What Types Of Toronto Real Estate Will Outperform When Canada Interest Rates Start To Rise In 2022?
Now we all know interest rates are due to rise, and traditionally, you might be taught that when that happens, we would see a slow down for real estate. But let me tell you that’s a simplified answer that I don’t 100% agree with, especially in the Toronto real estate market. So, in this video, let’s dive into this and see how real estate in Toronto is really affected once interest rates start to go up.
Interest Rate & End User Type Properties
Rising interest rates will slow real estate demand. I’d say this statement is probably more true for end-user real estate markets. What’s happened over the past 2 years is that home prices, especially in the suburban end-user pockets, have sky rocketed, but expenses have still been manageable because of rock bottom interest rates. Let’s say someone could afford a $1.2 million home on a 3% interest rate, paying a $4000 monthly mortgage payment.
When rates drop to 1.5%, with a $4000 monthly mortgage, they can now afford a $1.45M home, which is why prices are able to go up very quickly when rates drop. Now, we’re expecting rates to go up by 1% by year’s end. Even if we adjust for higher income after rising inflation, let’s say the budget is now $4,500 for a monthly mortgage. At a higher interest rate, this still means $1.45M isn’t affordable anymore, and now the budget has come down to $1.4M. This is the reason end-user home prices can’t go up as quickly once interest rates start going up.
Interest Rate & Investment Properties
But in my mind, I feel that this isn’t the case for investment properties. We know that interest rates are rising because of inflation. And as inflation comes up, the upside for real estate investments is that rents also tend to come up. Rents in Toronto are expected to rise 11% by the end of the year, according to rentals.ca.
So, if interest rates go up by 1% and rents go up by 11%, the next effect is that cash flows don’t really change all that much. Stable holding power means there’s less friction to slow down real estate growth here.
Comparison Of Toronto Real Estate vs. Bank Of Canada Overnight Interest Rates
I wanted to verify my hypothesis, so I went back to see how Toronto real estate reacted as interest rates changed over time, and the results are super interesting. In my simplified analysis, I split the data into three segments: Toronto detached homes, Toronto semis, and Toronto condos.
Detached homes in Toronto are the most expensive, and these homes are typically owned by end-users rather than investors.
Semis are cheaper and attract a good balance of end users and investors. Just so you know, semis attract a bigger relative investor pool because the entry price is cheaper and rent yields tend to be better than condos but even better than detached homes. What we find is that for the same sized home in the same neighbourhood with similar rents, semis tend to be cheaper to buy than detached homes. So what you end up with is that your rent yields are better, which is better from an investment holding power and returns standpoint.
Finally, we have our condos, and we know these are very popular with investors because they are the easiest pieces of Toronto real estate to get into; they have the lowest price and they make a more passive investment.
When there are more end-user homes like detached properties, lower monthly payments mean better buying power just like what we talked about, so these homes tend to shoot up more quickly. We also see that semis do just as well as detached homes when they have more investors in the mix. On the other hand, condos, which have a major chunk of investors, don’t do as well.
So let’s try to make sense of this and the big difference here is that the cash flow position plays a big role for investment properties when our economy is in a downturn. When things turn south, consumer goods and services tend to drop in price, and this affects rent as well. What we also notice is that luxury goods and services tend to drop more during these times, which is why condo rents usually see bigger drops. Based on the last downturn, interest rates dropped by 1.5% and condo rents came down by 20%. So the net effect is that cash flows actually got worse for the condo investor, which is why there’s less room for condo prices to come up.
But if this is happening to condos, how come it didn’t seem to have an impact on semis, which also have a big investor pool? Well, semis are different from condos because their cash flows are different. To begin with, we’re looking at stronger positive cash flows instead of negative cash flows.
Then, freehold rentals are less luxurious, I would say, so rents actually don’t get as affected in a downturn. So, instead of dropping 20% like condos in the last 2 years, freehold rentals dropped closer to 10% in rents. When you combine a smaller drop in rents with improved mortgage rates, the cash flows for semis actually look better when rates drop. So, this gives more room for freehold investments to go up in price.
Who Will Outperform When Interest Rates Go Up?
Once rates start coming up, you’ll see that our end-user type properties, the detached homes, start slowing down in growth as expected. At this point, condos started catching up, but perhaps the most interesting thing is that semis continue to do very well.
When rates go up, the reverse happens. Rents typically recover more than the previous pullback because more time has passed, and so you end up seeing improved cash flows for all real estate investments, which is why prices can go up more quickly than before.
When it comes down to investing, we’re still seeing investors with lots of cash to invest in. So, if money isn’t an issue, investors will typically go with the strongest and best-performing investment.And as we know, you can get the best rent yields with freehold investments, since demand always remains stable and they tend to outperform other real estate in Toronto.
Just to clarify, I did use semis as our “freehold investments” and detached homes as our “end user case” and it’s just to simplify my analysis. This doesn’t mean detached homes make bad freehold investments, and if I were to generalise it even more, I’d also put detached homes in investment pockets in the same outperform category as semis in Toronto too.
I hope this video helped you clear things up, and yes, you’d likely see the best long-term growth in freehold investment properties in Toronto because their returns stay strong no matter if rates go up or down. If that’s the investment that fits into your budget, condos are also a good buy.
It’s possible to see a temporary dip in all markets when rates start to go up, but it’s very hard to catch, and if you miss the boat on that, prices will likely resume their upward trend pretty quickly. In Toronto, experts are expecting high rent growth of 11% and 12% price growth by year’s end, so yes, it’s a good idea to invest in real estate.
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