Toronto Investment Properties: What Are The Key Differences Between A House And A Condo?
In this video, we’ll talk about the differences between a house and a condo in Toronto: how real estate investment property returns might differ, how your risks might be different, and what’s better for you depending on the type of investor you are.
You make money from real estate in two main ways: rental income and appreciation. From the rental income side, condos make less than houses. What we typically look at is the net rent yield, which is calculated by deducting operating expenses from the rent you get before your mortgage payments, which we call our cap rate – the higher the better. And on average, the cap rate for houses is around 1.5% higher than the cap rate for condos.
Cap rates do fluctuate and usually move in line with interest rates. When interest rates rise, cap rates tend to go up, and when interest rates drop, cap rates also usually go down. Right now, with variable interest rates at around 1.5%, we’re seeing around a 2.5% cap rate on a condo and closer to a 4% cap rate on a house. When variable rates were 1% higher than they are now, cap rates were also 1% higher. Because of this, the net income you get stays more or less the same even when interest rates change, with condos being around 1% and houses being around 2.5%.
Now I’ll quickly explain why there’s a difference in cap rates for condos vs. houses. The first big reason is barrier to entry. Investors tend to drop out as the purchase price increases, so you tend to get a better bang for your buck when you go bigger. The second reason is time savings. Condos tend to be newer and there’s generally less management because the condo management takes care of a lot of things in exchange for condo fees, so some investors choose condos because of this reason and are willing to exchange the management ease with a hit on rental income.
Note that income is not the same as cash flows. Traditional mortgages require you to pay off a bit of your loan each month, which totals roughly 2% of your purchase price per year. Think of this as a piggy bank and it’s actually a gain for you, not an expense, but the cash does get tied up in the property. Because the net income on condos are lower, after you pay into the equity gain each month, you end up getting negative cash flows on the condo whereas it’s still slightly positive for houses.
Appreciation trends are also a bit different between condos and houses. If you compare 416 condos with 416 detached houses between 2010 and 2020, you’ll find that condos saw around 8% price growth each year, whereas detached houses saw 10% price growth. So if we add up the net income plus appreciation, you’ll see condos get a total return of 9% and houses get 12.5% each year before leverage.
From what I just talked about, the more stable part of a real estate investment is the rental income, whereas appreciation can swing a lot more and it’s possible to see big swings from the average appreciation in any given year. In fact, what’s happened over the past 2 years is that Toronto houses have been on the higher end of their appreciation range, whereas condos have been on the lower end.
Appreciation is the big reason houses have been performing much better and if you think about it, the 1.5% difference on rental income doesn’t big enough to make a drastic difference. If we dig into actual numbers over the past 2 years, condos made 1.5% in rental income and 5.5% in appreciation, generating roughly 7% per year before leverage. Houses made 2.5% in rental income and 12.5% in appreciation, generating 15% per year before leverage.
Now some people feel that the pendulum for appreciation might swing the other way as we recover from COVID. So if appreciation gets swapped for the next two years and condos start appreciating 7% more than houses for the next two years, then condos will see better total returns for the first handful of years.
But remember if we look at history, houses do have the better long term appreciation and rental income. So, if things bounce back to how there were like starting year 3, you’ll see that the break even point is around 5 years. After the 5 year mark, houses which has the better average annual returns will ultimately be the better long term investment.
The important thing to understand here is that you do have the potential to make more money on a condo in the short term, but returns are highly dependent on where appreciation lands. With a higher weight on appreciation with bigger swings, I’d say that investing in a condo is higher risk and investing in a house is more balanced because rental income is a bigger part of your returns pie.
While we are on the topic of risk, I’d also touch on value-add opportunities. In my opinion, I think taking on renovations to boost your returns is a more reliable way to bump up your property value, so in a way, you’re reducing your investment risk when you take on renovations. Note that there tends to be more value add opportunities for houses, so it’s possible for you to further reduce your financial risk when you invest in a house that needs value add work.
The last type of risk that I get asked about frequently is tenant risk. Yes, the tenant profile is different for condos versus houses in Toronto, but I wouldn’t say that one is more risky than the other. I think the most important thing is to do your due diligence to make sure you’re putting in good tenants that pay rent on time and will take care of your property, and that’s not based on what type of job the tenant does.
The bigger difference here might be on how long the tenant stays. Typically, condo tenants turnover more, which lets you track market rents more closely. If you’re renting out a house to a family, they tend to stay longer, so you might see your cap rate start to drop until your tenant turns over.
Who Should Invest In A Toronto House?
For the best risk-adjusted long-term returns, I’d always say go with houses.
Who Should Invest In A Toronto Condo?
I think the first most important thing when you invest in real estate is to make sure you can hang onto it. Condos give you negative cash flows, so you need to make sure you can put an extra $300+ into the condo to support the investment each month. Note that if we assume rents go up 5% per year, it’ll take approximately five years before rents grow enough for your cash flows start to turn positive.
Real estate is a good way to build wealth, and even though houses can generate better returns, condos are still a good investment if you don’t have enough money to buy a house. If we look back at the difference in total returns, you can see that we’re looking at 2% lower annual appreciation and 1.5% lower cap rates in a condo. But based on the numbers from 2010 to 2020, that’s still a 9.1% return before leverage, and almost a 40% ROI per year, assuming that you put in 20% as downpayment. So, investing in a condo is still a very good idea.
The third big reason why I’d say condos are a good idea is if you’re looking to diversify. As we’ve been seeing, condo and house prices can move in different directions, so if you have both in your portfolio, then it’s more likely that your overall portfolio will see more stable appreciation. You might also want exposure to a certain high growth area which means it might outperform drastically, but perhaps that area is higher risk. If that’s the case, buying a condo in that area is less money, so you can limit your exposure in those markets.
The fourth reason for investing in a condo is if you want a more hands-off experience. Like I mentioned, condos are newer, so you’re basically taking a hit on your rental income in exchange for a more passive investment.
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