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.
Ten years ago when I was working on development pro formas (here in Toronto), we used to assume that we would launch condominium pre-sales, and then start working drawings once we hit somewhere around 50% sold. And for our hard costs, we would carry a modest inflation rate of say 2-3% per year.
The thinking at the time was that construction documents are expensive, let’s not spend the money until we know that we have a good amount of sales under our belt. In Toronto, you can also use purchaser deposits toward project costs, so this is an equity efficient way of managing your cash flow.
But then this go-to-market strategy started becoming too risky, probably around 2017-2018. Sales were happening faster and costs started increasing a lot faster, and so now everyone wanted to minimize the lag between their pre-sales (your revenue) and when they procured construction (your costs).
So as an ideal and totally risk-averse approach, the objective was to be ready to start construction and to know what your hard costs would be before you even started selling condominiums. It didn’t matter that you were going to spend a bunch of money on technical drawings, because it was still going to be many multiples less than your cost escalation exposure if you didn’t do it. There was also a high degree of confidence that you would get the pre-sales once you did launch.
This is how things mostly worked during the pandemic. But strategies once again changed in the second half of 2022. Pre-sales slowed and people started wondering, “wait a minute, could hard costs actually come down?” The answer turned out to be yes and, this year, most people in the industry expect them to come down even further.
This is a good example of how quickly and dramatically things can change in development. In 2021, it was “we need lock in construction costs immediately or we might get hit with a 40% increase on glass.” Now it is, “let’s wait as long as possible because we’re in a deflationary cost environment and I’m sure it’ll be cheaper later.”
To some extent, you can look to leading indicators like architecture billings and home pre-sales to determine what the future might look like. But it’s far from perfect. I don’t know anyone that accurately predicted what we just went through over the last number of years.
So as a developer, you just have to do your best to stay ahead of what’s coming and manage your downside risk as best you can. In all cases, you’re going to need to be creative and nimble. Because clearly a lot can change in the span of even a single development project.
As per tradition around here, I like to bookend the new year with two posts: a post that revisits my random predictions for the year and a post that talks about what might happen in the year to follow. Today’s post is the former. So let’s see how I did:
I thought the interest rate hikes would come to an end in Q1-2023. But that didn’t happen until the summer. I also thought this would lead to a mild recession in Canada. Technically, we are not actually in one, but according to some, we kind of are.
I thought the real estate sector would start seeing some distress in the first half of the year, and that a new equilibrium would be found in the second half. This proved to be overly optimistic in terms of timing. A lot ended up being on pause for the entire year, and I now think that my forecast was at least a year too early. The sea change is still underway.
Given the overall slowdown in real estate, I felt that construction costs had to see some softening. This did, in fact, happen with some of the “earlier trades”, such as shoring and excavation, and we did see some specific trade pricing, such as concrete formwork, come down by as much as 30%. The smart cost consultants we work with now expect to see overall hard costs come down by a further 5-6% next year in Toronto. This makes sense given construction starts are way down.
With me expecting the interest rate increases to stop in Q1, I thought that pre-construction condominium sales would return in a meaningful way by the spring. While we did see some buoyancy around that time, it was short lived. Sales remained nearly shutoff for the entire year, but for maybe a handful of projects. The more successful projects tended to be outside of the Toronto core and at lower price points.
With respect to home prices in more tertiary/fringe markets, my sense then, as it is now, was that these prices would remain below the peaks for many years. In addition to the upward momentum created by low rates, my view was/is that some of this pricing was the result of a bet on urban decentralization. I don’t think that has played out as many expected it to, so that’s why I think it will be many years before the pricing we saw in early 2022 returns.
The momentum around “expanding housing options” in our low-rise neighborhoods is many years in the making. And a lot of progress was made in 2023. Here in Toronto, we adopted new multiplex policies that now allow fourplexes plus an accessory dwelling (so 5 homes in total) on an as-of-right basis. I continue to believe that this momentum is only going to grow. I also think we will see the arrival of more mixed-use opportunities.
I believed that, broadly speaking, urban transit ridership would remain below pre-pandemic levels for all of 2023. This proved to be the case for most US and Canadian cities. But things are improving. For Canada as a whole, it looks like we’ll see full recovery sometime in 2024 based on this trend line.
I thought 2023 was going to be the year I took my inaugural ride in an autonomous vehicle. Sadly, this didn’t happen. The sector as a whole also saw some setbacks. Hopefully I’ll get a chance next year.
I assumed that Apple would finally release its augmented reality device. And though they didn’t technically releaseVision Pro, they did announce it. So I guess that counts for something. I also thought that 2023 would be a big year for “phygital” goods. Maybe it was. Or maybe it was more of a building year. A lot of people are curious to see how Vision Pro does in 2024. It’s not set up for the mass market, just yet, but I think it will do exactly what it is supposed to once it’s out in the wild.
Finally, crypto. I know that a lot of you like to skip over these posts, but it is something that I feel strongly about. A year ago, though, I was pretty bearish on Solana. Boy was I wrong. Solana ended the year as the best performing major crypto asset — up 933% at the time of writing this. Oops! However, Ether is also +91%, and I continued to dollar-cost average in all throughout the year.
Next up: What will, or more accurately, what might happen in 2024.
This week it was announced that Canada’s population grew by approximately 430,000 people over the last quarter (+1.1%). And that it represents the highest population growth rate of any quarter since the second quarter of 1957. Even more impressive, though, is the fact that in the first 9 months of this year we have already added over 1 million people in total. This beats all full-year periods since Confederation in 1867!
Here’s what all of this starts to look like visually:
The unfortunate side of these records is that it is coming at a time where we’re, perhaps counterintuitively, building a lot less new housing; which is to say that construction starts are declining. In fact, I was on a call this week where people who examine development and construction costs all day were predicting a 5-6% decline in hard costs in the Toronto region next year. And this is a direct result of fewer new projects getting started.
Broadly speaking, this is how things tend to work in real estate development: there are heavy lags between changes in demand and changes in supply because of how long it takes to build new buildings. But what’s happening right now is more than this. Interest costs are impacting everyone. And investor interest in pre-construction homes has softened significantly, demonstrating how much our industry relies on individual investors. Many projects cannot go.
What I ultimately think this is going to do is exacerbate our current supply-demand imbalances. Meaning that when the market does come back — and it of course will — it’s going to come back with a vengeance. And that’s because it is going to need to catch up to all of the new demand that is accumulating as we speak.
The central bank tightening and interest rate hikes that we saw last year will come to an end in the first quarter of 2023 as inflation gets under control. This will ultimately lead to a recession but my sense is that it will be more mild than severe. For this reason, I don’t think anyone should expect ultra-low rates to return in the short-term.
Much of the real estate sector went on pause in the second half of 2022. But ultimately this reset to a more balanced market is going to be necessarily painful for some. And I think we will see that pain play out in the first half of the year. This will obviously be bad for some, but it will create opportunities for others.
Construction costs tempered in the second half of 2022 and started to show some evidence of price softening. I think we will see more of this in 2023, which will be healthy for the market. Cost management over the last few years has been a meat grinder for the development industry.
Pre-construction condominium sales for well-located projects will return in a more fulsome way by the spring. This will be driven by buyers now having clarity around where interest rates will be hanging out in the short-term and, in the case of Canada’s largest cities, by record-high immigration levels.
For the tertiary/fringe housing markets that saw big run ups in pricing during the pandemic, I unfortunately think it will take many years for prices to fully rebound. The price increases we saw in these submarkets were of course a result of low rates, but it was also driven by a view on urban decentralization that in my view did not actually materialize.
The desire to add more housing to single-family neighborhoods will continue to pick up steam across North America. How exactly this plays out will be market specific, but in Toronto I expect to see new planning policies put in place, as well as supportive building code changes.
Public transit ridership will remain below pre-pandemic levels throughout 2023. This will continue to exacerbate public finances.
Autonomous taxis will grow rapidly this year. Companies, such as Cruise, will expand into a number of new US markets and, at some point during the year, I will take my very first ride in an autonomous vehicle.
2023 will be a big year for augmented reality and “phygital” goods. Last year I thought Apple would release a new product in this space. That didn’t happen, but it will this year. At the same time, we will see more companies releasing products that blur the lines between our online and offline worlds (hence “phygital”). This will include NFTs and other crypto-related things that will start to operate more seamlessly in the background of consumer-facing products/services.
I continue to be bullish on Ethereum and I think it will overtake Bitcoin in terms of market cap in the next 2-3 years. But I was very wrong about Solana last year. And now I am struggling with its value proposition. Today, layer 2 chains such as Polygon feel more likely to win out. Broadly speaking, I suspect 2023 will be a positive year for crypto, but not a record-setting one.
In summary, I think we are going to see more pain at the beginning of 2023, but that on the other side of it will be healthier and more balanced markets. This means that we can look forward to the end of the year feeling much better than it does right now. All of this said, please keep in mind that I’m often wrong and that nothing in this post should be construed as actual advice.
Back in May, I wrote a post about time to market and managing costs in condominium projects. What I wrote then remains true and equally, if not more, important today. But given all the uncertainty that we are continuing to see in the market, I thought I would elaborate on a few points.
It used to be the case, when I first started working on condominium projects back in 2007 or so, that you would go pens down on your design drawings while you launched pre-sales and worked toward meeting your construction financing requirements.
Once you hit 50% sales, or maybe once you completely reached your financing hurdle, you would then call your architect back up and kindly ask them to get started on working drawings.
And the reason you did it this way was because working drawings are kind of expensive and so you wanted to make sure that your sales were going to be there. You were also trying to push as many of your costs out to after you had your construction loan in place so that you had a lower peak equity requirement.
You can’t do this today.
Since the beginning of this year, we have seen average high-rise construction costs increase by about 12% in the Greater Toronto Area and, for the balance of this year, some are predicting as much as 4% per month. What this means is that if you wait like the old days, you will likely see costs run away from you and you won’t be able to finance your project based on the sales you do have in place.
So what you want to do is not go pens down. Keep going on drawings. Start buying construction (i.e. tendering). And work toward locking in as many of your costs as possible.
How much is ultimately up to you and the exact market conditions at the time. But I know a number of condominium developers now targeting at least 50% tendered, which means securing most of your key contracts: formwork, concrete & rebar supply, windows, M&E, and so on.
A lot of us are hoping that costs will eventually come down and follow certain commodities in the near term. But as our cost consultant effectively said to me this week, “just because the price of cold-formed steel has come down, do you really think you’ll be able to walk into a BMW dealership and ask for a deep discount?”
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.
Marlon Bray over at Altus recently shared the above chart on LinkedIn. Normally I only go on LinkedIn about once every quarter, if that. But thankfully our team likes to follow nerdy charts and so it got circulated around.
The chart is from Statistics Canada (table 18-10-0135-01 to be exact) and what it shows is the % change per annum of their construction price index, going all the way back to 1989. It is good context for the massive cost increases that we are all currently working through.
Increasingly, I think that most people in the industry feel as if we’re now reaching a tipping point. Costs — both hards and softs — cannot continue to go up like this. At some point supply will start to taper off or even shut off. The former has likely already started.
Many of you are probably acutely aware that the cost of lumber has risen dramatically over the last year. Builders are building and many people seem interested in renovating their home right now — so demand is outstripping supply. But here is a chart from Fortune, with data from Random Lengths, showing you just how wild things have gotten. Back in April 2020, lumber was going for about $358 per thousand board feet, according to this data. As of the beginning of this month, the number had jumped to $1,048, which represents an all-time high and a 193% year-over-year increase. Who knows where pricing will go next, but the National Association of Home Builders is estimating that current pricing has added about $24,000 to the price of a typical new single-family home in the US.
Why do some buildings cost more to build than others? And how is it that some cities, as a whole, seem to build more cost effectively than others? Without getting into the specifics of how different markets work, I thought it would be valuable to outline some of the cost drivers that impact new developments. But keep in mind that this is by no means an exhaustive list. So, please feel free to add whatever I’ve missed to the comment section below.
Below-grade parking is hugely expensive. It’s almost always a loss leader. You lose money building it. That’s why parking ratios matter a great deal. If you’re building in the suburbs at 1 to 1 parking vs. 0.2 in the core, you’re simply building more of something that doesn’t make money. There’s also the question of whether you need to build a watertight below-grade, or if you can discharge any groundwater into the municipal infrastructure. Big cost difference.
Union vs. non-union construction labor.
Building stepbacks add cost and create additional complexity. To build more cost effectively, you really want repetition. But terraces are awesome. I get it.
Impact fees, development levies, and other government fees can vary widely across cities. As I’ve mentioned many times before on the blog, these line items can add up to 20-24% of the price of a new condominium here Toronto.
Time is expensive. One of the bigger line items in a development pro forma is financing interest charges. The longer things take, the more expensive the housing needs to be.
Markets are unique. Quebec, for example, has relatively low electricity rates. For this reason, it’s pretty common for homes in Quebec to use electric heating, which is usually pretty cost effective to install. According to this 2019 study, 68% of Ontario households rely on natural gas heating. In Quebec, the number is only 5%.
Depending on what you’re building next to, you may face additional costs. For example, if you’re building right up against a rail line, you may need to construct a “crash wall” in order to safeguard against possible derailments and you’ll probably need to up the STC rating on your windows because of the higher noise levels. These costs will not be insignificant.
In theory, land costs are supposed to be the residual claimant in a development pro forma. What that means is that you should back into your land value after calculating your projected revenue and considering all of your other development costs. If your revenue is lower, so too should be your land cost. Land cost as a percentage of total costs will, naturally, vary across different markets.
Yesterday I made a comment on Twitter about most people not understanding to what extent government bureaucracy inhibits the delivery of new housing in this city. It received a number of responses, including remarks about how development charges have also recently doubled and how this statement applies to pretty much every city out there. But there was also a comment about developers not being transparent and not properly explaining the impact to the public. In other words: please demystify the development pro forma. I thought that was a fair remark, and so this post is going to be a response to that comment.
Before I begin, it’s important to keep in mind that most developers have investors. These investors put up most of the money required for a project and in turn they take most of the profits. However, there is typically a “promote” in place, which is just an incentive structure that pays the developer more of the profits (disproportionate to the cash they invested in the project) if they perform and hit certain return benchmarks. All of this is to say that developers aren’t usually the ones holding all of the cash (which is what a lot of the public seems to think) and they are accountable to their investors to do what they said they would do.
Now let’s run through the costs that make up a “typical” development pro forma. For this example, I am going to assume that we’re talking about a 100,000 square foot mid-rise building; the kind that you might build and find along any one of Toronto’s Avenues. If we were doing this in real life, we would get more precise with the areas and consider gross construction area, gross floor area (city definition), and the net saleable/rentable areas. But to keep the math simple, we will ignore these differences. That’s the approach I’m going to take overall in the post. What you need to know, though, is that you have to pay to build the entire building, but you only get to collect revenue on a portion of it. That’s why the “efficiency” of a building matters.
Land
The value of development land is a function of what you can build and the revenue you can ultimately collect. So location matters a great deal. Based on the latest high-density land report from Bullpen and Batory, the average price of an unzoned mid-rise site in the City of Toronto is about $231 psf. So let’s assume a land cost for our project of $23.1 million. Assuming we can get land financing at 60% of the value of the land (loan-to-value), that would mean we’re putting up $9.24 million of cash (plus a loan guarantee!) and borrowing $13.86 million to start our project. At 5.25% per annum (interest-only loan), our annual interest charges would be about $727,650. From now on forward, we’re going to pay ~$60k in additional interest charges for every month that our project is delayed. Buckle up.
You should now begin to see why time is so valuable and why government bureaucracy can be so frustrating. As a developer, you’re heavily incentivized to move things forward, whereas it can often feel like everyone around you is trying to deliberately erect roadblocks in order to slow you down and make your project more expensive to build. Oftentimes, it is because it is less risky for them to punt things down the road and not make a decision. That is not the case for us and our project.
Hard Costs
Onto construction (or hard) costs. As many of you know, these have risen dramatically over the last 4 to 5 years. On some of our projects, we have added over $100 psf in hard costs alone. Part of this has to do with a busy construction market and part of this has to do with new building requirements: watertight undergrounds, new Green Standards, and so on. For our project, which is on the small side, let’s assume $360 psf for a total of $36 million. This would include our direct construction costs and our construction manager’s overhead (general conditions). We should also prepare for some of the trades to decline to bid on our project because it is too small and not worth their time.
Soft Costs
Soft costs include everything from consultant costs and interest charges to government levies and management fees. Like everything in your pro forma, these absolutely need to be broken out line by line. Don’t be lazy here. But for the purposes of this simplistic example, we’re going to use 75% of hard costs, which works out to be $27 million (or $270 psf). When I first started out in the development business, the rule of thumb was closer to 25% of hard costs. But times have changed. Government fees, alone, can make up about 1/4 of the price of a new condo in Toronto.
Adding up all of these costs, we’re at $861 psf or $86.1 million in costs. It’s now time to consider the revenue side. $1,000 psf seems like a nice round number, so let’s start there and assume we’re going to sell our condos for that. Typically in Toronto, the price you pay is inclusive of HST, so that liability will need to be deducted from our revenue line. It’s not a straight 13% because of the new home rebate, but the rebate also hasn’t been properly indexed since it was introduced and so the liability could still be upwards of 10%. (This is worthy of a separate blog post.) The result is $900 psf in revenue and a margin on costs that is less than 5%. No sensible developer would want to do this project. One misstep (or development charge increase) and you’re dead.
So let’s increase our condo prices to $1,100 psf. Maybe that will work. In doing that, we get to a margin on costs that is nearly 15%. Okay, now we’re in the range. But let’s say we just got delayed by 6 months (boom, interest charges) and our hard costs turned out to be off by $15. They’re actually working out to be $375 psf because of some new tariff and because the formworkers in the city are all tied up on bigger projects and couldn’t give a shit about our cute little infill project. Now we’re offside again in terms of our margin on costs. No problem, let’s try and push condo prices a bit more. Is $1,150 achievable? Perhaps. But ideally, given the above, we would want to be at $1,200 psf just to be safe.
This is an overly simplistic example of the math that goes into a development pro forma. But hopefully it begins to show you (1) just how many moving parts there are in a development project and (2) the kind of pricing that is required in today’s cost environment. Developers are reacting to the costs that they are being thrown and it is creating upward pressure on home prices. (See related post: Cost-plus pricing.) So far there has been enough elasticity in the market to absorb these price increases, but that may not always be the case. If you have questions about this post or disagree with any of my assumptions, feel free to leave a searing comment below.
