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At the end of last year, I wrote this post arguing that development value has shifted from land to the build. And in it, I argued that it's no longer viable to be a high-density land developer in Toronto. The practice of buying land, rezoning it for a higher-and-better use, and then selling it for a margin, is over — at least for the time being.
It's also not easy to find value in the execution of new builds, but it's a better place to be looking. Because today, as we underwrite new development sites, we are seeing land prices (on a per buildable square foot) that are similar to what they were back in 2017 when we were assembling the land for Junction House. Meaning that, in some cases, land prices have been nearly flat over this 8 year period. This is despite a total inflation rate of approximately 25% and an average annual decline in the value of money of 2.86%.
This is not all that surprising, though. Land should, in theory, be the residual claimant in a development pro forma; so it should be one of the first things to reset during a market downturn. However, in the past, I have referred to land prices as being sticky in the face of changing cost structures, such as development charge increases and/or new inclusionary zoning policies. So which is it, Brandon?
Well, one way I think about this is that land prices tend to be sticky in the short term. Nobody wants to immediately take a loss. And as long as prices/rents continue to exhibit strong growth, there's a chance that these new costs will get absorbed into somebody's pro forma and that land prices won't need to adjust downward. But turn off demand and reverse price/rent growth, and now there's no other option but for land prices to come down.
This is what we've been seeing in Toronto since 2022.
Cover photo by Adam Vradenburg on Unsplash
After seeing this beautiful 6-storey and 21-unit social housing project in Lyon, I decided to retweet it and share the fact that we recently had a site under contract in Toronto with the intention of doing a very similar build. We wouldn't have been able to do the same outdoor spaces at the corner, but it was going to be 6 storeys and without any setbacks. The overall dimensions appear to be similar.
However, in the end, we had to drop the site because the margins were simply too thin. I was disappointed. Of course, some people responded to my quote retweet by calling this an example of developer greed. But once again, I don't think most people understand how development economics work. If the margins are too thin it, among other things, means:
It's going to be hard/impossible to raise capital and finance the project
You might be better off buying a "risk-free" government bond instead
That unexpected situations could sink the project (i.e. you lose money)
To give a specific example, let's assume that your expected base case rent at the time of occupancy is $4.75 psf. This would mean that if your average suite size is around 600 sf (which ours was), you would need a face rent of about $2,850 per month.
But what happens if you're off by only $0.25 and your face rent for this same 600 sf apartment is now $2,700 per month at initial lease up? $150 per month may not seem like a big deal, but it is. If you capitalize this income at something like a 4% rate, you will find that it becomes material.
This is what I mean by "the margins are too thin." And it's similar to any other professional not wanting to take on a job because they might lose money or because it's "not worth their time." It's about managing risk and understanding the opportunity cost of taking on such a project.
The Liberals just announced that, if elected, they will form a new entity called Building Canada Homes (BCH) which will, "get the federal government back in the business of building homes." Broadly speaking, this new entity is proposed to have three key functions: it will build affordable housing at scale (including on public land), it will help to "catalyze" the private sector, and it will provide financing to affordable housing developers. There's a lot that is interesting in the policy teaser, but let's focus on function number one today: Do governments make good developers?
The outlined intent is that BCH will "act as a developer to build affordable housing" and "partner with builders for the construction phase of projects." So it sounds like they will not be constructors. The language they use also suggests that BCH will be an acquirer of land. Sometimes it will develop on already-owned public land, but in other cases it will go out and buy new land, sometimes offering it back to the market via land leases.
Acquiring new land will be challenge number one. As we have talked about many times before on this blog, land should be the residual claimant in a development pro forma. Meaning the value of land depends on what you can build on it. So if BCH is looking to build affordable housing and the rest of the market is looking to build some higher-and-better use, it will be very difficult for them to complete in the market. This is the same reason why, historically speaking, the City of Toronto has struggled to acquire new parkland with the funds it collects from developers. It can't compete.
On the flip side, it's very possible that in a downmarket, like the one we're in right now, BCH might be the only real buyer of development land. Affordable housing requires subsidies and if the subsidies BCH has access to result in both feasible projects and higher residual land values, well then they'll be able to win sites. But it will depend on the market conditions at the time. It also raises an important question: What is the right level of subsidy for the affordable housing that BCH intends to develop itself?
The second challenge is going to be execution. Development is a risky endeavor, but most of the time the private sector accepts these risks because they believe they will be compensated accordingly. And once they have taken on these risks, they become highly motivated to deliver for their investors and partners. Will the federal government be equally motivated? Perhaps. There are, of course, lots of examples of public housing developers in other parts of the world. But is it the most effective way to deliver new affordable housing? An alternative approach would be motivating the private sector to participate.
At the end of last year, I wrote this post arguing that development value has shifted from land to the build. And in it, I argued that it's no longer viable to be a high-density land developer in Toronto. The practice of buying land, rezoning it for a higher-and-better use, and then selling it for a margin, is over — at least for the time being.
It's also not easy to find value in the execution of new builds, but it's a better place to be looking. Because today, as we underwrite new development sites, we are seeing land prices (on a per buildable square foot) that are similar to what they were back in 2017 when we were assembling the land for Junction House. Meaning that, in some cases, land prices have been nearly flat over this 8 year period. This is despite a total inflation rate of approximately 25% and an average annual decline in the value of money of 2.86%.
This is not all that surprising, though. Land should, in theory, be the residual claimant in a development pro forma; so it should be one of the first things to reset during a market downturn. However, in the past, I have referred to land prices as being sticky in the face of changing cost structures, such as development charge increases and/or new inclusionary zoning policies. So which is it, Brandon?
Well, one way I think about this is that land prices tend to be sticky in the short term. Nobody wants to immediately take a loss. And as long as prices/rents continue to exhibit strong growth, there's a chance that these new costs will get absorbed into somebody's pro forma and that land prices won't need to adjust downward. But turn off demand and reverse price/rent growth, and now there's no other option but for land prices to come down.
This is what we've been seeing in Toronto since 2022.
Cover photo by Adam Vradenburg on Unsplash
After seeing this beautiful 6-storey and 21-unit social housing project in Lyon, I decided to retweet it and share the fact that we recently had a site under contract in Toronto with the intention of doing a very similar build. We wouldn't have been able to do the same outdoor spaces at the corner, but it was going to be 6 storeys and without any setbacks. The overall dimensions appear to be similar.
However, in the end, we had to drop the site because the margins were simply too thin. I was disappointed. Of course, some people responded to my quote retweet by calling this an example of developer greed. But once again, I don't think most people understand how development economics work. If the margins are too thin it, among other things, means:
It's going to be hard/impossible to raise capital and finance the project
You might be better off buying a "risk-free" government bond instead
That unexpected situations could sink the project (i.e. you lose money)
To give a specific example, let's assume that your expected base case rent at the time of occupancy is $4.75 psf. This would mean that if your average suite size is around 600 sf (which ours was), you would need a face rent of about $2,850 per month.
But what happens if you're off by only $0.25 and your face rent for this same 600 sf apartment is now $2,700 per month at initial lease up? $150 per month may not seem like a big deal, but it is. If you capitalize this income at something like a 4% rate, you will find that it becomes material.
This is what I mean by "the margins are too thin." And it's similar to any other professional not wanting to take on a job because they might lose money or because it's "not worth their time." It's about managing risk and understanding the opportunity cost of taking on such a project.
The Liberals just announced that, if elected, they will form a new entity called Building Canada Homes (BCH) which will, "get the federal government back in the business of building homes." Broadly speaking, this new entity is proposed to have three key functions: it will build affordable housing at scale (including on public land), it will help to "catalyze" the private sector, and it will provide financing to affordable housing developers. There's a lot that is interesting in the policy teaser, but let's focus on function number one today: Do governments make good developers?
The outlined intent is that BCH will "act as a developer to build affordable housing" and "partner with builders for the construction phase of projects." So it sounds like they will not be constructors. The language they use also suggests that BCH will be an acquirer of land. Sometimes it will develop on already-owned public land, but in other cases it will go out and buy new land, sometimes offering it back to the market via land leases.
Acquiring new land will be challenge number one. As we have talked about many times before on this blog, land should be the residual claimant in a development pro forma. Meaning the value of land depends on what you can build on it. So if BCH is looking to build affordable housing and the rest of the market is looking to build some higher-and-better use, it will be very difficult for them to complete in the market. This is the same reason why, historically speaking, the City of Toronto has struggled to acquire new parkland with the funds it collects from developers. It can't compete.
On the flip side, it's very possible that in a downmarket, like the one we're in right now, BCH might be the only real buyer of development land. Affordable housing requires subsidies and if the subsidies BCH has access to result in both feasible projects and higher residual land values, well then they'll be able to win sites. But it will depend on the market conditions at the time. It also raises an important question: What is the right level of subsidy for the affordable housing that BCH intends to develop itself?
The second challenge is going to be execution. Development is a risky endeavor, but most of the time the private sector accepts these risks because they believe they will be compensated accordingly. And once they have taken on these risks, they become highly motivated to deliver for their investors and partners. Will the federal government be equally motivated? Perhaps. There are, of course, lots of examples of public housing developers in other parts of the world. But is it the most effective way to deliver new affordable housing? An alternative approach would be motivating the private sector to participate.
Getting the federal government "back in the business of building homes" may sound promising, but there's reason to be skeptical. There will be lots of details to figure out if it's actually going to be efficient and effective.
Cover photo by Eduardo Alvarado on Unsplash
Getting the federal government "back in the business of building homes" may sound promising, but there's reason to be skeptical. There will be lots of details to figure out if it's actually going to be efficient and effective.
Cover photo by Eduardo Alvarado on Unsplash
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