Urbanation released its Q1-2021 quarterly condo market update for the Greater Toronto Area at the end of last month. And there's some good stuff in it. New condo sales totaled 5,385 units in the first quarter of this year, which is higher than the 10-year average of 4,924 units and only slightly below sales from a year ago (Q1-2020). By and large, the numbers are starting to feel a bit pre-pandemic-like.

If you remember what happened back in the second quarter of last year, there was a quick shift in demand toward the suburbs and outskirts of Toronto. Part of this was driven by affordability. But I guess part of this was also driven by the fact that some people seemed to think that our cities had never before experienced a health crisis and were going to somehow die. Or perhaps it was because Zoom is so much fun (and not at all exhausting) and that this time was destined to be different. Either way, I never understood this.

Fast forward a year and the core is not surprisingly coming back. The oldest part of the city (former City of Toronto) saw 2,886 new condo sales in the first quarter of this year. This is actually higher than sales in Q1-2020. New condo openings in downtown Toronto sold for an average price of $1,419 per square foot. And overall absorption was about 76% in the quarter, which is the highest it has been since 2017.

Some of you may be looking at these numbers and thinking WTF. But when developers look at the costs in their pro forma, as well as what's on the horizon -- ahem, inclusionary zoning -- it's usually that same feeling. So it's hard to imagine average prices and rents going anywhere but up.

Building on yesterday's post about inclusionary zoning, below is a telling diagram from the Urban Land Institute showing which areas of Portland can support new development and which areas cannot. To create this map, ULI looked at achievable rents in each US census block to determine, quite simply, where rents will cover the cost of new development (all types of construction).

However, in their models they are also assuming a land value of $0. And typically people want you to pay them money when you buy their land. So in all likelihood, this map is overstating the amount of blue -- that being land where new development is feasible.

But it does tell you something about developer margins. A lot of people seem to assume that the margins on new developments are so great that things like inclusionary zoning can simply be "absorbed" without impacting overall feasibility. The reality is that there are large swaths in most cities where development is never going to happen even if you were to start handing out free land.

This map is also helpful at illustrating some of the impacts of IZ. If you assume that rents are the highest in the center of the city and that they fall off as you move outward, then the outer edge of the above blue area is going to be where development is only marginally feasible. And so any new cost imposed on development would naturally start to uniformly eat away at the blue feasible area -- that is, until rents rise enough to offset it.

Of course, this is a simplified mapping. Land usually costs money. Land values might also be highest in the center and fall off as you move outward, or there could be pockets of high-cost land. There may be more price elasticity in certain sub-markets compared to others. So the impacts of a new development cost may not play out as neatly as I outlined above.

Regardless, there will be impacts, which is why I find this map telling even if it isn't fully accurate or up to date. Maybe some of you will as well.

I asked this question on Twitter this morning because I am planning to write more development-related posts. It's a topic that seems to be of interest to a lot of people. One question that I received was about the kind of profit margins that Toronto developers have been making over the past few decades. More specifically: How much have they increased? My response was that they haven't increased. In fact, if anything, they've been compressing as a result of rising/additional costs. (I've touched on this before in posts like this one about cost-plus pricing.) I think a lot of developers are actually wondering how much elasticity is left in the market to continue absorbing these cost increases.

Follow-up question to my response: Why then does this report by Steve Pomeroy claim that developers could still make a 15% margin even if they earmarked 30-40% of their units as affordable? Well, this was news to me so I went through the report and committed to responding on this blog. To be more precise, the report finds that there's room in as-of-right developments to dedicate 10% affordable in medium-cost areas and 25% affordable in high-cost areas. For rezoned sites, the numbers are 30% affordable in high-cost areas and 15% affordable in medium-cost areas. These are a potentially dangerous set of takeaways for a few reasons.

Very little mid-rise and high-rise development happens as-of-right in the City of Toronto. I don't know what the exact percentage is, but I suspect it's low. It would be very difficult to buy land if you were valuing it on this basis. And when you are valuing it -- that is, running a development pro forma -- it's not enough to pull averages from a cost guide and run high-level numbers. You can start there, but ultimately you're going to have to get more granular. Are you factoring the hundreds of thousands of dollars (more for bigger projects) that the City will charge you to occupy any public right-of-ways? What about your public contribution monies? This has historically been hard to estimate because the math that is used is akin to a secret recipe.

In this particular report, they assume a 100-unit building with 88,750 square feet of gross floor area. Since GFA typically factors some allowable deductions, the gross construction area for the project is going to be greater. Let's assume it's 5% more -- so about 93,190 square feet. This is how your construction manager will think about and do take-offs for the project. In the report, they peg total construction costs at $23,208,480. That works out to just shy of $250 per square foot (costs divided by above grade GCA). You cannot build a reinforced concrete residential building with below-grade parking for this number in Toronto. In today's market, and at this small of a scale, you might be looking at $350 to 400 psf.

On the low end of this range, that would mean your costs have just gone up by $9.4 million -- which just so happens to be the expected developer/builder profit in this model. Except now you're underwater and you won't be able to finance and build your project. It's probably time to look at your revenues and see if you can increase your projected rents at all. This is what I was getting at with cost-plus pricing. I would also add that I/we typically shy away from projects of this scale. There isn't a lot of margin for error. One or two surprises and you might be cooked. So with or without inclusionary zoning, these can be challenging projects that many developers won't even look at.

My point with all of this is twofold: development pro formas are delicate and margins aren't as generous and locked-in as most people seem to think. More often than not we end up passing on sites because we simply can't make the numbers work. The land is just too expensive. Development happens on the margin. So talking about developers "absorbing" the costs of inclusionary zoning is perhaps the wrong way to frame this discussion. A more appropriate set of questions might be: Who is going to pay for the cost of inclusionary zoning? Are landowners going to suddenly drop their prices? Is the City going to reduce their development charges/impact fees? Or will developers wait until market prices and rents increase so that they can cover these new costs? This latter scenario is how it has worked so far.

If you have other questions about development that you would like me to take a stab at answering, please leave a comment below or tweet at me.