Longtime readers of this blog might remember a post that I published back in 2016 where I talked about the genesis story of Toronto-based developer David Wex and his company Urban Capital Property Group. In it, I wrote about his first project at 29 Camden Street in the Fashion District. It had a total of 55 condominium suites and an average price per square foot of ~$195. And it took somewhere around 2 years to pre-sell enough of the suites for construction financing.

The reason I bring this up today is because when I originally wrote the post, it seemed so far from reality. In 2016, I said that these same 55 suites could be sold within 2 hours at $800 psf! But now things have changed once again. The market realities that David was facing in the mid-90s with Camden Lofts feel remarkably similar to today. Selling even 55 suites might not be a sure thing. And this is the first time in over 2 decades that the market has been like this.

So for fun, let's consider what happened in the late 80s and 90s. The Toronto housing market peaked in 1989 at an average price of approximately $273,698 (according to the Toronto Regional Real Estate Board). It then went on to decline 27% over the next 7 years, finally bottoming out at approximately $198,150 in 1996. So it took around 8 years for the market to stabilize.

Of course, the market took even longer to return to its 1989 peak. The average home price crossed $275,000 in 2002, which means it took 13 years in nominal dollars. However, $275k in 1989 is the equivalent of around $610k in today's dollars. So in real dollars, it actually took until 2011 for the market to return to its prior peak, which is some 22 years later!

I'm not arguing that the exact same thing will play out with this cycle. Who knows, Toronto is a different city. But I have suggested that 2028 could be the year where we're on the other side of this downturn. The average home price peaked, most recently, in 2022 at ~$1,194,600. Since then, it has come down by around 8.5% (as a broad average). If the market does turn positive in 2028, that'll be 6 years after the peak.

Only time will tell.

Chart from the Toronto Regional Real Estate Board; cover photo by Melvin Lai on Unsplash

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