Brandon Donnelly

Daily insights for city builders, delivered every morning at 6 AM ET. I’m Brandon Donnelly — a Toronto-based real estate developer and founder of Globizen. I’ve been writing here since 2013.

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Category: Economics

  • A real estate sea change

    Earlier this month, Howard Marks published a memo called “Sea Change“, where he argued, among other things, that it is “nearly impossible to overstate the influence of declining [interest] rates over the last four decades.” In fact, he goes on to say that he would be “surprised if 40 years of declining interest rates didn’t play the greatest role of all” in the success that investors have seen since the 1980s. Of course, the reason the memo is called “Sea Change” is because his overarching point is that this tailwind is now over.

    Let’s consider this in the context of commercial real estate. If you bought a real asset at a 4% cap rate (calculated by dividing net operating income by the price of the asset) and were able to put debt on it at say 3%, you would be receiving positive leverage. Your cost of debt is less than the yield that your asset is generating, and so you are in effect magnifying your returns.

    Now let’s imagine a scenario where interest rates decline even further and somebody could put debt on this same asset at 2%. This is likely to put downward pressure on the cap rate, meaning that somebody might be willing to pay more for the same amount of yield. That is, they’re willing to accept a lower yield. This phenomenon is what Howard is describing in his memo. Declining interest rates tend to create upward pressure on asset values. And in the world of real estate, this is referred to as a compression of cap rates.

    But what happens when things go the other way? Well if you had the same real asset generating a 4% yield, but now the only debt you can find is at 7%, then you are in a scenario where, unless you can afford to pay with all cash, you will be receiving negative leverage. Your cost of debt is greater than the yield that your asset is generating. And that’s the thing about leverage: it cuts both ways. It can magnify your returns, but it will also magnify any losses.

    If the only debt that you can find for your asset is now at 7%, then your 4% cap rate is almost certainly going to need to widen/increase. That is, investors are going to want to pay less for the exact same income stream. This is significantly less fun than cap rate compression, where values just seem to always go up. But, it does also create new opportunities for well-capitalized investors.

    All of this is playing out right now. And it is part of the “sea change” that Howard has called.

  • A “New” New York

    Earlier this year, the Mayor of New York City, Eric Adams, and the Governor of New York, Kathy Hochul, assembled a panel of civic leaders and industry experts to try and come up with a plan for a “New” New York.

    Initially, this panel was intended to be entirely focused on reviving the city’s business districts, and in particular those that have been slow to recover from the pandemic. But scope creep happens and it ultimately grew to include two other important goals: make it easier to get around and encourage “inclusive, future-focused growth.”

    The recommendations from this panel were released today and it’s in the form of a report with 40 specific initiatives. In keeping with its original intent, the first recommended initiative is one that you would expect: “Make Midtown and other business districts more live-work-play.” And what that means is the following:

    We will remove barriers that have kept Midtown and other business districts stagnant by making it easier to convert and redevelop outdated office buildings to other uses, including residential, thereby empowering the market to create more vibrant, mixed-use districts. We will also update old-fashioned regulatory codes that have prevented small businesses from locating, expanding, and innovating in those districts, providing zoning flexibility for businesses to thrive. And we will unite our business districts behind a shared goal of vitality by aligning incentives for businesses to help maintain vibrant business districts.

    New York isn’t the first city to be encouraging office-to-residential conversions and it certainly isn’t going to be the last. I think most of you know that I am a firm believer in office-centric cultures and that I’m in mine 5 days a week. But this is a recalibration that is going to need to take place in some submarkets.

    And here is one of the capitals of the world — New York City — telling us that it needs to happen there.

  • How 20% affordable can impact development pro formas

    This Twitter thread by Richard Wittstock of Domus Homes (developer out in Vancouver) is a timely follow-on to yesterday’s post about housing supply, land-use regulations, and specific policies such as inclusionary zoning. What Richard clearly describes in his thread is the economic impact of a Community Amenity Contribution (CAC) that requires developers to provide 20% social housing.

    The thread will walk you through all of the specific numbers, but I think there are three important takeaways:

    1. Everything has a cost. It is entirely disingenuous for anyone to refer to inclusionary zoning or other similar policies as a mechanism for “no-cost” affordable housing. Even if you believe it is the right public policy approach, there is still a cost. Social housing doesn’t just appear out of thin air.
    2. In Richard’s thread, the remaining market rate condominiums end up needing to be sold for $1,750 psf in order for the entire project to pencil. This is a significant number. But in this case, it is a result of these homes needing to shoulder the cost of the social housing. It is basically saying “housing is too expensive, so let’s make it more expensive so that we can use some of the incremental proceeds to finance less expensive housing.”
    3. If the math doesn’t work, developers will not build new housing.

    P.S. Thank you Volodya Gusak for pointing out Richard’s thread to me.

  • Housing supply in low-cost and high-cost municipalities

    Here is a housing study that looked at housing supply — in the US from 2000 to 2020 — relative to median housing values. And here is the key takeaway:

    What this chart is saying is that new housing is rarely added in cities with the lowest-value homes. The bar on the left represents municipalities whose median housing values are less than 50% of the metropolitan average. And this makes sense. If values are low there is likely little to no incentive to build. The math just doesn’t work.

    However, as home values increase, the incentive to build and the ability to finance new projects also increases, and that is what we see in the above chart. This also makes sense.

    But something interesting happens in the highest-value cities — housing supply once again starts to fall off. And it turns out that there is a bit of a sweet spot. Municipalities whose relative housing values are 110 to 130% of the metropolitan average actually produce the most overall housing. Any higher than that and things start to decline.

    Why is that? The answer likely has to do with restrictive land-use regulations. The highest-value cities (and wealthiest suburbs) often have a lot of large single-family lots, as well as policies to ensure that this kind of built form doesn’t change. This has the effect of both limiting supply and enshrining values.

    So when it comes to housing supply, what you don’t want are low-cost areas. But you also don’t want the highest-value areas. What you want are areas that are doing well, but no so well that they start really restricting new entrants. This is what our industry often refers to as exclusionary zoning.

    Now, one of the most common ways to respond to this problem is to develop an opposing policy, namely inclusionary zoning. But usually what this policy doesn’t do is direct more supply to these high-value and low-density areas. Instead what it typically does is force the segment that is producing the most housing — let’s call it the 110 to 130% band — to deliver more affordable housing.

    It’s a neat trick that sounds pretty cool, but it is not at no cost.

  • Miami is the top US city for foreign businesses

    The Financial Times and Nikkei have just published their inaugural Investing in America report, which looks at the best US cities for foreign multinationals to invest in and do business in.

    To come up with this, they used about three dozen different metrics — everything from openness to quality of life. From what I can tell though, it doesn’t appear that climate risk factored much into this ranking. It should.

    There’s a lot of Florida on this list and Miami comes out on top, largely because, last year, it had the most foreign direct investment per capita of any US city. It also has a well-connected airport, two of the largest shipping ports in the US, and an international population.

    Lots of people and companies are going long Miami right now.

  • Sticking close to home — two-thirds of young Americans live near where they grew up

    Here in Canada, there is often a belief that Americans tend to be more mobile than Canadians. Don’t like the cold weather? Just move south. Taxes too high? Just move south. Housing too expensive? Just move south.

    But just how mobile is mobile? A new study by the US Census Bureau and Harvard University found that by age 26, more than 2/3 of young adults in the US actually just live where they grew up, with 80% living within 100 miles, and 90% living within 500 miles.

    Migration distances were also found to be impacted by both race and parental income (though these two things likely exhibit a relationship on their own). If you are a young white or Asian adult, the “radius of economic opportunity” tends to grow and you’re more likely to live further away from where you grew up.

    The most popular destinations overall are New York, Los Angeles, Washington, and Denver (in this order). And while New York and Los Angeles remain at the top regardless of who you are, San Antonio and Phoenix are top destinations for Hispanics, and San Francisco is a top destination for Asians.

    Regardless, home appears to be a pretty sticky place.

    But what about Canadians? Are we less mobile? Looking at net domestic migration rates, Canada saw 254,143 interprovincial migrants between 2018-2019, whereas the US saw just over a million between 2020-2021. So on a per capita basis, Canada’s rate is actually higher.

    Statistics Canada also estimated earlier this year that as of July 1, 2016, somewhere around 4 million Canadians were living abroad — or about 11% of citizens. This is a much higher percentage compared to Americans.

    Of those living abroad, roughly half are believed to have received their citizenship through descent, meaning they were born abroad to Canadian parents. About 1/3 are Canadian citizens by birth. And about 15% are naturalized citizens.

    So it turns out that Canadians are in fact pretty mobile. We also seem to like going further afield.

  • Toronto-Montréal should be a 2 hour high-speed train ride

    The Quebec City-Windsor corridor is the most densely populated region in Canada. The last time I checked Wikipedia, it was reported to house about 18 million people, or about half of Canada’s entire population.

    So it is not surprising that there have been numerous high-speed rail studies for this corridor over the decades, as well as studies for other important links in Alberta (Edmonton-Calgary) and other parts of the country.

    And yet, Canada remains the only G7 country without any high-speed rail. Though to be fair, the US doesn’t have all that much either; certainly with respect to the size of its population.

    However, there is some good news. In March of this year, the Government of Canada announced a Request for Expression of Interest related to high frequency rail service between Quebec City and Toronto. More information, over here.

    But from what I have read, it’ll be a faster upgraded service (~200 km/h), but not true high-speed rail (~250-300 km/h). I took the TGV from Marseille to Paris last summer, and this is how fast we were going:

    If we’re going to do this, let’s be the absolute best in the world and not settle for mediocrity.

  • Mid-year consumer trends update

    The New Consumer has just published its 2022 mid-year update. Some of you might remember that I wrote about their inaugural consumer trends report at the end of last year.

    It’s interesting, but not surprising, to see a lot of things returning to their means. Spending on home furnishings, for example, is coming down, whereas luggage and bag sales are up. Home fitness has also come way down as people return to gyms. It’s time to leave home.

    At the same time, it has become a lot more expensive to leave home, assuming you need to drive. Motor fuel increased 49% year-over-year as of May 2022. It’s the CPI category with the biggest change. But even with this, transit ridership has yet to fully rebound. NYC is sitting at around 60%.

    To download a free copy of the full presentation, click here.

  • Super-entrepreneurs by region

    A super-entrepreneur, according to the common definition, is a rich person who has amassed a net worth of at least US$1 billion dollars by either starting a company or taking a small company and growing it into a big one. A super-entrepreneur is, by definition, not someone who inherited their wealth. Though I’m not sure what the cut off is. If you inherited $1 million and then started a massive company, does that still make you a super-entrepreneur? What about if you inherited $100 million?

    In any event, here is a chart from New Geography showing super-entrepreneurs by region:

    The USA is in the lead in this chart at about 3.1 super-entrepreneurs per one million inhabitants. But the highest rate in the world, at least according to this data set, actually belongs to Singapore at 4.7 per million. Europe, as a whole, doesn’t look all that great here. But again, if you get more specific, some European countries are actually doing quite well. Sweden, for instance, is sitting at around 2 per million, which is higher than Canada’s figure.

    Why this data is potentially interesting is that it tells you a bit about these countries. It tells you whether they have strong property rights, whether it’s easy to conduct business, and whether it’s supportive of new ideas, among, of course, many other things. There also appears to be a clear link between the presence of super-entrepreneurs and unemployment. Turns out that the more people you have starting wildly successful businesses, the lower unemployment tends to be.

    For the full New Geography article, click here. In addition to what I just wrote about, it talks about Europe’s “entrepreneurial paradox” and issues of gender equality.

  • Rent control and inclusionary zoning

    I received an email from a reader over the weekend saying that my comments around rent control have been too critical, and that they are not doing proper justice to the challenges that renters face in today’s cities. I thought this was a fair comment and so I’d like to respond to it publicly on the blog.

    But before I get into that, it’s worth saying that housing issues are incredibly complex. And I am certainly not professing to have all of the answers. In fact, part of the reason I write this blog is so that I can think critically about these topics and hear what other people have to say.

    It is obvious that wages have not kept pace with home prices in many cities around the world. This is a problem. And so we can all agree that we need more economic opportunities, we need more housing, and we need more attainable housing. The question is how best to go about this.

    Mechanisms like rent control and inclusionary zoning might seem like obvious solutions. Just cap rents and force developers to build affordable housing. Problem solved at no cost to anyone, right? It’s not that simple. Every intervention creates distortions in the market.

    To give just one example, studies suggest that rent controls end up creating a misallocation of housing. Because if you are living in a rent controlled home and your rent is well below market, you are now heavily incentivized never to move. Even if you have an empty nest with 5 bedrooms, why would you?

    Of course, there are other possible repercussions. Residential contracts are typically gross leases (though some utilities might be sub-metered and paid for by the tenant). This is in contrast to commercial leases where net leases are common and most, if not all, of the operating costs are passed through to the tenant.

    Why this matters is that if your rents are capped but your utility costs, taxes, and other operating expenses are continuing to rise, you may run into a situation as a landlord where you can no longer afford to upkeep your building. And you’re certainly not going to invest in any new improvements if this is your situation.

    Rent controls could also impact the supply of new housing by making it no longer feasible to build. This is similar to what we have seen with policies like inclusionary zoning. Just last month San Francisco went on the record saying that it’s going to rethink its inclusionary zoning policies because of a view that it is now choking off new housing supply.

    And so herein lies one of our great housing challenges. We want more housing and we want more affordable housing. But depending on how we approach the latter, it could hurt the former, which ends up creating a viscous cycle.

    Building new rental housing is very challenging in Toronto (and elsewhere). Typically the way the process goes for a developer is that you start by preparing a detailed development pro forma. This pro forma will then tell you that your new rental development is infeasible. And so you go back, convert it to a condominium development, and then it magically becomes feasible.

    I am exaggerating, but only slightly. The point is that there are lots of developers out there who would love to build more rental housing — they just can’t make the math worth.

    My goal with this post was to explain where I have been coming from with some of my past comments. I also used the opportunity to link to a number of my related posts. But I haven’t really put forward any possible solutions. I plan to do that in a follow-up post, and I think I’m going to call it “the definitive but crazy guide to creating more affordable housing.”

    So if any of you have any crazy ideas, please send them over.