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Cap Rates Are Back!

Just when it seemed like the investment thesis in TO wasn't making sense anymore, things come roaring back.

In one of my first blogs in this series, I wrote about one of my investor clients who really studied the investment thesis in the TO condo market and we analyzed how/where the best returns could be found. That analysis took place near the end of 2016, when resale prices were much lower but rents were still high enough to justify an investment.

Then, between January and April of 2017, that investment thesis no longer made sense. Resale prices were shooting straight up and rents were actually stabilizing on their own for the first time in years. Good news for renters, bad news for investors. In situations like this, market prices tend to stabilize themselves because pure investors start disappearing out of the market. But rather than let this play out on its own, the government swooped in to try and "save the day" by imposing countless measures (and by countless, I actually mean 16) to keep folks from "speculating" in the TO housing market.

Unfortunately, when you try to mess with a market, you get exactly what we have today. A more evolved market that - to paraphrase Jeff Goldblum in Jurassic Park - found a way to survive.

First, a little quick math. Investors typically care about three things when considering whether a property is a good investment: 1 - The Capitalization (Cap) Rate - known as "cash on cash" return. 2 - The Overall Return on Investment - the true measure of the rate of return on your invested cash. 3 - Future Appreciation - which is something that cannot be controlled.

Calculating the cap rate is simple. You take the annual net income on a property and divide it by the price of the property. Let's take an example for a condo, which I'm basing on real-life listings I've seen recently:

List price: $380,000 Condo fees: $325/mo Property taxes: $150/mo Hydro: Paid by tenant Rent: $1750/mo

The cap rate would be ( ($1750 - $325 - $150) x 12 ) divided by $380,000 = 0.0402 <--- or a 4% Cap Rate.

The cap rate is effectively the return an investor would get on their investment, assuming they paid cash for the property (ie, there is no mortgage involved). And while most investors are not paying cash upfront for properties, cap rate is still the quickest method to make an apples-to-apples comparison between investment properties.

Overall ROI gives a much more accurate calculation of the investment return because it factors in down payment amounts, interest rates, equity build, etc. And since the actual return on your invested cash can change based on these factors that vary from property to property, the cap rate gives an effective quick and dirty calculation to see if an investment makes sense. And of course, nobody can predict the future appreciation of a property, so I never use appreciation in my calculations when working with investor clients to see if an investment makes sense.

So what's a good cap rate?

Well, there was a time when investors would only consider 5% or higher. But as the TO condo resale market rose over the years, those cap rates started to shrink (as prices rise, cap rates fall assuming rental rates remain the same). And even though rents were rising, resale prices were rising even faster.

As an aside, I remember a colleague of mine from Texas called me last year wanting to invest in a TO condo. He asked:

"Adil, what kind of cap rates can I expect up there?" I replied: "if you can get 4%, jump on it". His response: "If it ain't 6%, I ain't touching it".

Even last year, finding even 4% cap rates in Toronto was difficult. They were out there, but they were few and far between. Investors were settling for around 3.5% and starting to bank on appreciation to boost their overall return. A 0.5% difference may not sound like a big deal, but it does add up over the long-term, which is exactly what these investors are in it for - long-term investors, not speculators. But now, with the introduction of the government's "master plan to save the housing market" <end sarcasm>, we're seeing condo prices stabilize - not drop - because demand is still strong, while rents for new rentals are shooting straight up due to the introduction of rent control.

This is exactly the situation investors want to see and they are jumping back into the market with authority.

Today, finding a one-bedroom condo to rent in the core for under $1800/mo is next to impossible. But that same unit may sell for close to $400k, when in March of this year, that same unit would have likely seen a bid for $425k during the height of the frenzy, even though the rent would have been closer $1700/mo at that time. The situation has flipped so quickly that we're starting to see bidding wars again on small 1-bedroom condos in the $400k-$450k range - and those bidding wars are between investors who see the investment value again and first-time home buyers who realize that a condo is the only way to get into the housing market. And, just as importantly, all parties are realizing that condo prices are not really dropping in any meaningful way, despite what the media wants you to believe.

I've said it before and I'll say it again: Government intervention with a free market will never solve anything. Markets evolve, change, and they find a way to survive. And government intervention just causes these same market to morph into more complicated, confusing, and expensive beasts. So for everyone who thought that the government would swoop in and actually make housing more affordable for renters and first-time buyers, think again. All they did was make it much, much more expensive to rent in TO and, as an obvious consequence, started pushing up the entry-point for starter condos even higher. And who exactly did this help??

If you have a comment, feel free to leave it below. And remember, if you haven't already, please "like" my Facebook page and check back regularly!

Your Toronto condo lover, Adil Dharssi



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