Yesterday I made a comment on Twitter about most people not understanding to what extent government bureaucracy inhibits the delivery of new housing in this city. It received a number of responses, including remarks about how development charges have also recently doubled and how this statement applies to pretty much every city out there. But there was also a comment about developers not being transparent and not properly explaining the impact to the public. In other words: please demystify the development pro forma. I thought that was a fair remark, and so this post is going to be a response to that comment.
Before I begin, it’s important to keep in mind that most developers have investors. These investors put up most of the money required for a project and in turn they take most of the profits. However, there is typically a “promote” in place, which is just an incentive structure that pays the developer more of the profits (disproportionate to the cash they invested in the project) if they perform and hit certain return benchmarks. All of this is to say that developers aren’t usually the ones holding all of the cash (which is what a lot of the public seems to think) and they are accountable to their investors to do what they said they would do.
Now let’s run through the costs that make up a “typical” development pro forma. For this example, I am going to assume that we’re talking about a 100,000 square foot mid-rise building; the kind that you might build and find along any one of Toronto’s Avenues. If we were doing this in real life, we would get more precise with the areas and consider gross construction area, gross floor area (city definition), and the net saleable/rentable areas. But to keep the math simple, we will ignore these differences. That’s the approach I’m going to take overall in the post. What you need to know, though, is that you have to pay to build the entire building, but you only get to collect revenue on a portion of it. That’s why the “efficiency” of a building matters.
Land
The value of development land is a function of what you can build and the revenue you can ultimately collect. So location matters a great deal. Based on the latest high-density land report from Bullpen and Batory, the average price of an unzoned mid-rise site in the City of Toronto is about $231 psf. So let’s assume a land cost for our project of $23.1 million. Assuming we can get land financing at 60% of the value of the land (loan-to-value), that would mean we’re putting up $9.24 million of cash (plus a loan guarantee!) and borrowing $13.86 million to start our project. At 5.25% per annum (interest-only loan), our annual interest charges would be about $727,650. From now on forward, we’re going to pay ~$60k in additional interest charges for every month that our project is delayed. Buckle up.
You should now begin to see why time is so valuable and why government bureaucracy can be so frustrating. As a developer, you’re heavily incentivized to move things forward, whereas it can often feel like everyone around you is trying to deliberately erect roadblocks in order to slow you down and make your project more expensive to build. Oftentimes, it is because it is less risky for them to punt things down the road and not make a decision. That is not the case for us and our project.
Hard Costs
Onto construction (or hard) costs. As many of you know, these have risen dramatically over the last 4 to 5 years. On some of our projects, we have added over $100 psf in hard costs alone. Part of this has to do with a busy construction market and part of this has to do with new building requirements: watertight undergrounds, new Green Standards, and so on. For our project, which is on the small side, let’s assume $360 psf for a total of $36 million. This would include our direct construction costs and our construction manager’s overhead (general conditions). We should also prepare for some of the trades to decline to bid on our project because it is too small and not worth their time.
Soft Costs
Soft costs include everything from consultant costs and interest charges to government levies and management fees. Like everything in your pro forma, these absolutely need to be broken out line by line. Don’t be lazy here. But for the purposes of this simplistic example, we’re going to use 75% of hard costs, which works out to be $27 million (or $270 psf). When I first started out in the development business, the rule of thumb was closer to 25% of hard costs. But times have changed. Government fees, alone, can make up about 1/4 of the price of a new condo in Toronto.
Adding up all of these costs, we’re at $861 psf or $86.1 million in costs. It’s now time to consider the revenue side. $1,000 psf seems like a nice round number, so let’s start there and assume we’re going to sell our condos for that. Typically in Toronto, the price you pay is inclusive of HST, so that liability will need to be deducted from our revenue line. It’s not a straight 13% because of the new home rebate, but the rebate also hasn’t been properly indexed since it was introduced and so the liability could still be upwards of 10%. (This is worthy of a separate blog post.) The result is $900 psf in revenue and a margin on costs that is less than 5%. No sensible developer would want to do this project. One misstep (or development charge increase) and you’re dead.
So let’s increase our condo prices to $1,100 psf. Maybe that will work. In doing that, we get to a margin on costs that is nearly 15%. Okay, now we’re in the range. But let’s say we just got delayed by 6 months (boom, interest charges) and our hard costs turned out to be off by $15. They’re actually working out to be $375 psf because of some new tariff and because the formworkers in the city are all tied up on bigger projects and couldn’t give a shit about our cute little infill project. Now we’re offside again in terms of our margin on costs. No problem, let’s try and push condo prices a bit more. Is $1,150 achievable? Perhaps. But ideally, given the above, we would want to be at $1,200 psf just to be safe.
This is an overly simplistic example of the math that goes into a development pro forma. But hopefully it begins to show you (1) just how many moving parts there are in a development project and (2) the kind of pricing that is required in today’s cost environment. Developers are reacting to the costs that they are being thrown and it is creating upward pressure on home prices. (See related post: Cost-plus pricing.) So far there has been enough elasticity in the market to absorb these price increases, but that may not always be the case. If you have questions about this post or disagree with any of my assumptions, feel free to leave a searing comment below.
Photo by Marcos Paulo Prado on Unsplash
BRANDON DONNELLY 
Excellent post. From my window I look over a small res infill under construction. It’s taking forever, as trades seem to be in short supply. I can only imagine the sponsors profit dwindling each and every day.
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Do you have developer friends in other places? What would be really cool is a comparison of these costs (and relative percentages) for different cities and countries. Especially where financing or regulation circumstances are different. Maybe a European city with strong social housing habits, or someplace in Asia, or maybe just a Canadian city that ends up much cheaper than Toronto. (I guess San Francisco would be the opposite of that, and from what I’ve read, uncertainty plays a large part there too.)
In the best case, analysing these differences could lead to actionable suggestions for Toronto’s regulatory environment. In the worst case, it would be really fun and insightful.
One question about your particular example: iirc, the Avenues and its mid-rise buildings were specifically targeted by the municipal government to streamline processing and approval of projects assuming they adhere certain constraints for built form. Does this make a difference for your (unzoned) example, and if so, how much of a difference compared to non-Avenue land?
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Thanks for this. Just one question remains in my mind: what are the investors walking away with?
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Isn’t your land cost in this post exaggerated quite a bit?
If you are building a 100,000 sf building you wouldn’t need 100,000 sf of land.
23.1 million/100,000=$231/sf
But if you built a 4 story building you would only need 25,000 sf of land or a bit more.
I’m I missing something?
Thanks.
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Land in toronto is priced psf of building you can put on it. I’d say in this example you’d be looking at a 5x-6x density situation, so you’d need 15-20k sf of land to build. There’s a wide range however the land number used is not particularly abnormal.
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Thanks for the explanation. That’s an interesting way to price land but makes sense.
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Wonderfully informative, and easy to understand, post.
One question: Does the percentage for Soft Costs decline in a large project vs. a small project like in your example? In a theoretical world, if you could build the largest building possible, would the soft costs decline to much smaller percentage? Would hard costs still decline too, even though obviously you have to spend more to make a larger building?
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There’s a small component of soft costs that have economies of scale, however, most of them scale with the project size (financing costs go up with project size, most govt fees scale with the project) The big savings from a larger project is that, all things being equal, you’ll likely save a meaningful amount on the hard costs. Mid rise buildings are too large and complex for small trades, and too small for the big trades.
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Brandon,
Thank you for this very informative explanation. God help Ontario and the lower mainland if these regions tip into a recession. In Alberta, we are now into year six of a zombie economy. In our province, developers build nothing but mid and high rise residential for renters exclusively. Although there are government inducements to do so, it might be more appropriate to say that there are very few individual purchasers willing to buy residential product. I am living in your future and it is not pretty. Edmonton is bad, Calgary is worse; tumbleweeds and jack rabbits. Since the oil shock hit us, commercial and residential rents have gone down. Also, municipalities have tried to make up lost tax revenue with additional taxes charged to those of us clinging on.
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It’s not a stretch to say that “regulators” (i.e. anyone who has the power to restrict development), have zero incentive to make developers life easier and very few people talk about how their policies led to the Manhattanization of Toronto, with disproportionately tall towers in already dense areas, while entire single-family neighbourhoods remain downtown.
Is the city even accountable for what the DCs are used for?
On the other side, you have homeowners, whom I shall remind you to account for 66.5% of residential dwellers in Toronto, who have every reason and incentive to push away development from their beloved neighbourhoods. Since politicians are always looking to be re-elected, they’re not about to piss-off homeowners-taxpayers for fear of losing their seats.
What’s highly unfair is that it creates a situation heavily biased in favour of existing residents, without giving future residents a chance to succeed as well, a-k-a a very self-serving, dare I say selfish situation.
We can’t count on politicians to change their minds, so how do we go about dealing with this entirely preventable problem.
See how Tokyo dealt with it: https://mises.org/wire/why-housing-more-affordable-tokyo
Also, what about prefab? https://www.youtube.com/watch?v=zYJpCcx6TYU
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Given you can sell for $1200 psf, if hard costs were lower why would you sell for less than $1200 psf?
If your construction costs were zero, all that value would just flow to the landowner. Why would I sell you my land for $230 when I know you could sell for $1200 and zero cost? The margin will always be 15-20%.
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For the land costs I think he meant pbsft (price per buildable square foot). Usually developers buy land based on the amount of buildable square feet and not the actual land size. (PBSFT converts land sale prices into a measure based on what you can build)
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