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.
Next Tuesday, January 19, I am helping to teach the introductory class of a Certificate of Real Estate Development program that is jointly offered by Carleton University’s Sprott School of Business and Azrieli School of Architecture & Urbanism. Here is a full list of the instructors and key note speakers that will be participating in the program. Obviously it is all being done online this time around.
One of the great things about this program is that it’s a partnership between their school of architecture and their school of business. As you might expect given my background, I am biased in my view that this is a great way to teach real estate development. And it’s one of the reasons why I enjoyed my time so much at the University of Pennsylvania. I was free to take classes at whatever “school” I wanted to.
When I later went on to study at the Rotman School, I actually tried to advocate for a better real estate development curriculum and for increased collaboration across the business and architecture schools (both alma maters). The response I got, at least back then, was that Rotman already had a real estate major and that it was fine just the way it was. Cool.
For more information or to register for Carleton’s Certificate of Real Estate Development program, click here. I think there are only a few spots remaining.
When I was in grad school studying architecture and real estate, the Zell/Lurie Real Estate Center used to run a regular lunch series with real estate executives. The way it worked is that executives would come in to the school and 15 or so students — all of whom were studying real estate — could sign up to have lunch with them in a boardroom. I can’t remember if the school provided us lunch or we had to bring our own, but either way, you had an hour to hear them talk about the industry and ask them whatever you wanted to know.
One time somebody asked a question about what courses they should take outside of their business and real estate classes. And I’ll never forget what the executive said. His recommendation was to take courses that were as far away from business, finance, and real estate as possible. He said take fine art history classes, learn about ancient civilizations, or whatever. Just take classes that force you to think a little differently than everybody else.
The reason, I think, this resonated with me so much was because I had a certain amount of academic insecurity at that moment in time. I was coming from an architecture and design background and my classmates were former investment bankers and management consultants, all of whom had a far better grasp of “the numbers” than I did. It meant that real estate recruiters didn’t want to talk to me because I was the square peg for their round hole.
But being a square peg really motivated me.
I remember walking into the program director’s office at that time and requesting that I be put into what was considered to be the more difficult real estate finance class offered at Wharton. He said that he didn’t recommend it. Non-MBAs (which I was at the time) can’t typically handle it. And if he put me into it, I would likely come back to him crying about how hard it was. I asked him to put me in it and said that I would come back to show him my “A.” He put me in it and, yes, I got an “A.”
But at the end of the day, the point that this executive was making at the lunch was that the math and mechanics behind things like cap rates, IRRs, and DCFs is not rocket science. Real estate is not rocket science. You of course need to know how this stuff all works, but it is not the be-all and end-all. The other critical parts of this are more art than science. What are the assumptions that I am making as part of my analysis? What do I believe about the future of the world? To answer these questions, you need think critically and laterally. And having a different perspective can help you do exactly that.
This was true back in 2008 and it’s still true today.
I get that real estate developers don’t always have the best of reputations. We build buildings that cast shadows. We invest in (or gentrify) neighborhoods. And yes, like every other for-profit business, the goal is to make a bit of money along the way.
But believe it or not, there are developers out there who care deeply about the work that they do. They care about their craft. And they want to do the right thing.
Perhaps the best way for me to start to explain what I’m getting at here is to quote the late Steve Jobs. An obsessive perfectionist, Jobs was known for focusing on every little detail in the projects that he worked on. Here’s an excerpt from an interview he did for Playboy back in 1985:
“We just wanted to build the best thing we could build. When you’re a carpenter making a beautiful chest of drawers, you’re not going to use a piece of plywood on the back, even though it faces the wall and nobody will ever see it. You’ll know it’s there, so you’re going to use a beautiful piece of wood on the back. For you to sleep well at night, the aesthetic, the quality, has to be carried all the way through.“
As a developer and a fake architect, this paragraph really resonates with me. But here’s the thing. One of the differences between making a beautiful chest of drawers (or a computer) and making a beautiful building, is that buildings have an inordinate amount of rules that tell you what you can build where and then how you need to build.
Some of these rules, of course, make a lot of sense. Life safety is no joke. But some of these rules also make no sense. And sometimes these rules — that don’t make sense — prevent you from putting what I would metaphorically consider to be that beautiful piece of wood on the back.
The beautiful piece of wood isn’t about money. In fact, it’s going to cost you more compared to just using a piece of plywood. It’s about giving a shit and caring about your craft, even if nobody else does. It’s so you can sleep well at night.
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.
The venture capital industry likes to talk about the importance of investing in ideas that are and turn out to be both non-consensus and successful. The idea here is that if an idea or opportunity is already consensus, then there’s too much money flooding into that space and it becomes too difficult to make money. This is particularly true in venture capital where a select few companies usually end up generating most of the returns. This is a high risk business. Supposedly, even the best VCs end up having to write off a big portion of their deals.
But I don’t think that this logic need only apply to venture capital. In real estate development, you are often faced with similar situations. For example, if an area is already consensus — that is, it is already considered to be highly desirable — then capital is going to naturally flow into it and land prices will be relatively high. These high land prices might be justified by the revenue side of your pro forma, or they might not be. I know many developers who avoid “core” locations simply because the land is too much and the margins are too little.
On the other hand, if an area is non-consensus — that is, you’re not sure people will want to rent or buy new space in the area — then the land prices should reflect this. But here’s the thing. What you’re doing is trading, among other things, a lower land price for greater market risk. Because the non-consensus bet could turn out to be either successful or unsuccessful. People will either want to occupy space here or they won’t. And remember, by definition, it being non-consensus means that most people believe they won’t — or at least not at the prices you might need in order to make the math work.
What all of this means is that if you’re right about something that most people think is wrong, then you have the opportunity to do quite well. (Though I am not suggesting that you need to follow this framework in all situations.) This is on my mind right now because it feels to me that there are certain consensus opinions emerging as a result of this pandemic. For example, opinions around the demise of office space and the demise of downtown living. If you’re a regular reader of this blog, you’ll know that I think these death-of-the-city predictions are largely bullshit.
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?”
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.
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).
The submission documents for 1200 Bay Street — the supertall being designed by Herzog & de Meuron and Quadrangle Architects — are now publicly available through the City of Toronto’s development applications website. I went through the plans today out of curiosity. Below are the typical residential floors. The three tranches shown here are floors 19-46, 48-79, and 81-84. Note the side elevator core and the east-west shear walls — both of which I was expecting to see.
And here are some of the main project stats:
Site area after laneway widening: 890.1 square meters
Total gross floor area (residential & non-residential): 54, 898 square meters
Floor space index: 61.67
Building height (excluding mechanical penthouse): 324 meters
Number of residential suites: 332
Vehicular parking spaces proposed: 0
Bicycle parking spaces proposed: 673
As a rule and out of professional courtesy, I do not comment on other people’s projects on this blog (other than to occasionally point out awesome and ambitious projects). But I do enjoy going through drawing sets to see what others are doing and to see what I might learn. And I am similarly happy to collaborate with others who may want to learn from what we are doing.
