Understanding the Coming Changes to the Toronto Condo Market

21 March 2012

There are big changes underway in the downtown Toronto Condo market: not just in the number of cranes that dot the sky, but in the underlying economics. This will be the last year of the pre-construction boom in condo sales! The developers know it! Why do you think there are more new projects being rushed to market than ever before? The pre-construction market is dominated by investors. Investors buy pre-construction for only two reasons. First they buy on the expectation that prices they pay today will be lower than prices four years out, when the unit will be ready for occupancy and registered. Today investors are being tempted by projects in the financial district at $700-$800 per sf without parking. In comparison, you can buy resale for $520 per sf at 7 King East, and that includes parking. For today’s resale prices to reach today’s pre-construction prices in four years, you need the resale market to appreciate at 9+% per year. It’s never going to happen. The second reason that investors buy, is for rental income. When condo prices exceeded $500 per sf, most ‘Rate of Return’ investors (read North Americans and Europeans) left the market. The remaining buyers are what we call ‘Wealth Preservation’ investors (read Middle East, Asians, and SE Asians). They want a safe place to park their money and earn a return. At $600 per sf, they were able to achieve a ‘cash on cash’ return of about 4%. At $800 per sf, the return drops to 2%. Why would any investor put their money in a condo versus the bank? There is no logical reason for investors to buy at these pre-construction prices. Eventually the message will sink in. Still, there will be a pre-construction market in 2013. It will be smaller in offerings and the prices will be lower than today So how do these changes impact the resale condo market? Are these markets not interconnected? The answer is: not really. The resale market is dominated by end users. They qualify based on their income and the level of mortgage rates. Since 2004, prices have risen by 7% per year on average. This is not sustainable going forward as incomes are only rising by 2-3% on average. The reason for the big jump in prices was the drop in mortgage rates from the 5-6% range to 3%. Going forward, rates are not going to fall further. In fact we would expect them to start to increase slowly. The end result is that resale condo prices will level off at current prices and then increase in the 3% range (the historical average increase for real estate). Remember that most sales in the resale condo market take place because of lifestyle changes and not economic changes. People buy condos for the space they need today – not for five years from now. And when Grandma dies, I have never heard an Executor ask me about the condo market and whether they should rent the property out for a year. It is always sell! Worried about those buyers with 5% down, not being able to afford their condo if interest rates rise? Worry not. All these buyers have five year locked in mortgages. Why? They qualified at their own mortgage rate (3%) versus the posted rate of over 5%. With a 25 year amortization, after 5 years, these buyers will have repaid 15% of the principal and will have 20% equity in the property even if it does not go up by one cent in five years! Think these people will walk from their property? Not likely. There you have it. The resale condo market will continue to grow in size going forward. Lifestyle and continuing migration to Toronto will ensure that more and more people will want to live downtown. Prices will not increase like the past, but they surely won’t go down either!!