Build Or Buy? What's the Right Investing Move In Toronto's Real Estate Market Today
We think that investing in real estate and building a backyard house for extra rental income both make good financial sense. We stand by both and actively invest in both new purchases and backyard houses in our own portfolios.
But, if you have limited money to invest right now and have to pick just one, which option would be a smarter move?
Why Should You Build A Backyard House?
A backyard house will give you better rent yields. Investing in a new purchase can give you better long term returns. So ideally, you would want both. If you had to choose one at the moment, I’d say the immediate concern isn’t just about maximum returns but can be different depending on your goals.
For example, if your long term goal is to expand your real estate portfolio but you’re borrowing capacity is getting tighter – a backyard house could be the better first step. What happens is that you need to borrow less money and you get better rent yields.
So what this means is that you end up strengthening your debt servicing ratio, which improves your borrowing capacity and that’s going to help you qualify for bigger loans, which will then facilitate buying more properties. So in this case, the ideal roadmap would be to stagger it – buy, then build, then buy, then build, and so on.
Another reason why people are choosing to build instead of buy is because they want to de-risk and get stronger holding power. When you build a backyard house, it could cost around $400 per square feet to build a 1,000 square foot backyard house.
We’ve managed to fit a 3 bedroom unit in that space and that could translate to $3,500 in rents. Tenants pay for hydro and gas, so there’s minimal operating expenses which we can budget $200 for. That translates to a cap rate of close to 10% and very positive cash flows even if all of that is borrowed money from pulling out equity on your home.
Let’s see how it looks like if you borrow all of the money for a new purchase – the downpayment comes from refinancing your home and the balance is a new mortgage.
On a $1.1M purchase, you might be able to get a house with 3 separate units today. In this case, total rents are over $6,700 which is a strong cap rates of slightly over 6%. Because interest rates are high, you’re still getting negative cash flows with the new purchase.
Why Should You Invest In A New Property?
The main reason people buy real estate is because you can borrow more money for the potential of better absolute returns. Going back to the previous example, let’s assume that appreciation is the same for both the build and the new purchase at a conservative 3% per year. Let’s also assume all of the money is borrowed for simplicity.
With the build today, you have a cap rate close to 10%, less 6% in interest, plus 3% in appreciation – that makes a net annual return of 7% on our borrowed money of $400,000, which comes to $28,000. With a new purchase, although rental income isn’t as good, you still gain in appreciation.
If we assume the same 3% appreciation on your $1.1M in borrowed money, although net annual return isn’t as high at 3%, your absolute returns actually are more because you borrowed more money. And if we crank up the appreciation assumptions, the absolute difference gets even bigger, which is why real estate investing has been so successful in the past 10 years when average annual appreciation was over 7%.
Does Timing Make A Difference?
Finally, I’ll address timing a bit since we get asked about this a lot. We can’t advise on whether it’s the best time to invest nowadays because nobody has the crystal ball, but here are some facts.
Cap rates on purchases usually move with borrowing rates. If interest rates go higher, you’d typically see cap rates go up. The reason is because the purchase price usually adjusts lower to compensate for higher rates for investing numbers to make sense.
Note that the cap rates fluctuate more on new purchases but cap rates on builds don’t actually vary as much because the cost to build just doesn’t change as much.
Perhaps you can think about it this way. If you had limited money and had to choose one right now, buying might be the better deal now because purchase prices are more discounted in today’s higher interest rate environment.
Let’s look at the last example. The rate of return might be 4% more on a build today. If interest rates go back to more normal times, then cap rates should come down and so the return gap gets bigger.
So, if you believe that purchase prices are discounted today compared in our high rate environment compared to a normal market, then taking advantage to buy at discounted prices today first then building later could be the better choice if you had to choose one.
How We Can Help
Again, I want to stress that neither one nor the other is the absolute right decision because it very well depends on your personal investment goals.
The good news is that our team is experienced with both, and we can walk you through the pros and cons for your individual situation so that you can make better decisions. Eventually, if you’re looking to buy real estate in Toronto, our sales team would be happy to help you out with that.
But did you we can also help with builds? Our sister company, Urban Lanes, specializes in garden suite or laneway suite build in Toronto, so we can walk you through how that looks like too. Just take the first step and schedule a discovery zoom call with us!
Want To Get Started 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.