Condo developers are merchant builders. They build a project and then move on. Because of this, there's a belief that there's little incentive to build for durability, in comparison to say purpose-built rental buildings where the developer might continue to own over an extended period of time. While it is true that putting on an operations hat will make you hyper-focused on everything from garbage collection to how you're going to manage all of your suite keys, there are a few things to consider in this debate.
One, as developers we certainly think and care a lot about our brand and our reputation, both with our customers and with Tarion (warranty program). We ask ourselves: "What will our customers think if we do this?" Irrespective of the tenure we're building, we want our projects to be carefully considered. And in the case of condominium projects, we would like our customers to feel excited and comfortable about buying in one of our future projects. That's the goal. This is no different than any other product that you might buy that doesn't come along with some sort of ongoing subscription.
Two, there's often a spread between condominium and rental values. For example, let's consider a brand new 550 square foot condominium in a central neighborhood of Toronto and let's say it would cost you $1,300 psf to buy it today. (Obviously it could be more or it could be less depending on the area and the building.) Now let's start with a rent and back into a value, using some basic assumptions.
Condo developers are merchant builders. They build a project and then move on. Because of this, there's a belief that there's little incentive to build for durability, in comparison to say purpose-built rental buildings where the developer might continue to own over an extended period of time. While it is true that putting on an operations hat will make you hyper-focused on everything from garbage collection to how you're going to manage all of your suite keys, there are a few things to consider in this debate.
One, as developers we certainly think and care a lot about our brand and our reputation, both with our customers and with Tarion (warranty program). We ask ourselves: "What will our customers think if we do this?" Irrespective of the tenure we're building, we want our projects to be carefully considered. And in the case of condominium projects, we would like our customers to feel excited and comfortable about buying in one of our future projects. That's the goal. This is no different than any other product that you might buy that doesn't come along with some sort of ongoing subscription.
Two, there's often a spread between condominium and rental values. For example, let's consider a brand new 550 square foot condominium in a central neighborhood of Toronto and let's say it would cost you $1,300 psf to buy it today. (Obviously it could be more or it could be less depending on the area and the building.) Now let's start with a rent and back into a value, using some basic assumptions.
Unit Size (SF)
550
Monthly Rent
$2,400
Rent PSF - Monthly
$4.36
Rent PSF - Annual
$52.36
NOI Margin
72%
NOI
$37.70
Exit Cap
3.75%
Value PSF
$1,005
Here I'm assuming that same suite would rent for $2,400 per month. I'm converting that to an annual PSF rent. And then I'm assuming that if you were managing a whole building of these kinds of units, your operating costs might be somewhere around 28%. Crude back-of-the-napkin math to get to a Net Operating Income (psf). Finally, I'm capping this NOI at 3.75%. We can debate my assumptions and if this were in a development pro forma you might "trend" the rents. But I find this comparison helpful. Here we are getting to a value of around $1,005 per square foot. Less than our $1,300 psf above.
The point is that the margins are tighter, which helps to explain why for a long time we saw very few purpose-built rentals being constructed in this city. So even though you might argue that the incentives are in place to build for durability, you do have to weigh that against the realities of what you can actually afford to build. Development is filled with all sorts of these tradeoffs. But if you and/or your investors really want a consistent yield, this strategy can work just fine. Personally, I'm a fan of the long-term approach.
Three, rent control policies can have an impact both on the feasibility of new projects and on people's ability to actually perform maintenance. If you have a scenario where your operating costs -- everything from taxes to utilities -- are rising faster than your allowable rent increases, then you're in a bad situation and you have zero incentive or financial ability to actually invest in the building, despite being a long-term owner.
Finally, there is nothing stopping a purpose-built rental developer from also being a merchant builder. i.e. Selling the entire rental building once it is done and it has been stabilized. So you could argue that we're right back at my first point. Whether you're selling to individual condominium owners or the entire building to one entity, you as the developer have to sit back and ask yourself: "What will our customer(s) think if we do this?"
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.
Here I'm assuming that same suite would rent for $2,400 per month. I'm converting that to an annual PSF rent. And then I'm assuming that if you were managing a whole building of these kinds of units, your operating costs might be somewhere around 28%. Crude back-of-the-napkin math to get to a Net Operating Income (psf). Finally, I'm capping this NOI at 3.75%. We can debate my assumptions and if this were in a development pro forma you might "trend" the rents. But I find this comparison helpful. Here we are getting to a value of around $1,005 per square foot. Less than our $1,300 psf above.
The point is that the margins are tighter, which helps to explain why for a long time we saw very few purpose-built rentals being constructed in this city. So even though you might argue that the incentives are in place to build for durability, you do have to weigh that against the realities of what you can actually afford to build. Development is filled with all sorts of these tradeoffs. But if you and/or your investors really want a consistent yield, this strategy can work just fine. Personally, I'm a fan of the long-term approach.
Three, rent control policies can have an impact both on the feasibility of new projects and on people's ability to actually perform maintenance. If you have a scenario where your operating costs -- everything from taxes to utilities -- are rising faster than your allowable rent increases, then you're in a bad situation and you have zero incentive or financial ability to actually invest in the building, despite being a long-term owner.
Finally, there is nothing stopping a purpose-built rental developer from also being a merchant builder. i.e. Selling the entire rental building once it is done and it has been stabilized. So you could argue that we're right back at my first point. Whether you're selling to individual condominium owners or the entire building to one entity, you as the developer have to sit back and ask yourself: "What will our customer(s) think if we do this?"
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.
A good friend of mine, who is also in the industry, once described real estate development as a three-legged stool. In order to develop, you really need three things: expertise, capital, and a site (i.e. land). This probably seems fairly obvious. I mean, you need to know what you're doing, you need the money to do it, and then you actually need a place to build. But as simple and as obvious as this may seem, there are barriers to entry. Real estate is a capital intensive industry. And despite what the general public seems to believe about the pockets of developers, most are raising outside capital.
The thing about this three-legged stool is that you don't necessarily need to have all of the legs at once, and in many cases you won't. If you have two of them in place, it's usually feasible to figure out and get the last one. For example, if you know what you're doing (expertise) and you have a site (owned or "under control"), then presumably you have a development pro forma that makes some economic sense. And with those things, you generally should be able to find the capital that you need to execute on your project.
I've also met people who have managed to build this three-legged stool starting with only one leg. They didn't have much development experience or capital connections, but they learned enough to figure out how to value development land. They then went out and started knocking on doors, eventually putting together a development assembly. They then took this assembly to developers (people with expertise) and the stool eventually got built. Starting with only one leg just means you're going to have to work harder to fill in the others.
A one or two-legged stool won't stay upright on its own. But hustle will hold it up temporarily while you figure out a creative way to attach the missing leg(s).
A good friend of mine, who is also in the industry, once described real estate development as a three-legged stool. In order to develop, you really need three things: expertise, capital, and a site (i.e. land). This probably seems fairly obvious. I mean, you need to know what you're doing, you need the money to do it, and then you actually need a place to build. But as simple and as obvious as this may seem, there are barriers to entry. Real estate is a capital intensive industry. And despite what the general public seems to believe about the pockets of developers, most are raising outside capital.
The thing about this three-legged stool is that you don't necessarily need to have all of the legs at once, and in many cases you won't. If you have two of them in place, it's usually feasible to figure out and get the last one. For example, if you know what you're doing (expertise) and you have a site (owned or "under control"), then presumably you have a development pro forma that makes some economic sense. And with those things, you generally should be able to find the capital that you need to execute on your project.
I've also met people who have managed to build this three-legged stool starting with only one leg. They didn't have much development experience or capital connections, but they learned enough to figure out how to value development land. They then went out and started knocking on doors, eventually putting together a development assembly. They then took this assembly to developers (people with expertise) and the stool eventually got built. Starting with only one leg just means you're going to have to work harder to fill in the others.
A one or two-legged stool won't stay upright on its own. But hustle will hold it up temporarily while you figure out a creative way to attach the missing leg(s).
