Preconstruction Homes In Toronto: How Do Investment Returns On Precons Stack Up?
What are our thoughts on Toronto precons? I’ll be upfront – we are long term investors and we choose safer investments with the highest, most stable long term returns, and typically that’s in the freehold space in Toronto. But many new investors do consider precons and one popular argument is that it’s scary to put too much money in a bigger property, and it’s a easier first step to start smaller with a precon.
Another thing that attracts new investors is the passive nature of precons in the beginning, without having to worry about renters, operating expenses or mortgage payments, and even after taking possession, investors find condos still easier to manage than houses. Finally, they hear stories of huge precon gains at closing, so they can refinance right way without doing anything and enter another investment right away.
In this video, let’s dive in and learn more about precons in Toronto. How returns really compare, the good things about precons, and some other things to consider before you make you decision about what to invest in.
What Is A Precon?
Let’s backtrack and recap what a precon is. A precon, short for preconstruction home, means you’re agreeing to buy a house or a condo either before construction has started or before it’s finished, and the completion date is typically a few years down the road. Unlike a resale property where you need to come up with the entire downpayment in 30 – 90 days, you can pay for the deposit over a longer period up to completion. You don’t own the house until completion, so you don’t need to worry about finding tenants, managing the property, or paying for your mortgage or any expenses until further down the road.
As you can see, the uniqueness of precons really happens before completion, and after that, it performs just like a resale property. In a resale rental property, your returns come from your rent, minus operating expenses and interest, plus your property’s appreciation. In a precon, your returns come entirely from appreciation. Most precons are condos, so you really need to understand what’s going on in the Toronto condo market, and reality it has more ups and downs than Toronto freeholds.
Toronto Condo Price History
The reason precons have been getting so much buzz in recent years is because of how amazing they’ve done. If you look at the one bedroom condo price history, we can get a better picture of this. Between 2015 to 2020, one bedroom condo prices went up from $345,000 to $600,000, and that translates to an impressive growth of 11.7% per year.
But then if you go back to 2010 to 2015, you’ll realize that it’s not the case all the time. Over that five year period, one bedroom condos only went up 2.5% per year, from $305,000 to $345,000.
Now here’s another thing. You’ll find that the price of precons is typically higher than a resale property, because developers also factor in appreciation when pricing precons. Precon buyers are able to make money when actual appreciation is higher than the priced in appreciation set by the builders.
- For example, if the builders factor in 3% annual appreciation in their pricing, but actual appreciation is 5% per year, then you’ll gain 2% from the difference per year at four times leverage, meaning you’ll be making 8% per year during the precon stage.
- If actual appreciation is 10%, the appreciation differential is 7% at four times leverage, which is 28% per year.
- On the other hand, if appreciation is actually 2.5% per year, then you lose 0.5% x 4 = 2% per year instead. So as you can see, precons are much higher risk because your returns are solely based on the market price on completion.
Resale Property Returns
Besides the unknown appreciation factor, the known part is that you will lose out on rental income which is the other more stable part of the real estate investment equation until completion. If you’re buying a condo, you might run into slightly negative cash flows but for the most part, your renters are helping you build equity in your property. For freeholds, you’re likely in the positive cash flow territory so you benefit from both equity gain and cash flows on a monthly basis.
Let’s make things more concrete with actual numbers. For a resale condo assuming the same 5% appreciation, you won’t be making 8% per year in a precon, but rather ( 5% appreciation + 2.5% net rents – 2% interest ) x 4 leverage = 22% per year. On a freehold assuming the same appreciation but higher gross rents and slightly lower expenses without maintenance fees, you’re looking at 5% appreciation + 4% net rents – 2% interest ) @ 4x leverage = 28% per year. Many freeholds are old and if you put in renos yourself, you can also get a one time bump in value add appreciation as well.
Benefits Of Precons
So as you can see, from a numbers standpoint, resale properties in a typical market are way more stable and much better than precons but having said that, it’s definitely less passive.
And we’ll be fair and here are some things that we think precons are good for. The main one is that it gives you time to save up money for your investment if you don’t have all the money upfront, because the deposit is paid over a longer period of time. And even though you don’t get the value add appreciation, precons let you make more design decisions by choosing finishes and possibly even room layouts.
Other Things To Consider Before Buying Precons
There’s good and there’s bad. Besides more volatile returns, are the some other things you need to keep in mind when you considering precons. The big one is construction risk. If you choose the reputable developers, most times construction will go through, but the risk of delays is very real. Recently with construction prices going up, another thing that’s been happening is that builders might be asking for top ups to your purchase price to cover higher building costs.
Buying a new build also has extra costs that don’t exist with resale properties like occupancy costs and HST for new builds. Note that if you are owner occupying the unit, there will be a good chunk of HST rebates, but investors typically have to fork out the HST upfront and then get a smaller portion back at a later date.
Finally, if you need to liquidate before completion, this might be harder. Some builders restrict you from doing so, other builders enforce a high assignment cost if you wanted to pass your contract to someone else, and sometimes, and assignment contracts are just typically harder to sell especially if the builder is still releasing units themselves.
After it’s built, your precon will act just like a resale property and then it becomes more of a condo vs. house which we have another detailed video for. In general, condos are newer so they have less issues, but in exchange, you have lower absolute returns: lower ROI, less capital, more volatile prices and no value add, so refinancing to grow your portfolio will be slower than with freeholds.
How We Can Help
So after hearing all of this, do we recommend precons for clients? To be honest, it actually all comes down to your requirements and preferences. If someone doesn’t enough capital but wants to get started with real estate investing, precons are a good option.
Remember … not all precons are condos. There are precon towns, precon freeholds, and these generally have better rent yields, lower expenses, and more stable appreciation. When you work with us, we take time to understand your preferences and help you choose the best option where the numbers make the most sense.
If you have sufficient capital for freeholds & precons, but you like the passive nature of precons, we can help you solve that headache with our leasing and property management services if you choose a freehold.
Even after you factor in these extra costs on a freehold, you’re likely still in positive cash flow territory and can you still benefit from cash flows and equity gain that you don’t get with precons or even condos. If you want to have a chat to talk more about your investment needs and goals, we’re ready for you!
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