If you've been reading my blog as of late, you've been seeing my increasing fascination on how we arrive at 'valuing Toronto real estate'.
'Value' on the surface, is a seemingly straightforward concept. On the one hand, the basic economic principle of supply and demand essentially sets the parameters for value. Further to that, market dynamics for whatever commodity you are trading (in this case, of course, we are dealing with real estate) will dictate the price, which is a certain driver of value as well (as in, how much a person is willing to pay for a product at a given moment in time, ultimately determines what it is worth).
But as anyone who has spent time in and around the Toronto property market can tell you, there is far more to deriving and determining value, especially in a swiftly moving market, where a property's location plays a significant role, even beyond the condition of the dwelling. Today, a lot of properties selling for under $1million in the original City of Toronto, are being acquired simply for the land the dwelling sits on.
Recently, I shed some light on how Buyers ultimately arrive at their purchase decision in “How To Search For Your Next Property Purchase”. While housing wishes, wants and needs vary, there is a basic matrix system through which a Buyer will assign priorities for their housing choices, based on a home’s size, site and condition. Ultimately, there is always need for some level of compromise, but that personal housing matrix is how Buyers find a home that best suits their requirements in detail, while they reconcile their budget. I’ve also talked about how owning a home supports an intangible sense of value in “Maslow’s Hierarchy Of Needs And Toronto Real Estate For Sellers”.
Riding that train of thought, I thought I would delve a bit deeper into how a property is valued by appraisers in the City of Toronto, taking into account that there are three fundamental approaches used in real estate. I explored this in detail in the past in my blog called “What Is Your Home Worth Today?” but it bears worth repeating, with more focus on the value of land as a dominating variable.
Market Value Comparison Approach
What is most probably the most well-known approach to determining a property’s value is the Market Value Comparison Approach. The market value, as I've alluded to above, is determined by what people are willing to pay for your property, based on what the market “tells” them to.
The market value of a home is determined in quite a systematic fashion. The numeric framework begins with aligning recent sales similar properties with comparable features in the immediate area. You can then gauge variances from that value based on any “premium” features that your home might have, like private parking, unique qualities, high end finishes, renovations, etc. etc.
Although harder to attach a specific dollar figure, Buyers and their realtors also figure in some of the intangibles like visual appeal, historic charm or impressive views.
Really, this value approach is an estimate - but it is an estimate largely built on quantitative data with some intangibles thrown in. In real estate, past buying behaviour is often a predictor of the future, because of how it reflects Buyer attitude, tastes, tolerance for risk and budget. It’s not an exact science though, so it is based on a range of value, rather than assigning a specific dollar sum.
If you are looking for an income property (or to use a portion of your residence as an income property), your lender will take into account the potential income that you might derive from the rental. This can effectively boost their appraised value of the property, as it pertains to your financing. They calculate the likely income (based on past tenancy, size and features of dwelling and location) and also take into account the expenses that you’ll have to shoulder as a landlord. The income approach is a real estate appraisal method that allows investors to estimate the value of a property by taking the net operating income of the rent collected and dividing it by the capitalization rate.
What is the capitalization rate (or Cap Rate)? It's the rate of return on a real estate investment property based on the income that the property is expected to generate. It's determined by dividing the investment’s net operating income (NOI) by the current market value of the property (using other similar income properties as comparisons), where NOI is the annual return on the property minus all operating costs. The formula for calculating the capitalization rate can be expressed in the following way:
Capitalization Rate = Net Operating Income / Current Market Value
For example, if I buy a property for $1,000,000 and it generates $40,000 per year after operating costs, the capitalization rate for this investment is 4.0% ($40,000 / $1,000,000 = 0.04 = 4.0%). What this means is that, every year, I'm earning 4.0% of the value of the property as profit. In Toronto, securing an income property with a 4% return is quite unusual these days. Some investors will buy a property with as little as 1% to 2% return after expenses, mostly because they're counting on market values to increase during their ownership. Given values have skyrocketed upwards of 20% in the downtown core this calendar year (see October 2016 Real Estate Statistics Reveal Unrelenting Price Growth in the GTA) investors are counting on the escalation in the property's value over time to provide a return on investment, more than on the income it's generating. Is this wise? Certainly if the market flat-lines it calls into question the intelligence of this approach, but with the market escalating in value consistently for nearly two decades, many Buyers aren't even considering the possibility values will stabilize or decrease.
If you're considering an investment property, here's a great past blog called 5 Essentials For Toronto Real Estate Investment.
Land Value + Development - As A Cost Approach
You’ll often see insurance companies utilizing a Cost Approach to determine a home’s value. In this approach, they look at the approximate land value and then they estimate how much it would cost to rebuild your home, based on square footage, property components, location and any upgrades (i.e. landscaping, premium features inside, pool, etc.) and - if your policy isn't for full replacement cost - then they depreciate the value of your dwelling as it stands based on its age, condition and level of obsolescence.
What’s important to note, is how this concept of development costs combined with land value is emerging as a major method of valuation in the city, and has turned this development Cost Approach in a new direction. A robust market like this is fueling builders to pay top dollar to acquire a site, at which point substantial sums are invested into transforming the dwelling into a new highest and best use (basically a luxury residence geared to the professional class, though sometimes it could means multi-units like an infill townhouse or condominium complex). This is increasingly commonplace in the City of Toronto and, because of this, there's a rapidly diminishing supply of habitable housing under $1mil in the downtown core that first and second time buyers can consider. Because the vintage of our housing stock and its failing condition is increasingly commonplace, more and more builders are pursuing these listings and transforming them. And, as more of these newly rebuilt and renovated swish houses come to market (in the $1.5m+ price range), the more it reassures other Builders to follow suit, which allows Builders to begin outbidding users hoping to occupy the dwellings as-is and upgrade over time as their finances allow.
You see, given the scarcity of land in Toronto, most of a downtown property’s value is increasingly tied to the land that it sits upon. But that gap between supply and demand in a certain price point ($800,000 to $1mil range) within the downtown core, has widened to the point where Buyers (especially Builders) are essentially treating the property as just land value, assigning the existing dwelling that rests on it as obsolete.
I addressed this in a past piece called “Why Are So Many Downtown Homes Being Renovated.?” Not only does this phenomenon change the physical landscape of the city, it also serves to further squeeze supply in a price point and location where scarcity is the rule of thumb. As sold homes get torn down or substantially renovated, the pool of available housing under $1mil is reduced at a time where this price bracket has the greatest demand, especially with Millennials selling their singleton condos as they co-habitate and combine households (Click here to see my chronicle of just such a journey in one of my past Home of the Month tales). The offshoot of this is that high values continue to climb higher for product that is increasingly rare to find.
Because of this, the land value largely eclipses the value of the dwelling to the point where Buyers are paying huge sums for land and a fraction for the existing housing. The theory is that in addition to the purchase price, they will assume additional development costs to either gut and rebuild the existing home, or to completely level the dwelling and start again from scratch. Either way, the purchase price of an existing 'affordable' home in certain pockets of the city - basically anything in proximity to a subway or streetcar in the centre of the city - starts off with a base price based on the land plus a modest premium for the existing structure, if it's worth anything at all.
Here are some examples to give you a little context.
These four tear-downs on Markham Street north of Bloor in Seaton Village sold for over $700,000 each back in 2014. They're still undeveloped. With single family houses rare to market in this neighbourhood today, these lots would sell closer to $900,000 now. Want a habitable home in Seaton Village? Prices start at around $1,100,000, or $200,000 more.
The two semi-detached houses below - located on Shaw north of Bloor - are two of a row of houses which have sunk over the past years due to being located over Garrison Creek which was filled in at the time of development last century. Although they sold for $630,000 in August 2015, the builder who tears these down and builds new will be facing some pretty significant costs sinking helical piles down to hit bedrock to stabilize a new build. This will really push the cost of redevelopment up.
The property below - a pair of semi-detached houses (on each side of the driveway) with a large auto garage in the rear - located in Little Italy sold in June 2016 for $2,300,000 (that's $780,000 for three sites that are uninhabitable or obsolete). The challenge with this site will be the environmental remediation required to clean up its past use as an automotive garage. With all residential sites requiring a clean bill of health, this will increase their development budget substantially. Want to buy a single family 3 bed semi in this area? You're looking at a minimum $1.1m+ for a fixer upper.
This semi-detached house below with a private drive on a 27' wide lot - located opposite a park just steps from the Christie subway - came to market at $998,000 this past week and garnered six offers, landing at $1,265,000. The catch? The house had significant structural issues including sloping about four inches from front to back, while all the retaining walls wrapping the lot had significant cracks. Given the cost to stabilize and transform, this will need a substantial capital investment exceeding several hundreds of thousands of dollars. It's essentially better to tear down the semi and try get approvals for two zero-lot line 13.5 foot wide houses valued at $632,500 each.
There is an architectural re-invention occurring in the downtown core, where aging stock is being replaced with new (or substantially rebuilt) buildings. What is important to note that, in a number of cases, the costs of redevelopment and the process of building can be significant, depending on factors (environmental and other). It’s not always as straightforward as taking down one home and replacing it with a more up-to-date one. Having spent some years in the development industry, I explored the process behind redevelopment in these past posts , “Understanding the Development Process” Part One and Part Two.
If you are considering a property purchase with an eye to redevelopment, be mindful of all the costs when you are determining fair value. Development costs are hefty and continue to climb. Here is a recent post called The Pitfalls Of Permit Fees And Toronto Real Estate with a link to the City of Toronto development costs, which can climb to around $20,000 a unit depending on the size of the project. Not tearing down but simply expanding an existing property? Here's my Steps To Add Onto A House In Toronto which, in all likelihood, will require you to Navigate The Committee Of Adjustment In The City of Toronto.
Regardless of your end goal and your approach to your valuation of your intended property, due diligence is the order of the day. It’s not enough to observe the market, plan your entry point and set your budget. You’ve got to have a thorough understanding of criteria, process and real costs that can support or detract from value, depending on your approach.
With all the nuances and intricacies of this current market that can impact a home’s value in relation to your financial involvement, it’s a good idea to do extensive research. At urbaneer.com, my team and I have decades of experience, which means our intuitions are based on fact. We rely on what we’ve seen - along with solid data - to provide you with all the information you need to make a smart buy.
Are you mulling the idea of buying a property to purchase that provides the opportunity to elevate it to its highest and best use?
We’re here to help!
~ Steven and the urbaneer team
earn you trust, then your business
Steven Fudge, Sales Representative
& The Innovative Urbaneer Team
Bosley Real Estate Ltd., Brokerage - (416) 322-8000
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