Oftentimes, it feels like there is a perception that developers price new housing with the fattest of margins. Meaning, if only developers were less greedy, housing could be more affordable. But as we have spoken about many times before, real estate development is a competitive industry; therefore, projects happen on the margin.
Ordinarily, the prices you see are the result of a cost-plus pricing strategy. Developers figure out what it will cost to build and develop, they add on a margin that they think their investors will accept, and then they determine what sticker prices they need to make the project financially feasible.
I've been writing about this approach for many years, but today it's even more obvious. According to Urbanation's Q1-2024 condominium report, new unsold condominium inventory in the GTA is currently sitting at approximately 23,815 units. This is up 30% YoY and is equal to about 23 months of supply. Two years ago in Q1-2022, this number had reached an 18-quarter low of 8,726 units.
Oftentimes, it feels like there is a perception that developers price new housing with the fattest of margins. Meaning, if only developers were less greedy, housing could be more affordable. But as we have spoken about many times before, real estate development is a competitive industry; therefore, projects happen on the margin.
Ordinarily, the prices you see are the result of a cost-plus pricing strategy. Developers figure out what it will cost to build and develop, they add on a margin that they think their investors will accept, and then they determine what sticker prices they need to make the project financially feasible.
I've been writing about this approach for many years, but today it's even more obvious. According to Urbanation's Q1-2024 condominium report, new unsold condominium inventory in the GTA is currently sitting at approximately 23,815 units. This is up 30% YoY and is equal to about 23 months of supply. Two years ago in Q1-2022, this number had reached an 18-quarter low of 8,726 units.
Developers are highly motivated to sell and move their projects forward. Time is a killer, especially today. So the logical explanation for this rising inventory is simply that they can't sell it. Their cost-plus pricing doesn't overlap with what most buyers in the market are willing to pay. Like I said, development happens on the margin.
In theory, there is always a price where buyers would be willing to transact. If I listed a beautiful condominium for $100k today, many people would want to buy it. Supply would quickly run out. The problem is that no developer can build for this. There is always a very real price floor and, right now, that floor doesn't seem to be low enough for many buyers.
Generally speaking, the cost of building a new building is always going up. There are moments in time, like during a recession, where costs might temporarily correct downward. But generally speaking, there is a cost floor that is constantly rising. This includes everything from hard costs to rising development charges.
We have spoken before about how developers typically look at their costs, and then price accordingly through "cost-plus pricing." Put differently, it is answering the question, "what do I need to rent or sell this space for in order to cover all of these projected costs?" This can be tricky when costs are all over the place, as they are right now with double percentage point swings, but that's a different conversation.
As long as there remains some price elasticity in the market, cost-plus pricing can work just fine. Costs are up, but I'm just going to increase pricing to absorb most of it, or in some cases all of it. However, problems occur when and where you can't increase pricing. Maybe it's in a marginal area where rents aren't increasing. Or maybe interest rates are rising and overall price elasticity is tightening.
Whatever the case may be, in this scenario, it likely means that development will stop and supply will slow or possibly even shut off. We are starting to see some evidence of this happening in Toronto right now.
But if the fundamentals of the overall market remain strong, this should only be a short-term problem. Eventually the market will catch up (through higher pricing and/or some reduced costs), and then projects will return to being feasible. But if there's a structural problem in the market, maybe development never returns without some kind of subsidies.
Thankfully, it is obvious to most that markets like Toronto have incredibly strong fundamentals. We can screw up a lot of things as long as we remain open to smart immigrants from around the world. This makes it fairly easy to have conviction around what will happen over the longer term. And this is generally how I like to make decisions, whether we're talking about real estate or crypto (see above tweet).
But all of this doesn't mean that one shouldn't also be managing the short run.
Every year my friends at Urban Capital publish an annual magazine called Site. And every year it contains some great articles about the real estate development industry across Canada. (Some of you may also remember that I've written a few articles for it in previous years.)
Well this year's issue is out and there are a few featured articles that I'd like to draw your attention to:
What happens when 175 (mostly) women get together to design a condominium?Link
Why have Toronto condos become so %@$#$! expensive?Link
This last one is a topic that we have talked about many times before on the blog. But here, UC has provided a quantitative comparison between a project they did in 2005 and a project that they're doing today in 2020. Here's what they found:
Developers are highly motivated to sell and move their projects forward. Time is a killer, especially today. So the logical explanation for this rising inventory is simply that they can't sell it. Their cost-plus pricing doesn't overlap with what most buyers in the market are willing to pay. Like I said, development happens on the margin.
In theory, there is always a price where buyers would be willing to transact. If I listed a beautiful condominium for $100k today, many people would want to buy it. Supply would quickly run out. The problem is that no developer can build for this. There is always a very real price floor and, right now, that floor doesn't seem to be low enough for many buyers.
Generally speaking, the cost of building a new building is always going up. There are moments in time, like during a recession, where costs might temporarily correct downward. But generally speaking, there is a cost floor that is constantly rising. This includes everything from hard costs to rising development charges.
We have spoken before about how developers typically look at their costs, and then price accordingly through "cost-plus pricing." Put differently, it is answering the question, "what do I need to rent or sell this space for in order to cover all of these projected costs?" This can be tricky when costs are all over the place, as they are right now with double percentage point swings, but that's a different conversation.
As long as there remains some price elasticity in the market, cost-plus pricing can work just fine. Costs are up, but I'm just going to increase pricing to absorb most of it, or in some cases all of it. However, problems occur when and where you can't increase pricing. Maybe it's in a marginal area where rents aren't increasing. Or maybe interest rates are rising and overall price elasticity is tightening.
Whatever the case may be, in this scenario, it likely means that development will stop and supply will slow or possibly even shut off. We are starting to see some evidence of this happening in Toronto right now.
But if the fundamentals of the overall market remain strong, this should only be a short-term problem. Eventually the market will catch up (through higher pricing and/or some reduced costs), and then projects will return to being feasible. But if there's a structural problem in the market, maybe development never returns without some kind of subsidies.
Thankfully, it is obvious to most that markets like Toronto have incredibly strong fundamentals. We can screw up a lot of things as long as we remain open to smart immigrants from around the world. This makes it fairly easy to have conviction around what will happen over the longer term. And this is generally how I like to make decisions, whether we're talking about real estate or crypto (see above tweet).
But all of this doesn't mean that one shouldn't also be managing the short run.
Every year my friends at Urban Capital publish an annual magazine called Site. And every year it contains some great articles about the real estate development industry across Canada. (Some of you may also remember that I've written a few articles for it in previous years.)
Well this year's issue is out and there are a few featured articles that I'd like to draw your attention to:
What happens when 175 (mostly) women get together to design a condominium?Link
Why have Toronto condos become so %@$#$! expensive?Link
This last one is a topic that we have talked about many times before on the blog. But here, UC has provided a quantitative comparison between a project they did in 2005 and a project that they're doing today in 2020. Here's what they found:
Average condo prices in the City of Toronto are up about 150%. But...
Land costs are up 160%.
Soft costs are up 118%.
Construction and related costs are up 91%.
Financing costs are up 93%.
Government fees, charges, and taxes are up 413%.
And development charges (a subset of the above) are up 3,244%!
At the same time, the profit margin over costs is down about 45%.
(As a point of comparison, CPI only increased by about 26.5% during this same time period.)
The point here is that condos are so %@$#$! expensive largely because of cost-plus pricing. Government fee increases are also outpacing every other cost bucket.
If you're developing new housing in Toronto, you have no choice but to accept these rising costs. You have to pay development charges and you have to pay them when you're told, even if that means swallowing some new massive increase.
So by necessity, end prices get continually pushed as a way to try and absorb these costs. You figure out what your costs are going to be and then you price accordingly. But of course, you also have to ask yourself: Can people actually afford this kind of pricing and can this neighborhood support it?
Sometimes the answer is yes, which is why development continues. But sometimes the answer is no. In this case, the next step is simple: you don't build.
Average condo prices in the City of Toronto are up about 150%. But...
Land costs are up 160%.
Soft costs are up 118%.
Construction and related costs are up 91%.
Financing costs are up 93%.
Government fees, charges, and taxes are up 413%.
And development charges (a subset of the above) are up 3,244%!
At the same time, the profit margin over costs is down about 45%.
(As a point of comparison, CPI only increased by about 26.5% during this same time period.)
The point here is that condos are so %@$#$! expensive largely because of cost-plus pricing. Government fee increases are also outpacing every other cost bucket.
If you're developing new housing in Toronto, you have no choice but to accept these rising costs. You have to pay development charges and you have to pay them when you're told, even if that means swallowing some new massive increase.
So by necessity, end prices get continually pushed as a way to try and absorb these costs. You figure out what your costs are going to be and then you price accordingly. But of course, you also have to ask yourself: Can people actually afford this kind of pricing and can this neighborhood support it?
Sometimes the answer is yes, which is why development continues. But sometimes the answer is no. In this case, the next step is simple: you don't build.
