Daily insights for city builders, delivered every morning at 6 AM ET. I’m Brandon Donnelly — a Toronto-based real estate developer and founder of Globizen. I’ve been writing here since 2013.
Development is tough. Among a long list of other things, it requires making a lot, and I mean a lot, of decisions. Oftentimes you won’t have all the information. And sometimes they will be uncomfortable ones to make. But you need to decide on something. It is, arguably, almost always the case that any decision is better than no decision.
In situations like these, I often like to think back to something that my first boss in development used to drill into me. She would simply ask: What’s best for the project? Now, this is not to say that you should ever do bad things simply for the betterment of a project. That is clearly the wrong thing to do. What I am instead saying is that it can be helpful to keep this guiding light in mind.
Developers have a fiduciary duty to their investors and partners. But they also have a responsibility to the people who will ultimately occupy the spaces that they’re building and to the communities that they’re building in. And at the highest level, all of these groups should be aligned in wanting the best possible project.
So if you’re ever struggling with a development decision or you just need a goal reminder, try asking yourself this basic question. It may not work or apply in all scenarios, but I have found it to be helpful in situations where I’m wrestling with something and I need to take emotion out of the equation. What’s best for the project? That’s what it’s all about.
Big Ben Myers of Bullpen Consulting doesn’t usually have strong opinions on Twitter (obviously joking), but I did see him respond to this tweet this morning:
During significant downturns, developers can’t sell the units, and can’t get financing to build rentals. It has nothing to do with their intelligence. https://t.co/7G7n4B65CI
The assertion he is responding to is basically this: “developers are stupid because they tend to hold onto land during downturns, instead of building through them.” On some level, I think I know where this line of thinking is coming from. It’s the whole Warren Buffet philosophy of “being fearful when others are greedy, and greedy when others are fearful.”
But what it ignores is development feasibility. Developers typically rely heavily on the availability of debt financing. First you need land financing in order to acquire the land, and then, once you have your entitlements, condominium pre-sales and/or any other requirements in place, you move onto a construction loan (which often “takes out” your land loan).
Maybe you have deep enough pockets to fund everything with cash, but most of the time that is not the case. And so if these debt facilities are not available to you, then you are not building.
The other part of this equation is that, during downturns, it can be harder to forecast your future revenues. What can I sell/rent this space for, and how long will it take to absorb? These are difficult questions in the best of times, but they’re even more difficult when you don’t have a lot of market activity/comparables to point to.
All of this contributes to debt being less available, especially for smaller developers. It also makes new sites difficult to underwrite. Because as we have talked about many times before on this blog, land should be the residual claimant in a development pro forma. Revenue minus development costs equals how much you can afford to pay for land.
If the math doesn’t work and if you can’t get financing, it almost certainly doesn’t matter how much “leading” you feel like doing. You’re not building.
Generally speaking, the cost of building a new building is always going up. There are moments in time, like during a recession, where costs might temporarily correct downward. But generally speaking, there is a cost floor that is constantly rising. This includes everything from hard costs to rising development charges.
We have spoken before about how developers typically look at their costs, and then price accordingly through “cost-plus pricing.” Put differently, it is answering the question, “what do I need to rent or sell this space for in order to cover all of these projected costs?” This can be tricky when costs are all over the place, as they are right now with double percentage point swings, but that’s a different conversation.
As long as there remains some price elasticity in the market, cost-plus pricing can work just fine. Costs are up, but I’m just going to increase pricing to absorb most of it, or in some cases all of it. However, problems occur when and where you can’t increase pricing. Maybe it’s in a marginal area where rents aren’t increasing. Or maybe interest rates are rising and overall price elasticity is tightening.
Whatever the case may be, in this scenario, it likely means that development will stop and supply will slow or possibly even shut off. We are starting to see some evidence of this happening in Toronto right now.
But if the fundamentals of the overall market remain strong, this should only be a short-term problem. Eventually the market will catch up (through higher pricing and/or some reduced costs), and then projects will return to being feasible. But if there’s a structural problem in the market, maybe development never returns without some kind of subsidies.
Thankfully, it is obvious to most that markets like Toronto have incredibly strong fundamentals. We can screw up a lot of things as long as we remain open to smart immigrants from around the world. This makes it fairly easy to have conviction around what will happen over the longer term. And this is generally how I like to make decisions, whether we’re talking about real estate or crypto (see above tweet).
But all of this doesn’t mean that one shouldn’t also be managing the short run.
If you’re building a purpose-built rental building, you spend nearly all of your money up front and then you start earning revenue (i.e. collecting rent). On the other hand, if you’re building a condominium building in a market that generally relies on pre-sales for construction financing, which is the case here in Toronto, you spend a bit of your money up front, lock in (but not collect) most, if not all, of your project revenue, and then you spend the majority of your money.
(This is obviously a simplification and when I say “spend all of your money” I’m speaking on an unlevered gross basis and not based on equity in. But this nuance doesn’t change the point of this post.)
I have written about the above difference before on the blog, but I think it’s particularly relevant in today’s cost environment. Looking at the construction cost chart that I posted a few days ago, it is clear that a lot of us, myself included, have never had to work and build in an environment like this.
In the past 30 some years, we have never had to deal with construction costs rising as quickly as they are right now. Though I recognize that things did also suck in the early 80s when we had high inflation and double-digit interest rates, and in the early 90s when the real estate sector was particularly hard hit.
In any event, what does this current environment mean for development projects? Well for one, and this is a big one, it means that spending a bit of your money up front and then locking in most of your revenue (i.e. pre-selling condominiums), can present a lot of risks if you don’t have a good handle on how much it’s going to cost you to finish the project. And the reality is that nobody has a crystal ball, especially in this kind of environment.
So in my humble opinion, I think you need to spend a bit more of your money up front. I think it makes sense to spend the time and money on solid working drawings and on running a tight construction procurement process — all before you begin selling.
It used to be the case that many developers would start selling before they even had their zoning in place. That is far less common today (from what I can tell) for reasons like what I’m describing here. Of course, this means it’s going to take you longer to get to market. And time equals more money. But it feels like a necessary move in this environment.
I was having coffee with a developer friend of mine this morning and we got onto the topic of asking a lot of questions. We joked that that’s what we do all day.
But for the most part, we usually sit in rooms as the least qualified person. We are not structural engineers. We are not geotechnical engineers. We are not architects (though I sometimes pose as a fake one). We are not planners. And we are not façade specialists, among many other things.
But we are the ones taking on most of the financial risk and trying to bring everything together. And what that means is that you end up asking a lot of questions. You collect information, you try and consider what could go wrong, you lean on past experiences, and then you make a decision — often without perfect information or 100% certainty.
This is how projects move forward. You have to rely on others and you have to make decisions. Because not making a decision is even worse. It burns time, which is why too many cooks in the kitchen can be the kiss of death for development projects.
I’m sure the same thing can be said for many other things in life.
Read this today: “…City’s studies show [inclusionary zoning] has the potential to create thousands of units of affordable rental housing every year, without costing the City a dime.” So who does it cost? 🤔
It upsets me when I read things like this (click here if you can’t see the embedded tweet above). I think it creates a false sense of a free lunch and ignores all of the nuances and complexities associated with inclusionary zoning.
IZ is an obligation to provide a certain number of affordable units in new housing developments. There’s a lot of detail and debate around where this should apply, how much needs to be provided, and at what degree of affordability.
But at the end of the day, it’s important to keep in mind that at meaningful levels of affordability, these IZ homes are going to be built at steep losses. More info on the economic impacts of IZ can be found here.
The simple math is that the costs to build these homes are going to be greater than the revenues that they bring in. Which is why developers aren’t out building affordable housing everywhere. There’s no margin.
In order to build, somebody or something needs to provide a subsidy so that this revenue-expense shortfall can be made up. How this works its way through the market is where I have tried to focus the discussion when writing about IZ. There are complexities. Some lessons from Portland, here.
But to just assume that these costs will get magically absorbed by housing developers, with no other knock-on effects or distortions to the market, is incorrect.
We have a running joke in our office about the manic nature of the development business. Sometimes you feel like you’re having the best day of your life and everything is clicking and moving forward. And sometimes it feels like you’re about to die (slight exaggeration). Things are stuck, nothing is moving, and/or a new problem has just popped up. So our team likes to joke that we have a “manic meter” in our corner of the office. Sometimes it’s up and sometimes it’s down.
Part of the challenge is that progress in the world of development generally takes a very long time. Whenever I talk to someone who isn’t in the industry and I explain our timelines, they are usually shocked and question why things move so slowly. For example, we just spent the last 82 days trying to pull a building permit that realistically could have been issued in an afternoon. That is frustrating. Meter down. We have also spent more than half a decade working on some planning approvals. That’s even more frustrating. Meter down.
The way I have learned to respond to this dynamic is to try and move as fast as possible. Never assume you have enough time, because things will generally always take longer than you expect. You need to be constantly moving and pushing. So you need to be impatient in the short-term. I also find it helpful to break big projects down into smaller projects so that you have wins to celebrate along the way and you can feel some accomplishment. Having hobbies that don’t take decades to come to fruition may further help.
But alongside being impatient in the short-term, you also have to be patient in the long-term. Our team started working on One Delisle in 2015. We are now in 2021 and preparing to start construction. That’s a marathon, not a sprint. So what you need to do is find the right balance between short-term impatience and long-term patience. This, I guess, is part of the manic nature of this business.
If you’re building a multi-family rental building, you’re almost certainly building it “on spec.” What this means is that you’re building an empty building and, once it’s done, you will then work to rent it out. (Nobody rents an apartment years in advance.) In this scenario, you will know what your costs are once the building is complete, but you won’t really know what your revenue will be until you start leasing. If demand is strong and the market has moved since you started building, maybe your rents will be a pleasant surprise. If the market has moved in the opposite direction since you started building, your rents might be an unfortunate surprise. The laneway house I recently completed is an example of a spec rental building. I built it without a tenant, but I assumed that I could rent it out upon completion. That proved to be true, but mind you it was only one unit. So it was relatively low risk.
If you’re building an office building, it is bit more common to have some pre-leasing in place. Early on in my career, I worked on an office development where we started construction with about 25% of the leasing complete. This wasn’t enough for construction financing, but we saw that demand was strong and we needed to start right away in order to meet our lead tenant’s occupancy timing. And so we made the decision to go. We ran on equity for the first bit of construction, but once we completed enough leasing we were able to place our construction facility and lower the project’s overall equity requirement. We took a chance and everything ended up working out okay. But it could have not worked out. What would have happened if a pandemic hit after we started construction? Leasing activity would have completely stopped.
If you’re building a condo building (at least in this city), you’ll likely be pre-selling your suites. You don’t necessarily have to do this. There are examples of well-capitalized condo developers building on spec without any pre-sales whatsoever. (Build, lock in your costs, and then sell.) But generally most developers will pre-sell, secure their construction financing, and then begin construction. In some ways this lowers your risks, as well overall systemic risk in the market. It also lowers your equity requirement as a developer. But it does create another possible risk. Once you pre-sell, you’re effectively locking in and capping your revenues. So you better have a very good handle on your costs. Otherwise you could be exposing yourself to cost escalations without any way to claw back some of your margins.
The other thing to consider is whether you want to yield or not. Is it better to sell all of your suites as soon as possible (bird in hand) or sell only what you need, holdback the rest, and hope that prices increase going forward? I don’t think there is a right or wrong answer here. Some developers don’t want any market risk and so they take the bird in hand when they can. Other developers prefer to profit maximize and/or safeguard themselves against unforeseen costs, and so they sit on inventory. If you have unsold suites, you can always push revenues. Either way, what is hopefully clear from this post is that development is risky. This is just one example of some of the decisions that need to be made. There are countless others. Sometimes you’ll get it right. And sometimes you won’t. Hopefully the former happens more than the latter.
There are many development narratives that I don’t quite understand. (I’m thinking of Toronto, but you can probably replace Toronto with any number of global cities for this discussion.) One is the belief that our transit network is full and so no new development should be allowed in certain locations, next to certain transit stations. The thrust of this argument is that additional transit capacity must be added before any new development is allowed to occur. This might sound logical, except it ignores the fact that the need for new housing doesn’t magically disappear because subway cars are thought to be too busy during the morning rush.
Transit systems are also a network, and so does this mean that no more development should be allowed to happen anywhere in the city/region? Or is the goal to simply move development off of higher order transit and into lower-density areas so that the future residents in these new buildings can either take buses to the transit stations that were previously deemed to be at capacity or drive their cars everywhere? (Our highways have excess capacity during the morning rush, right?)
The second narrative that I find perplexing is that new developments don’t give back in any way. Above is a chart showing residential development charges in the City of Toronto, as of November 1, 2020. This chart outlines the fees that every developer must pay when building new residential, though it is important to keep in mind that there are many other government fees and charges that form part of almost every new development. These are things like parkland dedication and separately negotiated community benefits. But for the purposes of this post, let’s just focus on development charges (aka impact fees).
Assume you’re building a 400 unit apartment building, consisting of 240 one bedroom suites (60%) and 160 two and three bedroom suites (40%). Based on the above chart, your development charge bill would be:
240 one bedroom suites x $33,358 per unit = $8,005,920
160 two and three bedroom suites x $51,103 per unit = $8,176,480
For a total of $16,182,400.
But it’s important to keep in mind that these are the rates as of November 1, 2020. They will almost certainly go up by the time these charges become payable for your 400 unit apartment building. By how much you ask? Well according to Urban Capital’s most recent issue of Site Magazine, which compared a development pro forma from 2005 to 2020, development charges in the City of Toronto have increased by about 3,244% during this time period. (The S&P 500 was up about 220% during this same time.) These are obligatory fees that contribute to everything from transit and parks to subsidized housing and municipal services. (The line items above.)
So it strikes me that there are other more productive questions that we could and should be asking ourselves. Such as, why is it that our transit/mobility infrastructure hasn’t kept pace with new development and new housing demand? What are we going to do to fix that immediately? Why are we not taxing the things we don’t want (like traffic congestion) so that we have more resources for the things we do want (like transit and housing)? And most importantly, what is the best way for all of us to work together so that we can create the absolute greatest global city in the world?
The most popular post on this blog is this one here called, “What real estate developers do and why I became one.” This post alone has been responsible for a good chunk of the organic traffic that this site receives since I wrote it back in 2014. If you search for “real estate developer” in Google it usually comes up on the first page.
Probably because of this post, the number one question I receive in my inbox is about how to become a developer or how to transition into development from some other discipline. Usually this comes from someone who is early on in their career and/or is in architecture (which is not surprising given my background as a fake architect).
I have tried to respond to this question publicly and at scale with a number of different posts. But many of you probably haven’t seen them before, and so I figured it would be a good idea to summarize some of them here (they’re usually tagged with “developer dirt“):
If you’re looking for a more succinct summary of what to do, here is what I would suggest to you. You basically have three options.
1) You can convince someone to take a chance and hire you, even though you likely don’t have any development experience. Maybe you have a background in something relevant such as real estate law, architecture, or politics (good). Or maybe you don’t (less good). Either way, the best way to position yourself is to understand what it is that developers do and figure out a way to create value for them from day one. You want to be in a position to say, “Yeah, I know I don’t have any direct development experience, but I can do X, Y, and Z for you starting today and I think that would be helpful to you for the following reasons.”
2) Get a relevant degree. I’m thinking an MBA in real estate or some sort of master’s in real estate development. The reality is that the development business has, in many ways, become more institutionalized. It has gone, though obviously not entirely, from rich private families developing with their own balance sheets to more institutional capital sources, such as pension funds. Because of this, there are going to be hiring managers out there who need to check off certain boxes. For example, does this person have a real estate degree? This may make it harder for someone to take a chance on you if you don’t have the right experience and/or credentials.
3) Just go out and do it. Despite becoming more institutional, the development business remains, in my view, a deeply entrepreneurial endeavor. You have to be able to problem solve and you have to be creative. The best developers I know don’t focus on can’t, they focus on how. Because there are too many obstacles in this business. A can’t mentality wouldn’t get you very far. So consider renovating a triplex, building a laneway suite, or doing something else that allows you to take a piece of real estate and create some additional value. Because that’s all that development really is at the end of the day.
If you found this post useful, please consider sharing it with someone that you think would benefit from it. And if there are other topics that you would like me to cover (or cover in more detail), please feel free to leave a comment below or to at me on Twitter. I prefer Twitter over email because it forces brevity. Happy Canadian Thanksgiving, all.
