Does Pre-Construction as an Investment in Toronto Even Make Sense Anymore?
The gap between resale and pre-construction pricing has gotten so wide, I'm starting to wonder where the value really is.
I'm just going to jump right into this because it's been a topic on my mind for quite some time and I've been waiting to see if it was just a short-term blip, or a trend that's here to stay.
Pre-construction condo pricing in Toronto is getting too expensive.
Now I know that "expensive" is subjective and value is always relative but that's what this post is about. Maybe I should clarify. Pre-construction pricing for condos is getting too expensive relative to resale.
Sure, people will say "but Adil, pre-construction prices are projecting value 3-4 years in the future when the project is done". And these people are kind of proving my point. Why pay today, the potential value of something 3-4 years in the future, when you can buy today, an equivalent product at today's prices?
Let me step back a minute. I've bought pre-construction personally. I've sold pre-construction condos to clients. And in every one of those instances, yes, there was a premium on the price to buy into a new project (sometimes in a new neighbourhood) where the assumption was that the market would soon realize the value of the offering and would "catch-up" and the price paid would very soon feel like a bargain. And up until today, every one of these purchases was a winner.
This works when you pay a small premium for a premium product. Maybe it's a new neighbourhood or an infill project that will revitalize a neighbourhood (I'm thinking the east-side, King East, Corktown, etc. Or even King West fifteen years ago before it was "King West"). There was a time when pre-construction condos were sold below market value because, well, who wants to pay a deposit for a piece of paper and wait 3-4 years to finally see what they're getting, right? Well, the market spoke and many, many, many people are willing to do so, and developers quickly adjusted their model. Now you pay today what developers think something will be worth in the future. Fascinating.
Anyway, let's get back to the price spreads here. Not long ago (and I mean maybe 18-24 months ago) the spread between resale price-per-square foot and pre-construction was probably around 5-6%. If you consider the average resale condo at the time was selling around $650-$700/sq ft, we were seeing a pre-construction premium of around $40-$50/sq ft. Two years is a long time ago so here's a couple examples from two projects that sold in my 'hood (St Lawrence Market) in late 2016:
I'll save you the math but the pricing for 1-bed units was around $630-$690/sq ft for one project and around $720-$795/sq ft for another "premium" project (the smaller 1-beds aren't shown on the second one but those were selling at an average of around $750-$775/sq ft at the launch in late 2016). These prices were actually not far off what the resale market was at the time in the neighbourhood, taking into account the spread between "good" and "great" resale buildings in the area. I ran through my own historical analysis and "good" buildings were selling for the low to mid-$600's/sq ft and "great" buildings were hitting mid to high $700's/sq ft.
All in all, not a huge premium to put down a 15-20% deposit for a pre-construction project, not worry about being a landlord or getting a mortgage, and still being able to take part in the rising TO condo market. That was the point of pre-construction.
Now let's fast-forward to today. I'm sure you've seen the headlines where the average price per square foot for resale condos in the core has hit $1000/sq ft. Again, you know how much I hate averages but I bet if you strip out Yorkville and the higher-end luxury buildings, the average drops closer to $950/sq ft. But for the purposes of this analysis, it doesn't make much difference. Here's an example of pre-construction pricing at four projects that are selling as we speak:
There is a pricing spread between units within each building depending on the floor, view, etc but for entry-level 1-bedroom units, the prices here range from around $1120/sq ft up to $1300/sq ft. So let's call it $1200/sq ft for a small 1-bedroom pre-construction unit in King West with a decent view (ie, not staring into a garbage alley, which is what you'll get for $1100/sq ft).
What's the resale market like in the same neighbourhoods? I'll go with the generous media headline and say $1000/sq ft. That's a 20% spread between resale and pre-construction. I'll say it again - pre-construction units are, on average, 20% more expensive than arguably comparable resale units.
I'm going to do a little more math to drive this home.
A 525 sq ft 1-bedroom condo in a popular King West building would probably cost you about $525k today, resale. In fact, a unit like this just sold at Fashion House (461 Adelaide St W) this week for $527k, with a balcony and great view from the 9th floor. If you wanted to find a similar 525 sq ft 1-bedroom condo in a pre-construction project it'll cost you anywhere from $600k (if you want absolutely no view) to $650k for something more comparable. That's $75k to $125k more.
Let's look at the rental rates. That same resale unit would probably rent today for $2200/mo. If you consider the extra payments required to finance an extra $75k today, it'll cost you another $345/mo. An extra $125k will cost an extra $575/mo. So to cover your extra financing costs on the pre-construction unit, you'd have to rent this new 525 sq ft condo when the building is complete for at least $2545/mo (best case) but more likely for $2775/mo since we're trying to compare the investment math between the most similar units. Are TO rental prices there? No. Will they be? I have no idea but why force yourself into that situation? If you pay $650k for that 1-bedroom pre-construction condo as an investment, you are saying "yes, that's where rental rates will be". And if you don't believe it when you say it out loud, maybe you should really look at resale prices and run the numbers.
(For those of you that are curious if cash flow is all that matters, check out one of my previous blog posts where I go heavy into the math -> Is Cashflow All That Matters In An Investment Property?).
Finally, here's why I think resale is the better buy. 1 - Not every building is the same. When you look at resale condos, the market gives a premium to "better" buildings. It's a little subjective but not every resale condo gets or deserves $1000/sq ft. And yet it seems like almost every pre-construction condo project thinks they deserve $1150-$1200/sq ft, or more. I am all but certain that a pricing spread between "good" and "better" pre-construction buildings will show up when these projects are complete and they hit resale. Except we don't know which will be "good" and which will be "better". That's for the market to decide in 3-4 years. So be careful.
2 - The spread between resale and pre-construction can't keep getting wider. It just can't. The market will realize this and one of two things could happen:
a) New construction prices could actually drop when projects are complete and they hit resale. Something that's never happened in TO. Or...
b) Resale prices will rise faster than new construction to close the gap. I'm in this camp.
3 - And here's a big one: If rents don't keep rising as quickly as they have been, the math on a pre-construction investment will never work. It's already hard enough to break even on a resale investment unit. Toronto will need to get really, really expensive for renters in order for the math to work on some of these pre-construction prices. That's a little scary.
If someone buys pre-construction today at $1200/sq ft the expectation must be something like "when this project is done, it'll be worth $1400/sq ft or $1500/sq ft". That's about a 16%+ increase in value over the 3-4 years it'll take to complete. But is it even a possibility that when this project is done, and it's worth $1400/sq ft, that the resale market will languish and be only worth on average, say, $1100/sq ft? I mean, consider that if an investor or end user was looking for a 1-bedroom condo in 3-4 years and saw two buildings in the same neighbourhood, comparable in every way imaginable other than age, would they really pay $300/sq ft more for that brand new building? That would be $157,500 more than for a similar 525 sq ft 1-bedroom unit that just happens to be 3-4 years older. That's anywhere from $580-$725/mo in extra financing costs, (depending on their down payment), which would ultimately need to come from rent in order for the investment to make sense. If the rental market increases as fast as it would need to in those 3-4 years, maybe the math will work. But then again, doesn't it just makes resale that much more attractive over pre-construction if you can get those rents in the future but you can buy at today's resale prices? Am I wrong?
The math is starting to bother me. Which is why I think something has to give.
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