Where Will Toronto Real Estate Prices Go When Interest Rates Start Rising In 2022?
The Bank of Canada is ending their quantitative easing, has signalled that interest rates might start rising next year in 2022, and this will affect the real estate markets. But there’s actually a lot more moving parts besides interest rates. Rents are changing, cash flows are changing so if you want to know where Toronto investment property prices might go, it might get pretty complex. In this video, we’re going to tackle this question and take a closer look at the actual relationship of interest rates, rents, and price movements, so that we can them give you more accurate concrete answers in terms of where Toronto real estate prices will go!
Scope
To kick things off, let’s narrow down our scope first. I’m specifically going to focus on investment freeholds and condos in core Toronto. This means these projections will not apply to end user neighbourhoods and also will not apply to real estate in the GTA suburbs. However, you’ll have my methodology so you should be able to work through other markets on your own.
The second thing I wanted to say upfront is that because cash flows have compressed so much already, I’d say we’re very close to the cash flow threshold of what investors are comfortable with. If we want cash flows stay similar to what they are now, and we know interest rates are on the rise, the big question really is, how will changes in rents actually change up the Toronto real estate market?
And one more final thing before I dive in. This video is going to be more technical compared to my typically videos because I’m going to go through some math before I reveal the formula that shows the relationship between interest rates, rents and price. So if you want to spare yourself some algebra, then you are more than welcome to skip over the formulation bit and go right into the analysis in the next section. But if you’re up for the challenge, feel free to tag along for the ride and I’ll try to make things as easy to follow as possible.
The Relationship Between Interest Rates, Rents, and Prices
Let’s first review our basic real estate investment cash flow equation. You get your current cash flow by taking the rent that comes in, then deducting your operating expenses, and then deducting your mortgage payments. Later down the road, we might see rents change, so we’ll call this change little r, and mortgage payments change, and we’ll call it little m. Next, we’re assuming cash flows remain the same, so the current cash flows on the left needs to equal the future cash flows on the right.
Cash Flow = Rent - Expenses - Mortgage Payment
Later down the road, we might see rents change, so we’ll call this change little r, and mortgage payments change, and we’ll call it little m. Next, we’re assuming cash flows remain the same, so the current cash flows on the left needs to equal the future cash flows on the right.
Rent - Expenses - Mortgage Payment = (1 + r) x Rent - Expenses - (1+m) x Mortgage Payment
Now, if you rearrange the formula, you will be left with this simplified formula.
m = r x (rent / mortgage)
If you want to make sense of this equation, basically rent growth needs to be correlated to mortgage growth, but that doesn’t mean they grow at the same rate. If a property’s rent yields are better, then rent growth can be slower than mortgage growth and cash flows will still remain the same. And another way to look at it is that if both property’s have the same rent growth, the property wit the better rent yields will see faster price growth. So if we apply this to Toronto real estate, we’ll see that freehold prices should come up more quickly than condo prices when rents bounce back at the same rate.
But we’re not done quite yet because we want to actually add property prices and interest rates into the equation. Mortgage payments go up if prices go up, and we’ll call this little p, and it also goes up if interest rates go up, and we’ll call this little i, and so let’s replace m with p and i in our equation to get this.
(1+i)(1+p) - 1 = r x (rent / mortgage)
And finally, because we want to see how prices might change when rents and rates change, we can rework the formula to get this, which is the key formula that we’ll use for our analysis.
p = (rent / mortgage x r + 1) / (1+i) - 1
Interest Rates & Rents
Now that we have this formula, we can start taking a closer look at interest rate projections. Right now, the Bank of Canada has indicated rates will likely come up sometime next year and history tells us what this is typically gradual. From the consensus by major banks right now, they’re expecting the first 25 basis point increase between Q3 & Q4 of 2022. Then by year end of 2022, there might be another rate hike. And then, by Q1 of 2023, there might be another rate hike again. So from now until Q1 2023, which is more than 1 year from now, economists are expecting a total 75 basis points worth of rate hike.
So let’s hop over to a mortgage calculator and see what this means in terms of a change in mortgage costs. On a starter $950K house at 2% interest rates, the monthly mortgage is $2806. Once rates go up to 2.25%, the monthly mortgage becomes $2,901. In other words, the change in mortgage payments based on a 25 basis point rate hike, little i, is 3.4%.
In terms of rents, we know what’s happened so far. Toronto condo rents have gone down 20% and then finally over the summer, it’s rebounded 5%. Freeholds rents were also down 10-15% and it’s rebounded more slowly. Right now, both Toronto condos and freeholds have good upside potential for rental recovery. But at the same time, this is also our biggest unknown.
So instead of giving a single guesstimate of where rents might be, I’m going to play out a few rental recovery scenarios. And because things are going to pan out a bit differently for freeholds and condos, let’s start with freeholds first.
Toronto Freehold Analysis
In the current market, you can buy a starter freehold in Toronto for around $950,000 and receive $4,000 in monthly rent. So let’s see what happens when rates go up by the first 25 basis points.
In our most pessimistic case, freehold rents don’t change. Then if we plug in our numbers into our key formula, you’ll find that freehold prices need to come down by around 3% in order for cash flows to stay the same. I’d say that is more unlikely, since current market rents are way below what investors were getting in February 2020, and when rates rise, we expect our economy to be recovering, which means rents should also be on the rise.
Let’s try out another scenario where rents go up 2.5%, and when you do this, you’ll notice that the positive effects of rent increases cancel out with the negative effects of a 25 basis point rate hike, and so Toronto freehold prices might end up staying more or less the same.
But I think rent increases might still be able to do better, and we saw this already with condos this past summer going up 5% and another supporting factor is the fact that inflation and wages are running at multi-decade highs. So, it’s possible to see freehold rents increase by 5% or even 7.5% in the short term and I also worked out what that would mean for freehold prices.
As you can see, when this happens, we should expect freehold prices to start appreciating and higher rent growth means it’s possible to see much faster appreciation. Note that I did this again for the second 25 basis points in rate hike, and it turns out the impact to prices would be more or less the same.
Toronto Condo Analysis
Now let’s do the same thing with Toronto condos and when you do this, you’ll realize that there is a big difference. Let’s assume we go with a starter $600,000 condo that gets $1,800 in monthly rents. When rates go up by 25 basis points and rents go up the same percentages as freeholds, condo prices will not go up as quickly as freeholds. I also tested out the second 25 basis points in rate hikes, and you’ll see similar results.
Why Freeholds?
From this analysis, it’s very clear that real estate prices don’t only depend on interest rates, but they’re actually very dependent on where rents might be as well as what the rent yields look like. It an economical downturn, investment properties with lower rent yields usually fall quicker because of weaker holding power. And now we see based on our analysis that in rising rate environments, markets with better rent yields also translate to better expected appreciation.
In fact, if you look at the past 10 years of appreciation, this holds true as you’ll see that Toronto houses had better annual appreciation at 9.1% compared to Toronto condos which were at 7.5%, which is honestly still pretty awesome. But once you add in better rent yields, more value add potential if you’re up for it, and the fact that better cash flows make a safer investment, choosing to invest in Toronto freeholds is really a no brainer decision if you can afford them.
Another thing that I wanted to say is that we are definitely seeing more investors shift from condos to houses because of the very reason that I just talked about. And since these convert investors were comfortable with negative cash flows when they invested in condos, we’re now seeing a higher tolerance for lower cash flows on freeholds as long as it doesn’t dip negative, which is still better than condos. If this trend continues to pan out, this allows more room for freeholds to appreciate and we’re still a 10% price bump away before cash flows get close to 0.
In the long run, we continue to be bullish on freeholds because of steady and strong demand from immigration and investors combined with slow supply growth in Toronto because there’s no more land to build up new supply without knocking down old ones.
What About Condos?
After saying so many good things about houses, I do have a few positive notes to end with for Toronto condos. Condos rents are still down 15% and freehold rents are down 10-15%, so there’s a good chance that condos might have better rent recovery room. So if condo rents actually go up more or go up more quickly compared to houses, then you might see slightly better appreciation in the condo market. For example, if condo rents go up by 7.5% and freeholds go up by 5% within the same period of time and a 25 basis point hike, condos might move up 4.1% whereas houses might move up by 3.66%.
And of course, condos also have a lower barrier to entry and they’re generally newer so they can be more passive which are also bonuses if those are what your requirements are.
How We Can Help
At the end of the day, the most important thing is that you choose the best investment that’s right for you and this is where we can help. When you work with our team, we’ll look at your requirements and your preferences and then match you up with the best investment property that fits your needs.
After we help you buy it, our team also provides renovations guidance, leasing and property management if you need it. For your information, right now if you build in property management fees on a freehold, you’re still looking at better cash flows than a condo. So if you’re ready to start investing in real estate and want to know more about how we can help, just connect with us!
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