How Rising Rents Soften Impact Of Canada Interest Rate Hikes In Toronto Investment Properties!
Introduction
There are a lot of real estate bears out there these days. On our end, we agree that real estate prices are likely to take a plunge, but we don’t expect prices to stay low for long in the Toronto investment property pockets.
In another video, we showed the similarities between today’s market compared to 2017. What we showed was that the most resilient market were condos, which didn’t get dropped as much and were quick to recover and this is largely because of its big investor base. Now, if you dive into the freehold investor pockets in Toronto, you’ll also see that these properties rebounded much faster than the broad Toronto real estate market.
Buying at the lows is great. I mean, who doesn’t want to catch the lows? But instead of timing the market, most of the real estate investors who are buying these days are choosing to buy because of its superior long term performance. And more specifically, they’re choosing Toronto because they believe in Toronto’s greater growth prospects which is what really makes Toronto stand out.
I mean, it’s definitely possible to get better cash flows in other parts of Canada, but when you look at total returns, you’ll find that the best real estate returns come from areas with the best growth. So most of our investors aren’t trying to chase the highest cash flows but rather focus on the best growth and returns, and in many cases, they’re fine as long as properties are cash flowing neutral at least.
Of course, with rising interest rates and everything else remaining the same, cash flows will be compressed. In other words, prices that can cash flow neutral now might dip negative in the future, and this is what our investors are concerned about.
So in this video, let’s take a look at what cash flows would look like in three different situations:
- What do prices need to be at for a starter freehold investment property in Toronto to cash flow neutral today?
- How much would prices need to drop if rates rise to the market consensus of 3.4% or higher at the worse case scenario of 4.3% by year end 2023?
- How prices might move up when rents rise and soften the impact of higher interest rates.
Current Situation
Right now, in today’s Toronto market, starting price freeholds can go for around $1.1 million. So if you want this property to cash flow neutral at our current interest rate of 2.4%, then you’d need to get a total monthly rent of $4300, typically coming from two separate units in the house.
When Interest Rates Rise
Interest rates are rising, and this is the main factor that is going to compress real estate prices because mortgage payments will be higher. By year end 2023, the market is expecting variable rates to go to 3.4%. If that happens and nothing else changes, that $1.1 million property will cash flow negative at-$430.
I already mentioned that many investors aren’t comfortable with this, and so what would need to happen if rents don’t change is that the buyers will need prices to come down so that these properties can cash flow neutral again. And when you do this, you’ll see that prices will have to come down by 11%. We can also test the worst case where rates go to 4.3%, which is the most pessimistic forecast. If that happens, prices would have to drop 19% to stay cash flow neutral.
Of course, markets are not entirely rational. Even if you’re a numbers-based investor, there is a high chance that you might deal with a seller who’s more emotional and other buyers who are more fearful. When that happens, you might be able to get more discounts than 11% or even 19%. Last time in 2017, semis dropped by 21% and detached homes dropped by 25%, so it’s definitely possible to see bigger drops this time around too.
But what we also found was that prices didn’t stay that way for very long. You would see prices dip over a three-month period and then start retracing upwards again in the Toronto investment pockets. So last time around, there was just a narrow window where you could have gotten the best selection of properties and the best discounts out there.
When Rents Rise With Interest Rates
Now, our assumption here is that nothing else changes except for rising interest rates, which might not be the case. Historically, rents do rise as inflation rises. And because rents have been depressed for over two years now in Toronto, rent forecasters are expecting Toronto rents to go up this year by 11%. In Q1 of 2022, rents have gone up 3%, so there’s still 8% of room to go if these predictions pan out.
The good news is, rents are a good buffer for rising interest rates, and this is the main reason why investment-type properties drop less and rebound more quickly in rising interest rate environments. If rents rise by half of the predicted 4%, then prices can rebound 5% upwards. If rents rise by the full 8%, then prices can come back up by 10%.
Just another note: these rent forecasts are for 2022 only, and rents might continue to go up in 2023 as well. If that does happen, then we can see even more room for investment in property prices to grow.
Other Thoughts
We’ve been seeing many bears but there are some bulls out there too. For example, CREA projects that prices might go up by 23% year over year by December. So far, we’re up around 13% since December, which means they expect a 10% price growth from here on.
That seems too optimistic to us, and honestly, we think it’ll take a while before prices rebound back to the peaks from this year alone, because we’re expecting prices to drop from this point on. But what we think is that if we see those big 20% price drops from here on, then at that point, we’d consider those really amazing deals.
As rents continue to rise, investment property prices usually follow, which means there’s a good chance you’d be in for some pretty good short term gains.
How We Can Help
If you’re thinking about buying an investment property in Toronto and want to learn more, let’s chat! We can talk more about what our thoughts are, what might be right for you, help you prepare for your purchase, 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!
