Why real estate prices are overvalued A quick and easy way to determine if real estate prices are overvalued is to look at cap rates on unlevered properties and compare the returns to a risk free asset, say a 10 year treasury yield.
The current 10 treasury yield in the US is 4.08%.
In the greater Toronto area, where houses are unaffordable for the vast majority of "want to be" buyers, the cap rates are lower than a risk free rate. Something is clearly wrong with this picture.
Toronto condos have cap rates at about 2 - 2.5% and Toronto houses have cap rates at 3-3.5%.
At these rates, you won't even cover the interest expense on a house with a 20% down payment. In other words, you will have to put in your own capital just to cover your interest expense costs and then additional money for the principal amount.
example: Suppose you purchase a rental $1m property with a 20% down payment and a 3 year fixed term of 5.5% interest amortized over 25 years. The interest expense for the year would be $44k which is simply $800k*5.5% . The monthly payment including interest and principal would be $4,883.13 or the equivalent of $58,597.56 annually. In other words, after the first year, $44k is interest and $14,597.56 would go towards principal.
Let's make the assumption that rent minus operating costs is $35k for the year which is a 3.5% cap yield. We can clearly see that the owner of this property would have negative cash flow.
To be precise, the owner would have to come up with $58,597.56 - $35,0000 or $23,597.56 to meet their mortgage obligation. If the property rises in value after year 1 by exactly $23,597.56 then the owner would gain the principal amount on his $200k or a return on equity of
$14,597.56/ $200k =~ 7.29%. Keep in mind that your "real" returns would have to include selling costs when the property is disposed which would reduce your returns.
example 2: You sell the property after year 3 and you incur selling commission costs of 4%. You speculate that the property will rise in value by 3% per year over the next 3 years.
sol'n: after 3 years, your proceeds after the sale is $1,049,000. Rents increase at a maximum rate of 2.5% per year due to city limitations.
After 3 years, you've received in net rent payments:
$35k + $35k*1.025 + $35k*1.025^2 =~ $107.65
Your mortgage obligation is $175,792.68 which is a difference of about $68.14k from rent proceeds.
After 3 years, you've gained 3 years of principal payments with a value of $49,044.26. You had to dish out $68.14k in payments to meet your obligation. Finally, the property gained in value by $49k from the date of purchase.
Your returns = $49k -$68k + $49k = $30k
original down payment = $200k
After 3 years, you've earned a measly $30k/$200k =~ 15% which is less than 5% compounded per year.
final commentary: in order to achieve better returns, you would have to speculate that home appreciation will exceed 3% per year which sounds a lot like what happened to tech stocks during the dotcom era. Hope is not an investment strategy and putting too much faith on speculation is a dangerous game to play.
final verdict: one of two things will have to play out. Either interest rates/mortgage rates will have to come down, or home prices will have to continue to fall. It is clear to me, that the Federal mandate is to bring inflation down and one of the biggest reasons why we have high inflation is because home prices have risen too quickly. I believe interest rates will come down when we see a further softening in the housing market and an increase in the unemployment rate. It doesn't have to be as bad as the GFC but a correction is in order.
https://tools.td.com/mortgage-payment-calculator/