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Warren Buffett is fond of saying that "you never know who is swimming naked until the tide goes out." Well, when interest rates start to climb, Toronto's condominium investors may be about to get a lesson in the perils of swimming in the buff.

Bond yields worldwide jumped in recent weeks as the Federal Reserve hinted its bond-buying program could soon begin to wind down. The Canadian bond market has not been immune to this force, with 5-year government bond yields up from 1.33 per cent five weeks ago to 1.84 per cent last week.

Ten-year yields are up 80 basis points over the same short time span. (A basis point is 1/100th of a percentage point.) Posted mortgage rates in Canada have moved higher in lock-step, with the cheapest five-year fixed mortgage rate up 65 basis points over the same period, putting it back above 3 per cent.

This puts significant pressure on Toronto condo investors. Yet a recent blog post on Urbanation, a website that tracks Toronto's condo market, touted the invest-to-rent option – presumably because the previously popular invest-to-flip option is no longer profitable – noting that the average rent for a Toronto condo is now $1,856, handsomely up 10 per cent from two years ago.

Based on the average condo sale price of about $330,000, this appears to be a healthy rental yield of 6.7 per cent – on the surface, it's a tidy sum compared to the low-risk option of parking money in a "return-free" savings account at a chartered bank. What the report failed to mention, however, were the carrying costs.

So, here are the sober math facts of the net rental yield. Interestingly, banks do not charge a premium for an investment-property mortgage (under a puzzling assumption that there is no added default risk to investment properties versus owner-occupied purchases) so the posted rates apply to an investor.

Based on a 3.05 per cent mortgage rate, a five-year fixed mortgage with 20 per cent down-payment and 25-year amortization period requires a payment of $1,265 per month or $15,187 a year on an average condo, a 7-per-cent increase from just one month ago. Monthly maintenance, including utilities, will set the investor back conservatively $4,000 per year on a one-bedroom downtown condo. Take another $2,600 per year off for real estate and income taxes.

All that is left is $535 per year, for a net rental yield of 0.16 per cent. And a repair or a paint job could wipe out that profit in a flash.

The question becomes, why would an investor take on the risk of owning a condo for virtually no annual return?

The answer: They are not. Even before rates began to spike in May, Toronto condo sales were flagging, with sales down a whopping 55 per cent in the first quarter of 2013 versus a year ago. Diminished affordability was no doubt a contributor to the sales slump as the market felt the pinch from the new regulations requiring a shortened amortization period – the equivalent of a 100-basis-point increase in the five-year mortgage rate.

However, potential buyers are also worried about a price correction. Price gains in the condo market were a skimpy 1.2 per cent in May, which is a far cry from the 10-per-cent-plus returns investors had come to expect before the federal government's mortgage crackdown. Double-digit returns made condo purchases worth the risk; 1 per cent annual returns, not so much.

Added to the reduced affordability and flagging price expectations that have beaten down demand is that builders are using flawed demand projections. Urbanation cites the latest household formation number for Toronto of 34,000 units per year, according to the Census published by Statistics Canada, as the expected annual sales figure for condominiums.

The problem is that – at best – only half of those households are interested in high-rise living. According to the same Census report, the true household formation rate for condo demand is 17,000. This 50/50 split between single-family households and multi-unit dwellers has not changed in Toronto in the past 10 years. As such, the often-heard argument that shifting demographics will absorb this excess inventory does not stand up to the facts.

With these facts in mind, the pipeline of condo construction becomes much more daunting. Condominium builders completed 17,000 units in the past year, yet still have more than 50,000 units under construction. As such, the facts are that builders are sitting on more than three years' supply at a time when it will only take another 50 basis point rise in mortgage rates to put a rental investor into a position of negative carrying costs.

From oversupply, to reduced price expectations, to surging mortgage rates, the Toronto condo market is feeling the squeeze from all sides now. Here's hoping the spike in mortgage rates is short-lived.

Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.


Editor's note: An earlier online version of this story and the original newspaper version of this story incorrectly stated that real estate and income taxes on an average Toronto condominium are about $2,600 per month. In fact, this is the figure per year, not per month. This online version has been corrected.

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