting up so real estate prices took a breather.
- Starting 2021, the market is on fire again.
The rental market was also affected by the pandemic and there were shifts to renters’ income, work situations and choices of home. The end result is that there was a lot more turnover of tenants as there are now more options out there, and the added supply also caused freehold rents to be down around 10% year on year.
What’s Happened To Rent Yields?
Let’s take a look at our favourite rent yield metric: cap rates. Right before COVID came, the properties we invested in had cap rates around 5 percent, but now they’ve compressed to around 4% for a similar starter freehold investment property in Toronto.
Now if you look strictly at cap rates, real estate investments do look less attractive. But this is not the only element of real estate returns!
What’s Happened To Interest Rates?
The main reason why people continue to buy is because interest rates are sitting at all time lows right now. 5-year fixed rates in early 2020 were around 3%. Now, 5-year fixed rates are almost cut in half at 1.6%.
This is great for end user buyers. With the same monthly mortgage payment of $2,700, you could only afford a house that was $800,000 before because rates were at 3%. But now, $2,700 monthly translates to a property that costs $965,000 – people can afford to buy a more expensive house, so that’s why property prices continue to go up.
This is also the reason why real estate investors continue to pour into the freehold investment market as we speak today. Essentially, you’re getting free money to invest in after adjusting for inflation. Rent yields have come down, but so have interest rates.
What’s Happened To Cash Flows?
Before, we were looking at $900 of positive cash flows whereas right now, it’s close to $550 per month. It’s more accurate to compare returns as a percentage of capital since property prices are different, so the ROI portion from cash flows went from 5.8% pre-COVID to 2.9% today.
But the most important thing is that cash flows continue to be positive, so you’re not taking money out of pocket to sustain the investment – making freehold properties a more stable investment.
What’s Happened To Equity Gain?
We also have changes to equity gain and there is a difference here too because rates have dropped. If you’re on a fixed rate mortgage, your monthly payment is fixed throughout your term. And because you have a bigger loan at the start, your interest would be higher making the principal percentage of your monthly payment lower. As you pay down your loan each month, principal percentage of your monthly payment will increase with time.
Now because interest rates have dropped, the principal portion of your monthly payments at 1.6% right at the start of your own are higher than when rates were at 3%. In other words, you build up equity faster when rates are lower and you can see this more obviously by looking at the equity gain ROI. The year one equity gain portion of the ROI pre-COVID was 7.2% whereas now the equity gain is higher at 9%.
Five year fixed rate mortgage comparison with interest rate at 3% vs. 1.6%, based on a property price of $800,000, 20% downpayment, 30 year amortization.
Appreciation is the last piece of the ROI puzzle. Different people have different opinions of what’s going to happen so to make things simple, I’ll assume that the long term appreciation rates are similar for both pre-COVID and now. This means the appreciation portion of the ROI remains the same. If we use 3% appreciation, the appreciation ROI would be around 13%.
Total Returns: A Final Comparison
Because appreciation doesn’t make a difference, it really comes down to the changes in cash flows and equity gain. And when you tally things up, the net change from pre-COVID to now isn’t all that different. We’re looking at total ROI of 25.9% pre-COVID vs. 24.7% now.
Basically, freehold investments continue to have stable, attractive returns, and it’s still safe because they remain cash flow positive.
lot of things can happen in the future, and these numbers are definitely not set in stone. For example, rates can go up. That isn’t expected until closer to 2023 and even at that point, it’s expected to be gradual. When rates go up, the economy is likely to be picking up again so rents are likely to erase the 10% declines which can continue to balance cash flows and equity gain out.
If you’re wondering what to future appreciation looks like, we continue to be strong believers in Toronto real estate. Historical, Toronto’s seen the best long term appreciation compared to the rest of the GTA because Toronto is still the more desirable place to live in the long run. When you look at post COVID appreciation, Toronto freeholds haven’t jumped as drastically as the suburbs. When you combine this with added demand once immigration picks up again and more people go back to work, we believe that Toronto will see better, more stable rates of appreciation compared to the rest of the GTA moving forward.
How We Can Help
If you’re just getting started with real estate investing in Toronto, we’re happy to chat to learn more about you, educate you on real estate investment basics, and eventually help you get that first investment property.
If you’re currently a real estate investor and are looking to grow your real estate portfolio, we also want to help you out. We can review your current portfolio and give recommendations on how to optimize it so you can grow your returns more effectively.
And if time is an issue, we have other services like leasing and property management to help you out.
Do You Want Help With Real Estate Investing In Toronto?
We’d be happy to learn more about your situation and help you find the best investment opportunities for you.