How To Analyze Investment Properties In Toronto!
Investors are holding back right now not necessarily because interest rates are so high because at that point it comes down to price. There’s many others who are scared simply just don’t know how high interest rates might go.
But things are changing. We were seeing expectations for inflation go higher and higher month after month, but lately, inflation expectations are finally stabilizing. And once inflation stabilizes, more investors will feel more confident about their numbers, and then it just comes down to price.
Now if you’re new to real estate investing, you might ask, what does the right price mean? Let’s figure it out!
Comparison Of Cap Rates Over Time
We’re strong believers in investing in houses in core Toronto because of the stronger holding power and the fact that’s there’s more ways that you can make money with the property, like taking on value add renovations.
But cash flows is really the core thing and that’s what puts investing in houses at a different level compared to condos. Right now, condos are cash flowing very negative because interest rates are so much, which means you’ll have to take money out of pocket each much to hang onto the investment.
On the other hand, houses with two or more units are still cash flowing positive in today’s much higher interest rate environment. The big bonus now is that they’re also a lot more accessible compared to before. Starter bungalows with 2 units are actually going for around $800,000, which is similar in price to many 2 bedroom condos but you’re getting basically getting much better risk adjusted returns.
I talk a lot about cash flow, but even freehold investors in Toronto aren’t looking for big cash flows to support their lifestyle but they want positive cash flows for better holding power.
Take a look at this chart that compares Toronto multi family cap rates, which is basically our NOI divided by the property value, stacked against interest rates. One thing that you can see is that even though mortgage rates have been fluctuating, the obvious trend is that cap rates have been dropping.
Cap Rates & Appreciation Over Time
What we can see here is that as Toronto continues to grow as a city, there is a shift in investor mindset. People are investing in Toronto because they believe in our continued growth prospects.
Now, looking at the last chart might be a bit deceiving too because the drop in cap rates look pretty massive, but once you stack cap rates against appreciation, we see another perspective more clearly.
The reason investors are ok with lower cap rates is because they are in it for the full picture with appreciation. And from a total returns standpoint, investing in Toronto is still pretty good.
Cash Flows Over Time
Now that you understand more about what most Toronto investors are looking for, let’s dive a bit deeper into cash flows. Cap rates only show the net income before the mortgage, and it might look pretty different after we factor in the mortgage payments.
Here’s the chart with the annual average cash flows over time, and here’s you’ll see a couple more things.
The first one is that absolute cash flows haven’t actually been dropping as much over time. It’s true that cap rates have been dropping but because purchase prices have gone up, absolute cash flows haven’t dropped as much.
The second thing is that freehold real estate investors need the positive cash flow not only for better risk adjusted returns but also with future growth. If you have positive cash flows, it actually improves your portfolio’s debt servicing ratios, which will help you get more mortgages in the future.
As you can see, in 2019 and 2020, when cash flows got too close to break even, they ended up creeping back up. Two years ago, low interest rates definitely helped a lot there.
Now if we go to where we are today, our cash flows are actually looking tighter than normal again and we’re counting on interest rates helping out this time, nor rents going up beyond this because it’s already see very big jumps in the past year.
So at this point, we’re probably just limited to price coming down a bit more if we need to be back at slightly higher cash flows. And to bring up from $200 to $500 of cash flows, we’d need to see another 6% drop in prices.
How We Can Help
Now keep in mind that this is not an exact science at all. Past preferences might not be the same moving forward. And if you believe that the trend of compressing cap rates to continue, we might see more investors willing to take smaller cash flows moving forward because today’s prices look a lot more attractive.
What we are sure of though is that we are getting close to the bottom, and if you get a bargain, it’s likely that you can get the same cash flows or better that what we might expect at the bottom because we are in such a buyer friendly market these days. The benefit of buying right now is that there’s less competition and you are in a much lower stress environment compared to when more investors start coming back to buy.
So if you want to learn more about what today’s deals look like, just reach out to our team!
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