Toronto’s Real Estate Bubble May Have Just Got A Price Floor From Politicians 

Politicians in Canada’s largest city just approved a new law that may help prop up its bubble. The City of Toronto adopted a broad upzoning measure this week, converting single-family zoning into multiplex zoning with up to 4 units. The City is notoriously slow when it comes to increasing zoning applications, so this was pitched as a way to improve affordability by increasing supply. Despite the popularity of the narrative, it’s contrary to basic real estate valuation principles and typically does the opposite—raises home prices and makes little to no difference in new supply.

Real Estate Values Are Determined By Highest & Best Use

Real estate valuations are determined by the catchy phrase, “highest and best use.” Values are based on the maximum utility of the property, not its current use or what it’s now making. If an improvement can be reasonably obtained, then it’s added to the valuation of the home. 

For example, a landlord might be selling an apartment building with long time tenants. Those tenants are likely paying significantly less than market rents, but market rents are used to determine the value. It’s up to the buyer to find out how to collect market rents, which is why long-time tenants often find themselves being shoved out the door after a building is sold.  

A real estate fundamental and an important part of “highest and best use” is zoning. If a property has additional zoning available, it’s probably not at its maximum utility, and the seller would consider the possibility of what could be built there. If a tiny house is zoned for a 50-foot tower, the value should be roughly the cost of a 50 foot tower, less the cost of demolishing the existing structure and construction—plus or minus liquidity.  

Highest and best use isn’t a principle only known by real estate pros and investors. It’s a part of the basic education for the industry. Real estate agents in Ontario use a textbook written by the regulator called Principles of Appraisal that literally has a whole chapter and numerous exercises on the impact of zoning to limit and increase valuations.

“In the overwhelming majority of cases, properties are already developed to their highest and best use. The typical buyer/owner will use a property to its best advantage whether for enjoyment or profit. This is not only because of natural human nature, but also because of economic pressures to do so.”

— Principles of Appraisal, RECO.

Overwhelming majority of cases… until lobbying establishes a new highest and best use, eh? 

Toronto Will No Longer Have Single-Family Homes For Sale, It’ll Have Mini-Developer Lots 

Toronto’s broad upzoning effectively turns every single-family detached home into a developer lot. Buyers can no longer buy one of these homes, they’re buying a developer lot of four homes, minus the cost of building them, plus/minus liquidity. In a high demand market like Toronto, that can establish a price floor when prices are falling, since you’re no longer comparing two of the same homes. 

Vancouver used this brilliant tactic to turn $2 million homes into four $1.8 million homes on the same lot, at a quarter of the size of the old units. And we all know that Vancouver is notorious for how well they handle housing affordability.

Zoning Before Planning Means Higher Input Costs To Build

Toronto needs a lot more housing at any price though, and at least this helps create supply, right? Not exactly. The day after the changes are made, you have homes with newly adjusted valuations and, well… no more new housing yet.  

The homes still have to be developed, and not many homeowners were waiting to redevelop their home. Developers still have to go out and purchase those units, and then build the actual housing. In effect, the only thing that changed is the input cost for the developer building a home. The same amount of housing could have been created with an expedited upzoning process, while preserving lower input costs. Whoops. 

Don’t just take my word for it. An MIT study set out to prove that this sort of broad upzoning helped create more supply and cheaper housing. The author ends up concluding, “short-term, local-level impacts of upzoning are higher property prices but no additional new housing construction.” 

So close! 

“But Texas Is Deregulated & Cheap!”  

Texas is often used as the argument for a deregulated market that will make housing affordable. It’s true, you can pretty much build anything anywhere and home prices are cheap in Texas. It’s not an issue of there being so much supply that credit has little influence though, it’s an issue of significantly higher carrying costs. 

Texas property taxes are nearly 3x the rate of Toronto. In Toronto, the million dollar homes that line the streets would have a property tax bill of roughly $6.5k/year. A home of similar value in Dallas would set you back $22.2k/year in property taxes. No one in Texas wants an expensive home because the carrying costs are just not worth it.   

High property tax rates are basically a requirement of this kind of broad deregulation. First, a deregulated city doesn’t plan it’s density, it responds to it. It’s impossible to figure out where to place schools, hospitals, and other public services if you’re waiting to see where it’s needed. It’s also a lot more expensive to respond instead of plan.  

Second, high property taxes are one of the basics of deregulated capitalism. Adam Smith, the godfather of capitalism, advocated for only one tax—a land tax. He felt land was a natural monopoly, and required a tax rate high enough to deter hoarding and inefficient capital allocation, which would be diverted from more productive use. 

Texas is about as capitalist as it gets, so deregulation makes sense in that regard. Toronto’s adoption of broad upzoning almost certainly means larger subsidies from higher levels of government. That’s another way of saying income and businesses across Canada can help subsidize Toronto homeowners.  

Toronto needs more housing, and a lot more. Broad upzoning to prevent the need to adopt faster planning and approval processes is just about the sloppiest way it could have been done. Though it’s starting to feel like all of these happy policy accidents that result in higher shelter costs aren’t an accident.

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