Are single family homes a good investment?

One of the main metrics investors use to measure the potential return on a real estate investment is something called the capitalization rate (cap rate for short). To calculate the cap rate, investors first estimate the net income of the rental property by adding up the estimated rents for the entire year then subtracting all expenses (excluding mortgage payments). Once they have the net income for the property, they divide it by the estimated purchase price to get the cap rate.

As an example, suppose I bought a $500,000 home as an investment and I estimate that I’ll be able to collect $2,000 in rent each month and the annual expenses for the home are approximately $4,000.

My net income for the home would be $20,000 ($24,000 in rent minus $4,000 in expenses).

This would leave me with a cap rate of 4% ($20,000 net income / $500,000 purchase price).

Real estate investors would generally be satisfied with a cap rate in the 4%-6% range for a residential property.

Single family homes have never been popular investments in Toronto because the cap rates are quite low making them less attractive when compared to other investments.

Below is a chart showing the average cap rate for all the properties purchased by investors between 2012 and 2016.

The cap rate for the single family homes purchased by the investors in this study has declined from 3.1% in 2012 to 2.38% in 2016. The primary reason for the decline in the cap rate for single family homes has to do with the fact that home prices have grown at a much faster rate than rents.

The chart below shows the percentage increase in the average price of the homes purchased by investors from 2012 to 2016 against the average price of the rent they generated during the same period.

The average price of the homes purchased by investors was $669,564 in 2012 and increased by 47% to $949,175 in 2016. The average rent generated on these homes was $2,124 in 2012 and climbed just 7% to $2,283 in 2016.

Are These Investments Cashflow Positive?

Another principle concern when real estate investors are considering buying a property is whether or not the rental income from the investment can cover all expenses along with the mortgage. Investors generally don’t want to be losing money each month when they buy investment properties.

Determining cashflow

To estimate the percentage of investment properties breaking even each month, I was able to rely on information in the MLS including the price the investor paid for their property, their annual property taxes and how much they leased the house for.

The table below highlights the source of the data for my income and expense calculations along with several assumptions.

The mortgage payment was calculated based on the actual sale price of each home and I assumed a 35% down payment and an interest rate of 2.8% and a 25 year amortization.      

What the Data Says

Most are Losing Money

Using the methodology described above, I was able to estimate what percentage of properties were cash flow positive vs negative each month.

When taking into account the actual purchase price of each home, the amount it was leased for and the estimated expenses, 95% of the investment properties purchased in 2016 would be losing money every month. This means that 95% of the owners who bought investment properties would personally have to contribute to the carrying costs of the property because the rent alone is not sufficient to cover the expenses of the home. The average monthly loss per property in 2016 was $1,121.

In 2012, 68% of all the investment properties were losing money each month with the average loss coming in at $406.28.

The chart below shows how the average monthly loss on the investment properties purchased has changed over the past five years.

The chart below shows the average monthly loss for the investment properties purchased in 2016.

It is important to note that the estimated average monthly losses for these investments assumes that investors are making a down payment of 35% of the purchase price. While this is a reasonable assumption in terms of how most buyers finance an investment property, I recognize that not all buyers will fit this assumption.

Specifically, we have heard anecdotal accounts that many foreign investors are purchasing properties with more equity than I have assumed in our example. This means that the losses for these investors may not be as significant as described above.

On the other hand, domestic investors are likely purchasing investment properties with less equity that I have assumed. Anecdotal accounts suggest that most domestic investors are borrowing against the equity of their principal residence to come up with the down payment for their investment properties.

Even with the assumption that domestic investors are making a 35% down payment when buying an investment property – this means that in many cases their investment properties are effectively being financed entirely by debt – 65% though a mortgage on the investment property and 35% borrowed against the investor’s principal residence.

York Region

The chart below shows how the monthly profit and/or loss from these investment properties has changed over time in York Region.

In 2012, investments in Aurora were on average breaking even while investments in Newmarket were making a slight profit. Markham and Richmond Hill both saw monthly losses in the $500 per month range.

By 2016, all municipalities on average were running at a monthly loss on their investments with King, Markham and Richmond Hill seeing the biggest losses.

Durham Region

In 2012, three out of the four municipalities in Durham region had an average monthly profit on the real estate investments purchased that year.

Oshawa, Whitby and Ajax showed the highest monthly profit on investments in 2012 out of all GTA municipalities. This profitability attracted investors and explains why Oshawa, Whitby and Ajax saw the most rapid growth in the percentage of homes purchased by investors between 2012 and 2016.

Rising house prices have wiped out all average profits for investment properties in 2016 for each of the municipalities.

Peel Region

Brampton and Mississauga both saw their average monthly loss on investment properties double in the four years from 2012 to 2016.  

The average monthly loss in Brampton increased from $205 in 2012 to $418 in 2016.  The average monthly loss in Mississauga increased from $358 in 2012 to $718 in 2016.

Toronto

Toronto saw the average monthly loss on investment properties increase from $571 per month in 2012 to $1,384 in 2016.

This research reveals a number of interesting trends in Toronto’s real estate market, some of which we should be cautious about.

Firstly, the subset of investors I analyzed (investors who buy freehold homes and list them for rent on the MLS) are responsible for between 17-21% of all sales in Aurora, Newmarket and Richmond Hill and as much as 36-39% of all sales in some of the GTA’s hottest neighbourhoods.

Furthermore, Whitby, Ajax and Oshawa all saw the steepest increase in investor demand as sales to investors increased by over 400% in just 4 years.

Finally, 95% of all investment properties purchased in 2016 – provided they were purchased with a 35% down payment or less – are losing money every single month.

This research only focused on a subset of investors in the GTA’s real estate market and yet it still accounted for 10% of all sales in the GTA.

I estimate that we could expect to see investor demand responsible for as much as 25%-30% of all home sales in the Greater Toronto Area if we accounted for all types of investors including the following:

a) Investors that decide to rent their properties themselves through third party websites rather than listing it on the MLS;

b) Investors that decide to leave their home vacant;

c) Owners who decide to hold on to their existing house as an investment property rather than selling it after they have moved to a new residence;

d) Homes that are partially or infrequently occupied; and

e) All types of condo investors.

Understanding today’s speculator

If the cap rates on single family homes are decreasing and investors are losing more money each month just to hold on to these investments – why is the demand for them on the rise rather declining?

To answer this question, we need to turn to the original observations that prompted this analysis – the assumption on the part of some investors that house values will keep going up 20% per year.

What’s particularly interesting about the mood of many of these investors is that while their properties are likely losing money every month, they see them as the closest thing to a guaranteed secure investment.

They see no end in sight to the rise in house prices we have been seeing over the past 20 years and are banking on it continuing to increase at the same rate.

What is also particularly interesting is how investors rationalize their decisions. Many of the investors we hear from don’t approach these decisions with a gambler's excitement. They don’t sound like greedy speculators looking to make a quick buck.

These investors believe that what they are doing is just common sense and that there is nothing really speculative or odd about buying a single family home that is losing money each month.

As an example, suppose we’re talking to an average investor who is considering spending $800,000 on a single family home as a rental investment knowing that he will have to pay roughly $1,200 per month to cover the expenses that can’t be covered by the rent alone.

The investor’s first step in rationalizing this investment is by stating that they are not in fact losing $1,200 per month. They assume that the shortfall is to cover the mortgage expenses specifically – rather than the other costs, and because it’s covering the mortgage, roughly half of their mortgage payment is going to pay down their principal. So out of the $1,200, they are losing every month, $600 is actually going back to them in the form of their principal repayment (building the equity they have in that house) which means they are really only losing $600 per month.

The investor then states that even if their house doesn’t appreciate 20% per year the way it has been, and it only goes up 10% per year, then losing $600 per month is a small price to pay if your investment is appreciating by $80,000 per year – or roughly $6,600 per month.

It almost seems irrational not give up $600 per month of your own money for the virtual guarantee of making $6,600 per month as your safe and secure investment appreciates.

This speculative mood and rationalizing of buying investment properties that in many cases people can’t really afford is so compelling that on more than one occasion I have overhead potential investors rationalize paying the expected shortfall in the carrying costs of an investment property through cash advances on their credit card. In each case, the investor’s rationale was the same – who cares if they have to pay 25% interest on the $1,200 they need to borrow each month if they’re earning 25% on the $800,000 purchase price of their home?

What if you are buying or selling a home today?

Invest don’t speculate

As someone who grew up in a family of real estate investors and who personally owns investment properties – I fully support people who want to buy their own investment property.  But the key here is that you need to be thinking and acting like an investor – not a speculator. 

Investors do not bank on short term gains in house prices to make a quick profit. Investors don’t buy rental properties that they have to personally finance out of pocket because the rental income can’t cover their expenses. These kinds of investments are in fact speculations which leave such investors in a more precarious position than their rationalizations allow for.

Given the increase in supply of single family home rentals, if demand for single family home rentals declines and it takes many months to rent a property – monthly carrying costs (and losses) only increase and become more difficult to manage.

In the event of a slow down in the real estate market or the wider economy (real estate slowdowns are usually accompanied by a recession), in which you find your job or income impacted, you’ll find it hard enough keeping up with your principal mortgage and personal expenses, let alone a money losing income property.  

The better strategy is to think and act like an investor. That means being honest about the downside risks of your investment and asking yourself how you will cover them.

We have been advising many of the investors who come to our brokerage originally seeking a single family home to instead focus on multi-unit properties. In the GTA, investing in properties with at least two to three units is necessary to earn enough rent to cover all monthly expenses and to limit vacancies. These kind of investments also retain the benefit of capital appreciation as home prices appreciate.

Be defensive

Many buyers worry about buying at a peak just before a decline – but experts cannot pinpoint real estate markets that precisely. Home price appreciation can slow down gradually this year if governments introduce policies to cool the market or if the government doesn’t act or demand is still strong regardless, prices could also continue to appreciate at the same rate for another two years, widening the price gap.

Many buyers cannot put their life on hold trying to time the housing market – changes in relationship and family status including leaving home for the first time, getting engaged or having kids are often key drivers.

Instead of trying to time the market, we advise that buyers always buy defensively to enable them to withstand house price downturns in the market while advancing their position on the real estate property ladder over the long run.

Read Realosophy Defensive Home Buying Guide

Get the right data

While we don’t recommend trying to time the market – it’s important to have the right data and information in your hands when you are making real estate decisions like how supply and demand for homes and prices are changing in a particular neighbourhood.

Neighbourhoods with higher rates of speculation may be more vulnerable to a decline in prices should the market begin to cool. If there is a high rate of speculation in your neighbourhood, and the market as a whole appears to begin to cool down, you may want to consider selling earlier than you originally planned.

Likewise, defensive buyers should avoid buying in the neighbourhoods that are showing the highest rate of speculation.

Learn more about how Realosophy uses data to advise buyers and sellers

Advice for policy makers

When speculators begin to impact a city’s real estate market, one of two things can happen.

Prices can continue to rise at a rapid rate as more and more investors jump into the market, making rapid price appreciation a self-fulfilling prophecy. This cycle can continue for a year or three or more, but eventually it stops when prices get so detached from fundamentals that the only place they can go is down. This usually results in a significant decline in house prices and almost always a wider economic recession. 

The other option is for all levels of government to step in and introduce coordinated policies aimed at protecting the real estate market and economy in light of the speculative activity we are seeing today.

Investments should be financed like investments

There is a loophole in today’s financing policies that allows investors to buy money losing investment properties entirely with debt. 

Today, anyone buying a single family home as an investment can borrow the entire down payment from the equity in their existing home and can buy a money-losing investment provided that their income can cover the expenses. This means that investment properties are underwritten with the same rules as an owner occupied property or principal residence. 

This is very different from how banks finance small multi-unit residential properties and small commercial properties. With these kind of properties, lenders want to ensure that the net income on the property can more than cover the monthly mortgage payments. Specifically, lenders like to see that the net income of the property is at least 20-25% more than the mortgage payment.  The additional 20% acts as a buffer in case the property is vacant longer than expected or if unexpected expenses arise. As an example, if the mortgage payment is $1,000 per month the property should be earning at least $1,200 per month in net income. This ratio is commonly referred to as the debt coverage ratio.

The problem with underwriting investment properties the same way our principal residences are underwritten is that such policies assume that the risk associated with buying two to three investment properties is the same as buying a principal residence. Lenders are not pricing in the risk associated with these types of investments – and investments that lose money every month in particular. 

In my analysis, the average debt coverage ratio for the freehold homes bought as investments in 2016 was 66%. This means that the average net income of each property covered just 66% of the mortgage payment – which explains why the properties were losing money every month. 

In order for these properties to not only break even, but also have a debt coverage ratio of at least 20%, buyers would have needed a down payment of approximately 65% of the value of the home. 

As an example, the average sale price of the investment properties purchased in this analysis was $949,175. At that price, an investor could buy an average investment property with just a 20% down payment – or $189,835 – provided their personal income could support the property.  If lenders require that the property has a debt coverage ratio of at least 20%, an investor would need a down payment of 65% or $616,964 to buy the same property.

While such a policy would not prevent homeowners from borrowing against their own home to finance their investment properties, it would make it significantly harder for them to buy an investment property.

Firstly, investors would need more equity either in cash or through the equity in their home to even qualify to buy an investment property. There are significantly fewer people that can take $600K out of their home equity than those that can take $200K out of their home equity.

Secondly, for buyers who are financing their investment property down payment through the equity in their home, a bigger down payment may act as a psychological barrier preventing these risky investments. For most people, it’s fine to take out a small mortgage on your home to buy an investment property that has a relatively large mortgage. This leaves the investor with the feeling that their principal home is secure and the investment property with the bigger outstanding mortgage is the riskier bet. If home owners instead have to take out a much larger mortgage on their own home to fund their investment property, they are more likely to think carefully about what they are doing.

Speculation tax

Speculation taxes are an additional tax applied to properties that have been owned for a relatively short period of time – typically less than one to two years. Speculation taxes are designed to discourage people from taking advantage of short term gains in house prices by flipping properties shortly after they’ve been purchased.

But my preliminary research suggests that a traditional speculation tax that only targets investors who have owned their properties for less than one to two years would have less of an impact on our market because relatively few speculators fit this definition today.

My research suggests that speculators in the GTA are more likely to hold onto their properties for between three to four years. I suspect that this is the case because up until 2016, house prices in the GTA were only appreciating at a rate of under 10% per year. Given the relatively high transaction costs of buying and selling a home, investors would generally want to see their property’s value appreciate by 30-40% in order to realize a decent profit after taking into account the transaction costs.

Any speculation tax should target investors who are selling their non owner occupied property within four years of buying it.

As home prices continue to appreciate by 25%-30%, I suspect that the number of investors buying and flipping after just a year or two will also grow significantly.

Foreign buyer tax and ownership

A single family home is the new gold. Just as investors historically turned to purchasing gold as a safe haven when there was uncertainty, foreign investors are opting to park their cash in single family homes in the world’s most attractive cities – like Toronto. 

While this behaviour is understandable, this injection of foreign capital inflates house prices higher than local factors like income and population growth would, at the expense of longer-term residents who live, work, pay taxes and build the cities being bought into. Ironically, growing economic inequality may undermine the very social stability that all buyers, domestic and foreign, value in Toronto.

As a first step, Ontario should introduce a tax on foreign buyers similar to the one implemented in Vancouver by the British Columbia (BC) government, but with improvements.

In August 2016, BC introduced a 15% tax on all residential properties purchased by individuals who are not Canadian citizens or permanent residents which had a significant impact on demand in the Vancouver area – more than can be explained by a decline in foreign buyers alone. Prior to the introduction of the tax, foreign buyers accounted for 15% of all sales in the Vancouver area. In September 2016, the first full month after the tax was introduced, sales declined by 33% according to the Real Estate Board of Greater Vancouver. In their most recent report sales were down 42% in February 2017. This suggests that the decline we are seeing is not precisely correlated to demand from foreign buyers, but also from domestic buyers who fear that less foreign demand may cause Vancouver home prices to fall.

Purchases by foreign buyers have once again increased in Vancouver in the first three months after the introduction of the tax. The province has also recently introduced an exemption that allows foreigners on temporary work visas to avoid paying the foreign buyer tax, a well-meaning policy that may be exploited as a loophole by those wanting to avoid the tax.

In the longer term, a more strategic measure from Australia which prohibits foreign buyers from purchasing resale houses but allows them to purchase newly built properties should be considered. Such a policy prevents domestic buyers from being priced out of homes today while leveraging foreign capital to build the homes that will be needed tomorrow.

A more balanced tomorrow

At Realosophy, we focus on using data and analysis to help buyers and sellers make better real estate decisions. We know first-hand that for many Torontonians, their single biggest financial asset is their home. That is why we think that the overall health of the residential real estate market must be prioritized above all other considerations and any destabilizing speculation curbed.

Some of those speculating on real estate are at great financial risk in the event of a personal change in circumstances or decline in house prices; while many will be critical of speculators who suffer losses, we are concerned that some in the real estate industry may not be advising these buyers sufficiently as to their downside risks.

We are also concerned that the ability of regular buyers to afford homes in the GTA will continue to erode with the influx of foreign capital. Part of what makes Toronto attractive as a city is its social stability, but this stability is not immune from the destabilizing effects of rising economic inequality and housing unaffordability.

It is our hope that policy makers will act quickly to help curb speculation in Toronto’s real estate market – and that all consumers will get the data and advice they need to make smarter real estate decisions.