August 10, 2012
Major changes are underway in the downtown Toronto Condo market. I’m not merely referring here to the number of cranes that dot the skyline, but speaking to the underlying economics. 2012 might very well be the last year of the downtown pre-construction condo boom; major condo developers are keenly aware.
It’s no coincidence that there are more new projects being rushed to market at a faster clip than ever before, coupled with all sorts of financial incentives being offered to realtors to bring their clients.
Historically, the pre-construction market has been largely dominated by investors. Investors acquire these units for only two reasons. The first is based on an expectation that today’s purchase price will be lower than prices four years down the road when the condo will be ready for occupancy and registered.
Today, investors are being tempted by projects in the financial district being offered in the $700-$800 per square foot range, without parking.
In comparison, one can acquire a resale condo for $520 per square foot at 7 King East (the heart of the financial district), that includes parking. Using a 650 square foot condo example, this translates to a price differential of $182,000.
For today’s resale prices to match the levels of today’s pre-construction pricing, we would need the resale market to appreciate at 9+% per year over the next 4 years. It’s not going to happen.
The second reason investors purchase condominiums is for rental income. When prices exceeded the $500 per square foot mark, most ‘Rate of Return’ investors (i.e. North Americans and Europeans) left the market.
The remaining buyers are what we call ‘Wealth Preservation’ investors (situated in the Middle East, and SE Asia). This group seeks a safe place to park their funds while earning 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 barely 2%.
At this paltry level, 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. That said, there will still be a pre-construction market in 2013. It will be notably 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.
What contributed in large part to this jump in prices was the lowering of mortgage rates from the 5-6% range to 3%. We will not continue to see rates fall further. In fact we would expect them to start to a steady increase—as evidenced with RBC, National Bank and a few other lenders ending the 2.99% rate frenzy this week. 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).
It’s important to remember that most sales in the resale condo market are influenced by lifestyle changes more than economic changes. People purchase condos for the space they need today – not necessarily for what’s required five years down the road.
In a nutshell, the resale condo market will continue to grow in size going forward while the pre-construction market will soften, resulting in some of these current projects simply not getting built. Lifestyle and continuing migration to Toronto will ensure a steady flow of people who will want to live downtown. Prices will not see tremendous gains like the past, but they surely will not see tremendous declines either.
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