Part 1 of 3 where local actuary and Sky View Suites Partner John Melinte, debunks fears of the local Toronto real estate market bubble.
The recent media frenzy on the topic of real estate in Toronto has presented various plausible causes for the city’s seemingly ever-increasing real estate prices, including foreign buyers, low mortgage interest and inflation. What we haven’t seen, however, is a detailed explanation of just how much some of these factors have contributed to the problem (which it is, for Torontonians who do not yet own any real estate). Also, talk of how to address this problem has been all over the map. Our government has recently implement measures to address what they see as the main problem – foreign buyers. There is logic to this, because in a global context, Toronto is a world-class city with real estate prices that are still relatively cheap (think Hong Kong, New York, London, etc), However, statistics show that only 4% – 5% of recent real estate deals in Toronto involved actual non-resident buyers. It’s quite likely that a significant proportion of deals involve foreign money being passed through local residents (spouses, relatives, business associates, etc), although there is no way to quantify this and no easy way for the provincial government to control it either (which may explain their focus on foreign buyers instead of foreign money). To tackle any issue intelligently, one must first try to understand its root causes, and more importantly, the magnitude of each cause. We looked at this and started with the most basic question – is this an actual bubble, or just a case of unaffordability & globalization? Is there a difference? The average value of residential real estate in Toronto has increased by 97% over the last 9 years (from 2008 to 2016). That’s almost double. It sounds impressive, but if you actually compare Toronto residential real estate to other investments, then 97% over 9 years works out to an annual “rate of return” of just under 8% per year. In happier times, a gross return of 8% per year would have been considered a reasonable stock market return. Mind you, economists and investment gurus will say that generally, real estate is less risky than stocks, which means real estate is “outperforming” expectations if it’s earning a rate of return similar to what would be expected of stocks. However, note that 8% is the “gross” return – prior to taking into account expenses. It’s more costly to buy and sell real estate than a stock. In order to quantify this, we looked at expenses (maintenance & repairs, insurance, and property tax) which typically run about 1.5% per year (more for older homes), and transaction fees (land transfer tax, and realtor and legal fees), which can easily add up to 6% of the purchase price of a property – that is, roughly 0.7% per year over 9 years. This brought the annual “net rate of return” (after annual expenses and transaction fees) down to roughly 6% per year. Not bad, but not as high as one would assume for an asset that virtually doubled in value over 9 years. Basically, residential real estate in Toronto has been performing relatively well as an investment, but it’s nothing to write home about. These annual rates of return tend to refute the “bubble” theory. But what if we just happened to be looking at a “reasonable” time frame (the last 9 years). What if other time frames showed different results? For increased certainty, we ran the same type of analysis over other time periods ranging from 5 years to 20 years. Most of them revealed similar results, with the exception of the last 5 years, which showed average annual net returns of roughly 7% (instead of 6%) over the period. However, this does not mean that there isn’t a problem in the real estate market in Toronto. First of all, 2017 has been insanely hot so far (although we have yet to see how the recent regulatory changes will impact the market). More importantly, over the long run, average wages have not increased by anything close to 6%-7% per year, which means we definitely have an affordability issue.