Better Dwelling
August 2, 2017
By Daniel Wong

“Toronto condos are over $600,000? Poppycock, that’s too expensive!” Compared to what? We’ve been hearing this a lot over the past year, but few economists and even the big banks have provided any numbers to back this claim. At best we’ve heard an argument about affordability, but no numbers on how many people can afford this market. Today we’ll put some numbers to Toronto condos, using a House Price-To-Rent Index. This is a tool top investment firms and economists use to gauge deviation from historic norms.

House Price-To-Rent Index

Today we’ll be looking at a House Price-To-Rent Index. There’s a lot of methods people use to determine if property is over or undervalued, which is why you get so many different opinions. Today’s model looks at the price of a home, relative to the historically accepted rental yield for a similar class of home. It’s a favorite used by economists at fancy organizations like the IMF and OECD. By comparing the annual cost of homeownership to the annual cost of renting, we can determine how much value a home has. More important, we can track how this value has deviated from historically accepted levels.

Using it is pretty straight forward. If the index is above the historic trendline, the market will balance itself by having prices drop or rents rise. If the index is below the historic trendline, the market will balance itself with rising home prices or rents dropping. It’s in no way an affordability index, but real estate markets don’t take that into consideration in the age of super-investors. How many people do you know paying less than 30% of their income on their mortgage? Exactly.

A House Price-To-Rent Index For Toronto Condos

Earlier this week we talked about the House Price-To-Rent Index, and added a regression model to estimate prices across Canada will drop 28%. Numbers like this are great for politicians, policy makers, and even macro market investors, but not so useful if you’re looking to actually buy a home. The fact that detached homes in Moncton might be 50% higher than traditional rents would command, isn’t very important if you’re looking at a condo in Toronto. That’s why we’re building micro-indexes, to track home types for specific markets. Today we’ll be looking at a House Price-To-Rent Index for Toronto’s condo market.

Toronto Condos Were Underpriced By Over 2%

At the end of 2016, Toronto’s condo market was underpriced according to the index. The House Price-To-Rent Index scored 97.76, 2.24% lower than it did at the end of 2007. This means if rents stay the same this year, condo prices need to come up another 2.29% to balance the market. The other option is rents drop by 2.24%, or any combination of the two.

One problem to consider is rents didn’t stay the same. They’re seeing an increase of almost two orders of magnitude from previous years. The year end of the second quarter of 2017 saw rental prices increase 17%, compared to a normal increase of less than a point in previous years. Landlords likely did this ahead of rental increase restrictions being considered by the province. These are unusual market mechanics, but the end result is the same – rental yields increased dramatically. Either rents will come down quickly, or condos will command higher prices in the near term.

WTF Just Happened, I Thought Things Were Overpriced?

Do I agree that condo prices should go higher? No, not at all. Can they go higher? Sure, and here’s why. Detached homes will have a limited market, even renting them will become a luxurious thing. Prices will likely come down in this segment, as less people can afford them. Will Toronto’s detached homes be affordable in the future? Probably not for the majority of Canadians. This will put additional pressure on rental stock. The problem is, Toronto isn’t building rental stock. The city builds towers of condos that individual landlords rent out. This is known as the secondary rental market.

If Toronto continues to grow, more and more people moving to the city will need the “cheapest” form of housing. This is increasingly becoming the secondary rental market. While condos are less affordable for the majority of Toronto that requires a mortgage, we can see a rise of well heeled investors becoming super landlords. Major Canadian funds are circling on the idea, and foreign investors are crunching the numbers if it works out as an investment. Advertising guaranteed rental yields for Toronto in investor cities like Hong Kong, certainly weakens the case that a foreign buyer tax makes it unattractive. Actually, the tax is likely being passed on to renters right now.

There’s two types of people in this country looking at home prices right now – homebuyers and investors. Homebuyers are easily swayed by the nicest suit on TV that says prices will go up or down, then doesn’t need someone to back it up with any numbers. Then there’s investors that have been using tools like these for years, and know where to invest. Will there be a downturn? No idea, and you might be able to get units cheaper – especially if the government interferes with normal market mechanics. However, statistic probably shows that prices will end the year higher or rents will start coming down.