Over the years on this blog, we have spoken about at least two ways to think about development pro formas. In the purest academic sense, you could say that pro formas are a way to determine the value of development land. You start with your forecasted revenues, deduct all of your expected costs, and then at the end you're left with some amount of money that can be spent on land. Said differently, land becomes the "residual claimant" in your financial model.
This is an important exercise, but in practice, pro formas sometimes (oftentimes?) need to be worked in the opposite direction. Meaning, the land price is what it is, development charges just increased, and now you're trying to figure out a way to make the math work. In this direction, you could say that you're undergoing a "cost-plus exercise." The costs are the costs and now you're trying to figure out some justifiable revenue figure that will make everything work.
If you do this latter exercise for a new rental apartment in Toronto today, you will end up with a rental rate that is likely hovering somewhere around $5 per square foot. This is a broad generalization and every site is of course different, but for the purposes of this post, let's assume it's $5. What that means is that a 500 square foot one-bedroom apartment will rent for $2,500 per month and a 1,000 square foot three-bedroom will rent for $5,000 per month.
A lot of people like to look at rental rates and say, "oh my, greedy developers are charging too much." But the reality is that this is what the cost-plus exercise is telling developers. There isn't the option of just charging less because there's only so much you can do about costs.
In fact, because development happens on the margin, some degree of optimism is often required to make new projects feasible. What I mean by this is that $5 psf may be what you need to make the project feasible, but there may be zero market comps in your submarket to actually support it. So in order to move forward, you just have to believe that in the future this will be the market rent.
This is harder to do in Toronto today because rents are not growing, they are declining. I personally believe that will quickly reverse once new housing completions fall off a cliff, but it doesn't change the fact that it's harder to underwrite rental growth in this kind of market environment. And because it's harder to underwrite rental growth, it's harder to make projects work.
The other consideration is that pushing rental rates higher is naturally going to slow down absorption. The Law of Demand tells us that as the price of something increases, the quantity demanded decreases. So you take on more risk in multiple ways when you push rates. As a developer, I'd rather be in a position where I could underwrite lower rents and feel more confident about leasing up the building quickly.
One way this could obviously be done is to lower costs. So as an exercise, I opened up one of our rental pro formas and removed just two cost items: development charges and parkland dedication. The result, in this particular instance, is that we could lower our average rent by almost $300 per month and still have a more or less equally feasible project. That's meaningful.
A cynic would say that developers will still charge the higher rent, but again, I would argue this isn't necessarily true, especially in this market. A cheaper cost structure means that more sites / projects become feasible and that developers should now face lower market risk. I'll take that. I'll take a full building with minimal vacancy and lower turnover.
Cover photo by taufiq triadi on Unsplash
A close friend of mine is part of a company here in Toronto called Ourboro. They are a home financing company that offer up to $250,000 toward down payments on homes. In exchange for this, they take a stake in the home and their pro-rata share of any future appreciation. So they are really co-owners. And they make their money on the gains. The maximum hold period is 10 years, but the principal owner is free to buy out Ourboro and stay in the home if they want.
It's an interesting model (and I have written about analogous ones before on the blog). Because in expensive housing markets like Toronto, saving up enough of a down payment is usually the biggest barrier to homeownership. But the question that I continually ask my friend is this: Does a model like this actually end up hurting overall affordability by increasing people's buying power? Similar to what happens when interest rates go down. People can now afford more home.
Perhaps. But Ourboro’s roots are in social enterprise and their focus is on helping people who might not otherwise be able to buy a place. They also see their approach as addressing the "fundamental imbalance of housing supply and demand in Canada." We know that more supply would help with affordability, but so does this I guess. And it's easier to implement.
I suppose another way to look at this model is that it's allowing individual homeowners to bring on co-investors, which is, of course, normal practice in the world of commercial real estate and development. Most developers don't have all the equity needed to finance their own projects. They raise it from outside investors (and prosper through the magic of carried interest). Now end-users can do that too (but sorry, no carried interest per se).
So if you're in the market for a new home in the Greater Toronto Area and are looking for a little help with the down payment, Ourboro might be an option for you to consider.
Newly released data from the US Census Bureau has just revealed that the average household size is increasing for the first time in over 160 years. Put differently, the formation of new households has started to trail overall population growth. And that is causing the average number of people per household to increase.
In 1790, there were about 5.79 people per household in the United States. That number has been in decline pretty much since then, though there was a slight increase in the decade that began in 1850. Last year (2018), the number grew to 2.63 people per household (2.71 for owner occupied households and 2.48 for renter occupied households).
Here are two charts from Chris Fry's recent piece at the Pew Research Center:
So what is causing this?
Well, we know that US fertility rates aren't on the rise. In fact, they're generally viewed as hitting record lows. I say "generally" because there are a number of different ways to measure fertility. There's the general fertility rate, completed fertility, the total fertility rate, and others. But we are seeing some alignment here: fertility rates are down.
One probable explanation is the fact that more Americans are living multi-generationally. According to the Pew Research Center, 1 out of every 5 Americans lived in such a household as of 2016. Part of this may be a result of immigration. Asian and hispanic populations are more likely to live in a multi-generational household compared to white people.
Another demographic trend is the increase in people living in shared quarters, whether that might be with a roommate or someone else. This is interesting because it suggests that there's an affordability constraint. Are people being forced to "double up?" The current co-living trend is at least partially because of this.
These are all noteworthy trends because household formation is viewed as "the underlying driver of long-term demand for new housing." I am assuming that more people per household also means less square footage per person.
Graphs: Pew Research Center
Over the years on this blog, we have spoken about at least two ways to think about development pro formas. In the purest academic sense, you could say that pro formas are a way to determine the value of development land. You start with your forecasted revenues, deduct all of your expected costs, and then at the end you're left with some amount of money that can be spent on land. Said differently, land becomes the "residual claimant" in your financial model.
This is an important exercise, but in practice, pro formas sometimes (oftentimes?) need to be worked in the opposite direction. Meaning, the land price is what it is, development charges just increased, and now you're trying to figure out a way to make the math work. In this direction, you could say that you're undergoing a "cost-plus exercise." The costs are the costs and now you're trying to figure out some justifiable revenue figure that will make everything work.
If you do this latter exercise for a new rental apartment in Toronto today, you will end up with a rental rate that is likely hovering somewhere around $5 per square foot. This is a broad generalization and every site is of course different, but for the purposes of this post, let's assume it's $5. What that means is that a 500 square foot one-bedroom apartment will rent for $2,500 per month and a 1,000 square foot three-bedroom will rent for $5,000 per month.
A lot of people like to look at rental rates and say, "oh my, greedy developers are charging too much." But the reality is that this is what the cost-plus exercise is telling developers. There isn't the option of just charging less because there's only so much you can do about costs.
In fact, because development happens on the margin, some degree of optimism is often required to make new projects feasible. What I mean by this is that $5 psf may be what you need to make the project feasible, but there may be zero market comps in your submarket to actually support it. So in order to move forward, you just have to believe that in the future this will be the market rent.
This is harder to do in Toronto today because rents are not growing, they are declining. I personally believe that will quickly reverse once new housing completions fall off a cliff, but it doesn't change the fact that it's harder to underwrite rental growth in this kind of market environment. And because it's harder to underwrite rental growth, it's harder to make projects work.
The other consideration is that pushing rental rates higher is naturally going to slow down absorption. The Law of Demand tells us that as the price of something increases, the quantity demanded decreases. So you take on more risk in multiple ways when you push rates. As a developer, I'd rather be in a position where I could underwrite lower rents and feel more confident about leasing up the building quickly.
One way this could obviously be done is to lower costs. So as an exercise, I opened up one of our rental pro formas and removed just two cost items: development charges and parkland dedication. The result, in this particular instance, is that we could lower our average rent by almost $300 per month and still have a more or less equally feasible project. That's meaningful.
A cynic would say that developers will still charge the higher rent, but again, I would argue this isn't necessarily true, especially in this market. A cheaper cost structure means that more sites / projects become feasible and that developers should now face lower market risk. I'll take that. I'll take a full building with minimal vacancy and lower turnover.
Cover photo by taufiq triadi on Unsplash
A close friend of mine is part of a company here in Toronto called Ourboro. They are a home financing company that offer up to $250,000 toward down payments on homes. In exchange for this, they take a stake in the home and their pro-rata share of any future appreciation. So they are really co-owners. And they make their money on the gains. The maximum hold period is 10 years, but the principal owner is free to buy out Ourboro and stay in the home if they want.
It's an interesting model (and I have written about analogous ones before on the blog). Because in expensive housing markets like Toronto, saving up enough of a down payment is usually the biggest barrier to homeownership. But the question that I continually ask my friend is this: Does a model like this actually end up hurting overall affordability by increasing people's buying power? Similar to what happens when interest rates go down. People can now afford more home.
Perhaps. But Ourboro’s roots are in social enterprise and their focus is on helping people who might not otherwise be able to buy a place. They also see their approach as addressing the "fundamental imbalance of housing supply and demand in Canada." We know that more supply would help with affordability, but so does this I guess. And it's easier to implement.
I suppose another way to look at this model is that it's allowing individual homeowners to bring on co-investors, which is, of course, normal practice in the world of commercial real estate and development. Most developers don't have all the equity needed to finance their own projects. They raise it from outside investors (and prosper through the magic of carried interest). Now end-users can do that too (but sorry, no carried interest per se).
So if you're in the market for a new home in the Greater Toronto Area and are looking for a little help with the down payment, Ourboro might be an option for you to consider.
Newly released data from the US Census Bureau has just revealed that the average household size is increasing for the first time in over 160 years. Put differently, the formation of new households has started to trail overall population growth. And that is causing the average number of people per household to increase.
In 1790, there were about 5.79 people per household in the United States. That number has been in decline pretty much since then, though there was a slight increase in the decade that began in 1850. Last year (2018), the number grew to 2.63 people per household (2.71 for owner occupied households and 2.48 for renter occupied households).
Here are two charts from Chris Fry's recent piece at the Pew Research Center:
So what is causing this?
Well, we know that US fertility rates aren't on the rise. In fact, they're generally viewed as hitting record lows. I say "generally" because there are a number of different ways to measure fertility. There's the general fertility rate, completed fertility, the total fertility rate, and others. But we are seeing some alignment here: fertility rates are down.
One probable explanation is the fact that more Americans are living multi-generationally. According to the Pew Research Center, 1 out of every 5 Americans lived in such a household as of 2016. Part of this may be a result of immigration. Asian and hispanic populations are more likely to live in a multi-generational household compared to white people.
Another demographic trend is the increase in people living in shared quarters, whether that might be with a roommate or someone else. This is interesting because it suggests that there's an affordability constraint. Are people being forced to "double up?" The current co-living trend is at least partially because of this.
These are all noteworthy trends because household formation is viewed as "the underlying driver of long-term demand for new housing." I am assuming that more people per household also means less square footage per person.
Graphs: Pew Research Center
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