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What will our customers think? Condo vs. rental.

Condo developers are merchant builders. They build a project and then move on. Because of this, there’s a belief that there’s little incentive to build for durability, in comparison to say purpose-built rental buildings where the developer might continue to own over an extended period of time. While it is true that putting on an operations hat will make you hyper-focused on everything from garbage collection to how you’re going to manage all of your suite keys, there are a few things to consider in this debate.

One, as developers we certainly think and care a lot about our brand and our reputation, both with our customers and with Tarion (warranty program). We ask ourselves: “What will our customers think if we do this?” Irrespective of the tenure we’re building, we want our projects to be carefully considered. And in the case of condominium projects, we would like our customers to feel excited and comfortable about buying in one of our future projects. That’s the goal. This is no different than any other product that you might buy that doesn’t come along with some sort of ongoing subscription.

Two, there’s often a spread between condominium and rental values. For example, let’s consider a brand new 550 square foot condominium in a central neighborhood of Toronto and let’s say it would cost you $1,300 psf to buy it today. (Obviously it could be more or it could be less depending on the area and the building.) Now let’s start with a rent and back into a value, using some basic assumptions.

Unit Size (SF)550
Monthly Rent$2,400
Rent PSF – Monthly$4.36
Rent PSF – Annual$52.36
NOI Margin72%
NOI$37.70
Exit Cap3.75%
Value PSF$1,005

Here I’m assuming that same suite would rent for $2,400 per month. I’m converting that to an annual PSF rent. And then I’m assuming that if you were managing a whole building of these kinds of units, your operating costs might be somewhere around 28%. Crude back-of-the-napkin math to get to a Net Operating Income (psf). Finally, I’m capping this NOI at 3.75%. We can debate my assumptions and if this were in a development pro forma you might “trend” the rents. But I find this comparison helpful. Here we are getting to a value of around $1,005 per square foot. Less than our $1,300 psf above.

The point is that the margins are tighter, which helps to explain why for a long time we saw very few purpose-built rentals being constructed in this city. So even though you might argue that the incentives are in place to build for durability, you do have to weigh that against the realities of what you can actually afford to build. Development is filled with all sorts of these tradeoffs. But if you and/or your investors really want a consistent yield, this strategy can work just fine. Personally, I’m a fan of the long-term approach.

Three, rent control policies can have an impact both on the feasibility of new projects and on people’s ability to actually perform maintenance. If you have a scenario where your operating costs — everything from taxes to utilities — are rising faster than your allowable rent increases, then you’re in a bad situation and you have zero incentive or financial ability to actually invest in the building, despite being a long-term owner.

Finally, there is nothing stopping a purpose-built rental developer from also being a merchant builder. i.e. Selling the entire rental building once it is done and it has been stabilized. So you could argue that we’re right back at my first point. Whether you’re selling to individual condominium owners or the entire building to one entity, you as the developer have to sit back and ask yourself: “What will our customer(s) think if we do this?”

7 Comments

  1. John Buzz Arnott

    Great fan of build quality simply from a sustainability stand point. But what if you were to build to a short-term model – say the building should last for 20 years, not 100+. Are there enough cost reductions available (within structurally sound limits) to make the numbers even work for a shoddy build?
    Love your blog!
    John.

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  2. Jakob P.

    I’ve never understood the concern about operating costs rising higher than rents.

    Rent control policies don’t generally set the cap lower than inflation. In your example, operating costs are a quarter of rent. Now, even if operating costs rise by 4x inflation, year after year, and rents can only be increased by 1x inflation, the income still doesn’t shrink because with a higher absolute value, rent doesn’t need nearly as high of a multiplier to make up for it.

    Even in a scenario where costs rise at a higher *rate* than rents, basically the worst case is that the increase in profits is delayed by a year or two. Say, as a 2br condo owner, my maintenance fees have maybe gone up from under $500 to over $600 over the course of almost a decade, with rental rates going from just over $2000 to the $3000-something mark they’re at now. Even with extra expenses for landlords, the actual operating costs would have only required a fraction of the increase that we’ve actually seen in Toronto rents.

    So if it’s profitable from the start, it’ll very likely be profitable in the long term. If not, maybe people should stop banking on future increases as much like they did in the previous recession? Am I missing something here?

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    • Let’s assume you buy a $1 million property at a 3.75% cap rate (same as what I used above).

      That would mean an NOI of $37,500.

      Now put debt on your $1 million purchase. You can choose the assumptions.

      How much cash are you generating after debt service?

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      • Jakob P.

        Ah, I see. So the problem is really then that everything is financed by expensive debt. Got it. Thanks for making that point clear.

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    • Jakob P.

      In other words, if operating costs increase by 2%, and you’re increasing rents by 2%, your income actually goes up by 6% of what you netted last year. If landlords do this on a regular basis, I just don’t see a reason to complain about a year or two going the other way.

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  3. Thank you, Brandon, for this insightful writeup. I have been thinking of moving into a condo by buying it here in Las Vegas. I had seen rental advertisements once posted on mobile billboards by https://www.maximedialv.com/. After reading your post, I have reconsidered my options and now have decided to go with one.

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