Brandon Donnelly

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.

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Tag: development feasibility

  • Cost-plus price floor

    Oftentimes, it feels like there is a perception that developers price new housing with the fattest of margins. Meaning, if only developers were less greedy, housing could be more affordable. But as we have spoken about many times before, real estate development is a competitive industry; therefore, projects happen on the margin.

    Ordinarily, the prices you see are the result of a cost-plus pricing strategy. Developers figure out what it will cost to build and develop, they add on a margin that they think their investors will accept, and then they determine what sticker prices they need to make the project financially feasible.

    I’ve been writing about this approach for many years, but today it’s even more obvious. According to Urbanation’s Q1-2024 condominium report, new unsold condominium inventory in the GTA is currently sitting at approximately 23,815 units. This is up 30% YoY and is equal to about 23 months of supply. Two years ago in Q1-2022, this number had reached an 18-quarter low of 8,726 units.

    Developers are highly motivated to sell and move their projects forward. Time is a killer, especially today. So the logical explanation for this rising inventory is simply that they can’t sell it. Their cost-plus pricing doesn’t overlap with what most buyers in the market are willing to pay. Like I said, development happens on the margin.

    In theory, there is always a price where buyers would be willing to transact. If I listed a beautiful condominium for $100k today, many people would want to buy it. Supply would quickly run out. The problem is that no developer can build for this. There is always a very real price floor and, right now, that floor doesn’t seem to be low enough for many buyers.

  • Less new housing — for now

    Approving new housing is one thing. And it is an important one thing. But you also need to sell/lease and finance the project. And that is a lot more challenging in today’s environment compared to a few years ago. I think a lot of people look at our cities, see a shortage of housing, and wonder why developers don’t just build more of it. But it’s not that simple:

    “Our industry is now taking a second look at our [calculations] and saying it’s costing more to build, it’s costing more to lend,” he said. “And there is a threshold in regards to what a purchase price or sale price can be. So there’s a bit of a pause in the market right now in regards to starting construction.”

    Throughout this last development cycle and, in particular, during the pandemic, development costs increased dramatically. But the revenue side was also increasing — meaning you could sell and/or lease space for more. That kept development going. You could still successfully underwrite new projects.

    But now the cost of debt has increased and the revenue side has expectedly slowed both in terms of pricing and velocity. This dramatically changes the feasibility of new projects, which means the market is going to need time to adjust to this new environment. This, of course, will happen. But in the interim (i.e. right now), it is going to mean a lot less new housing.

    This should not come as a surprise.

  • What are the opportunity costs of not building new housing?

    The stated policy goal of inclusionary zoning is to to produce more affordable housing. We can debate who ultimately pays for this below-market housing, and we have many times before on the blog, but for the purposes of this post let’s just focus on its stated goal.

    Given this ambition, it makes sense to carefully measure the number of affordable homes produced. And that is ordinarily what is done: “We implemented this new policy on this date, and since then we have produced X amount of new affordable housing.”

    It is then likely that we will take X and form opinions on whether it was a successful policy or not. If X seems like a lot, then maybe we think it’s a good policy. And if X doesn’t seem like a lot, then maybe we think it was a bad policy, or perhaps just an ineffective one.

    But what is largely impossible to measure with any real precision is the number of new market-rate homes that are now not being built as a result of a policy. Let’s call this number Y. It is, of course, possible to come up with an estimate by looking broadly at rents across the city, plugging in some development costs, and seeing what pencils. But this is a rough approximation.

    It does not capture the countless times that a developer has looked at a possible housing site, only to come to the conclusion that it is not feasible to build. There is no official Y figure. And any amorphous estimates of Y are going to be easy to ignore by the general public anyway. Unbuilt homes? Opportunity costs? What?

    I am saying (okay repeating) all of this because I continue to feel like most people believe that development will just happen no matter what is thrown at it. There is a housing shortage, right? So developers should just do what they do best and build today. Surely they could if they were genuinely nice people and really wanted to. Hmm.

    What many people seem to ignore (or not know) is that development, and in turn new housing supply, operates under this very simple decision tree:

    • Find development site
    • Underwrite said site
    • If math works, seek capital/investors and then build
    • If math does not work, do not build
    • If math works, but capital doesn’t like it, also do not build (most can’t in this scenario)
    • Repeat

    Just because you aren’t seeing or noticing something, it does not mean that it doesn’t exist and that it’s not happening behind the scenes.

  • California has a plan for 2 million new homes

    On July 1 of this year, a new California bill, called the “Affordable Housing and High Road Jobs Act of 2022”, will go into effect. And the goal of this legislation is to significantly increase the supply of new homes in the state by allowing multi-family construction on lands that are currently zoned for commercial uses.

    On some level, it is of course curious that there even needs to be this bill. Because what we are effectively saying is, “hey, we should allow people to build a mix of uses on our main streets and with high enough densities that we might actually be able to support transit.” Why was this not always the case? (Rhetorical question.)

    In the words of architect and planner Peter Calthorpe, who was recently interviewed here in ArchDaily, this is a “landmark piece of legislation” that has “received very little attention.” So that’s why we’re talking about it today.

    Calthorpe was actively involved in crafting this legislation, and his work apparently started with different scenario land-use models. The first experiment looked at a 43-mile stretch of El Camino running from San Francisco to San Jose (pictured below). And what they found was that this one strip alone could accommodate somewhere around 250,000 new infill homes.

    To put this into context, the state of California is currently building about 140,000 new homes each year, through a roughly equal (1:1) split of multi-family and low-rise single-family. Already this represents a shift, as supply used to be slanted (3:1) toward low-rise. (I don’t know when exactly this was the case, but Calthorpe mentions the figure in his interview.)

    Moving on from El Camino, Calthorpe and his team then ran a similar exercise for the five-county inner Bay area. And here they found that some 700 miles of commercial land could produce up to 1.3 million multi-family homes at “reasonable densities.” This was then expanded to the entire state of California and the number increased to 10 million new homes.

    Of course, as we have talked about before on this blog, not all of this land might actually be feasible for development. Sometimes the math doesn’t work even at a zero land cost; you might need a negative land cost in order to pencil a new development. Meaning, you might need to be paid, perhaps through some sort of subsidy.

    So what Calthorpe and the team did was use MapCraft to quickly run development feasibilities on the above sites. They had it run 6 different pro formas using local rents, construction costs, city fees, and so on. And what they determined was that this 10 million number drops down to 2 million when you apply the economic realities of the world.

    As a disclaimer, I’m not at all familiar with MapCraft. But I’m going to take this number at face value and say that this is still a lot of new homes. And this is what people are hoping for come July 1 of this year.

    Image: HDR / Peter Calthorpe

  • Real estate developers are stupid

    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:

    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.

  • Where developers won’t build even with $0 land

    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.

  • Solving the rubik’s cube

    Developing a building can often feel like you’re trying to solve a rubik’s cube. Among other things, you have to manage a myriad of different stakeholders, all of which — naturally — operate in their own self-interest. There’s the city, community, politicians, various agencies, consultants, tenants, purchasers, lenders, investors, the market at large (of which you really have no control of), and many others. Oftentimes you even have stakeholders whose interests are mutually exclusive. Indeed, the things that they want can sometimes be at odds with each other. Your job is to figure out a solution that satisfies as many of these interests as possible.

    To give you an example, let’s say that you’ve been asked to introduce a stepback into your building in order to break up the elevation. From an urban design standpoint, this may make perfect sense. Hello, datum line. But now your construction costs just went up. You have to transfer your mechanical lines, insulate the roof, introduce new bulkheads, and, for the purposes of this example, let’s say you now need to introduce a structural transfer. This is big cost item that you hadn’t accounted for. And because you just reduced the height of the building to satisfy another stakeholder, you don’t have the excess clear height to accommodate the additional depth required by this new structural element. There is, of course, always a solution. But usually something will need to give.

    At the same time, this raises some interesting philosophical questions. What’s more important in this example? The urban design move or keeping construction costs low so that the building can be delivered more affordably? The cynics will argue that this is a moot point because developers will always profit maximize. But I would encourage you to check out some of my past posts, such as “Cost-plus pricing” and “The impact of inclusionary zoning on development feasibility.” This problem solving dynamic is one of the things that makes development so challenging. But it is also one of the things that makes it incredibly rewarding.

    Photo by Ivan Bandura on Unsplash

  • One year of Inclusionary Housing in Portland

    image

    About a year ago, Portland enacted “Inclusionary Housing” policy requiring new apartment buildings of 20 units or more to offer up a portion of the units at below market rents.

    Developers are able to select from a few different options and the rents are calculated according to a percentage of the city’s median family income (30-80%). I’m not sure how this policy would apply to new condo buildings.

    This is an interesting account by The Portland Mercury of what this policy may be doing to the housing market. I say may because it’s only been a year and there could be other factors at play.

    Between 2013 and 2017, Portland typically built between 3,000 and 6,000 new units per year. Since the IH policy went into effect on February 1, 2017, 682 new units have applied for permit. 

    About half are coming from one developer who appears to be building the requisite affordable units in exchange for no parking minimums. They are now proposing buildings with zero parking.

    Again, in all fairness, it’s only been a year. But already Mayor Ted Wheeler is looking at other incentives to encourage more new construction in the central city. The biggest levers: height and density.

    All of this begins to speak to the very real impact of inclusionary zoning on development feasibility.

    Photo by Zach Savinar on Unsplash