Does Investing In Toronto Real Estate Actually Make Sense In 2023? Number Crunching Deep Dive
The very speculative pandemic real estate market is finally cooling off, and the focus is now shifting back to real estate fundamentals. If you’re new to real estate, you might not know exactly what this means.
So in this video, I’ll walk you through this, and once you understand this, it should be easier for you to figure out where real estate prices are headed in the next while.
Investing: Basic Relationship Between Risk & Return
Cap Rate vs. 10Y GoC Yield
For real estate, the yield we look at is the net rent yield, or something we can call the cap rate, and it’s the NOI (which is rents minus operating expenses) then divided by the property value.
In Toronto, the multi-family cap rate has a risk premium of 1.5% to 3.5% above the 10-year government of Canada yield, and this premium accounts for certain higher risks that you’re taking on as a landlord, like tenant risk and vacancy risk.
Most investors don’t just look at rent yields when they decide to invest in real estate; the value of real estate also goes up over time, which is less predictable but definitely another plus in the long run. And then there are also the downsides of higher transaction costs: Land transfer taxes, legal and agent fees, and HST total around 10% of the property value, which is definitely pretty significant.
Now, assuming we compare the 10 year GoC yield with real estate, we can also look at holding real estate for 10 years, and that cost would drop to around 1% per year.
And so if you think real estate will grow at least with inflation at around 3% per year, then you’ll still make 2% net from appreciation plus higher rent yields, and so real estate numbers still make sense simply from an unlevered returns standpoint, meaning you don’t use borrowed money to buy real estate.
Toronto Real Estate Returns In January 2021
Now let’s see how the returns looked like in early 2021. Back then, the 10-year GoC yield was 1%, condo cap rates were around 2.5%, and house cap rates were around 4%. Appreciation isn’t guaranteed, of course, but it’s been very good over the last 10 years, and so many investors were assuming historical appreciation rates of around 7% per year when they ran their numbers.
So let’s see what the returns look like if we buy with cash. For a condo, that’s around 2.5% annual net rent, plus an expected 7% from appreciation per year, and then you would take away 1% from transaction costs assuming you hold the investment for 10 years, and that would be 8.5% in unlevered total returns on the condo.
For a house, cap rates are 1.5% better, so the unlevered total return would be 10% per year. And so when you look at this, the numbers make sense.
Of course, real estate has a higher risk compared to government bonds, but it’s actually lower risk compared to stocks, and yet you can get very attractive returns, so the numbers here make a lot of sense. Not a lot of people can invest in real estate with just cash, and one big advantage traditionally associated with real estate is that you can get a cheaper mortgage to help you generate better returns, and so your ROI can get magnified. But just be mindful that this works both ways, so if an investment goes south, you can also lose a lot more money.
If we assume we put down a 20% down payment at the current mortgage rate of around 1.75%, the actual annual interest would be 1.4% of the purchase price. But remember, the mortgage payments each month also have a portion that goes to principal paydown.
So what we have is slightly negative cash flows on a condo, but you still manage to get 30% levered returns on investment, so many investors were willing to take on the negative cash flows. Freehold cash flows look better with positive cash flows, and you can get even higher levered returns here at around 36%. Once you factor in leverage, the volatility of real estate returns is similar to that of stocks. But because you can get much better returns than the S&P index, investing in real estate with leverage made a lot of sense.
Toronto Real Estate Returns Now
Let’s fast forward and see how things have changed drastically now. Mortgage rates are now at best 5%, rather than 1.75%.And this caused Toronto real estate prices to come down; starter freeholds like semis have already dropped 25%, but other properties like condos have only dropped 11%.
And because interest rates are so high nowadays and are expected to remain stable, many investors are now adjusting their appreciation expectations downward. We’ve been using a 3% annual appreciation rate in the long run, assuming you’d be investing for 10 years, and I’d say that’s pretty safe with prices going up in line with inflation.
With prices going down and rents going up, condo cap rates these days are around 3.5%. Starter freehold prices have dropped more, so their cap rates went up even closer to 5.5%. Once you combine this with new appreciation expectations of 3%, you’re looking at unlevered returns of 5.5% for condos and 7.5% for houses. The gap between real estate and the 10-year GoC bond yields has compressed, but it’s still better.
Let’s look at the more likely case with levered returns. Freeholds are cash flow positive, and because they have better rent yields, you end up seeing levered returns of 15% still, so it’s still a good investment.
But on the condo side, you’ll find that condos aren’t cash flowing very well. And after you deduct the interest, it turns out the levered ROI is even lower at 6.4%, so when you compare it to risk-free 1-year GICs, for example, the condo numbers don’t look that great until prices drop more.
Toronto Real Estate Returns Future
Honestly, it’s hard to tell what the point is. Some real estate investors might be comfortable with similar cash flows to pre-rate hikes. and to get there at these current interest rates, prices might have to come down 15%.
But note that at these prices, the cap rate is around 4%, and so the levered returns are still not that high at 6.8%, so we don’t suspect many investors will jump to buy at these prices unless the appreciation assumptions come back up.
If appreciation assumptions go to 4%, then the levered ROI goes to 11%, so that’s something that might change as market conditions change.
In the meantime, we believe condos will be more popular among end-users. They are easy to maintain, they have great amenities, and they are still the most affordable home purchase option for new homebuyers.
But if that’s the case, the mortgage payments would still need to get to more affordable levels compared to before rate hikes. If mortgage payments need to be the same as pre-pandemic for them to be more affordable, then this would require a substantial 25%+ drop in price, which is hard to imagine at this point.
I also mentioned previously that investors will still be buying in this environment because, as you can see, the freehold numbers still work. And once more real estate investors see this, we expect there to be a continued shift towards cash-flowing freeholds.
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