Purpose-built rental pro formas under pressure

Purpose-built rental pro formas under pressure

Housing market fundamentals hold institutional investors firm
Friday, August 13, 2021
By Barbara Carss

Already tight margins in purpose-built rental pro formas have become even more precarious during the COVID-19 pandemic. Developers are now facing escalating material costs, supply chain disruptions, labour shortages and — perhaps most surprisingly from a demand perspective — climbing vacancies and falling rental rates that were not contemplated 18 months ago. Even so, market analysts report that strong fundamentals continue to draw investors to the sector.

“There’s just an insatiable demand amongst institutional capital to be in the multifamily space, to have a higher allocation to multifamily space than they have traditionally had, and to own really good product,” Paul Morassutti, CBRE Canada’s vice chair, valuation and advisory services, observed during a recent webinar examining Canadian commercial real estate dynamics. “Buying brand new apartment buildings, certainly at scale, is virtually impossible so there’s now this desire to create product. If the initial returns are skinny, I don’t think they care because, down the road, they will own the type of assets that they’d like to own.”

Proponents with shallower resources and/or shorter horizons for investment returns have a tougher business case. Citing a recent report from the consulting firm, Finnegan Marshall, which found that construction costs rose by 53 per cent over the past five years, Morassutti estimated that additional increases in development charges, contributions procured through Section 37 of Ontario’s Planning Act and spiking land prices have actually pushed up costs by as much as 75 per cent since 2016. Typically, developers need about a 3 per cent gain in revenue to balance out a 10 per cent jump in costs.

“On the condo side, revenue has also increased, so the condo industry has been able to absorb a lot of these costs and continue forward,” Morassutti acknowledged. “The pressure has been most acute on the purpose-built rental side and that’s because, even pre-pandemic, the returns for that type of development were very skinny. You have a combination of construction costs going up and revenues not moving so it is really making a lot of these pro formas difficult to pencil out.”

Rental revenue slippage is expected to be short-lived once COVID-18 wanes, and is already climbing back up from pandemic lows. A return to pre-pandemic immigration levels and the resumption of on-campus post-secondary learning should bolster demand for rental accommodation relatively soon. Looking farther into the future, homeownership affordability barriers are likely to keep a growing portion of urban dwellers in rental accommodations.

Morassutti also speculates that many of today’s asset-rich homeowners will feed an uptick in demand for purpose-built projects that offer secure tenure. In particular, he points to a largely uncounted but presumed significant cohort of near-retirees who have inadequate savings for the future.

“I think a lot of those households will cash out of their houses and move into rental product, and they’re not going to move into a 400-square-foot condo with an owner who can evict them at any time,” he submitted.

Meanwhile, Benjamin Tal, deputy chief economist with CIBC World Markets, theorized that the base of prospective renters and owners has been undercounted and that upwards of 165,000 potential permanent residents weren’t identified as new arrivals during the course of the pandemic. That includes about 150,000 international students who became automatically eligible to stay in Canada after their visas expired and 16,000 to 17,000 repatriated citizens who returned from Hong Kong.

“Demographically speaking, we are doing better than advertised,” Tal said.

Flight to the suburbs, or even farther afield, is likewise projected to abate as urbanites are again immersed in the lifestyle that drew them downtown in the first place.

“The cities are back,” Tal asserted. “The premium of living in a city when the city is shut down is zero. When you open back up, the premium is all of a sudden much more significant.”

On that theme, Morassutti concurred that only a dramatic upward spike in interest rates is likely to quell the housing markets in cities like Toronto and Vancouver. “We have a finite supply of single-family houses and we have increasing demand every year. That is a fundamental supply-demand imbalance that is not going to go away,” he stressed.

That’s all factored into investors’ outlook and willingness to contemplate less favourable purpose-built rental pro formas.

“When you speak to most of the capital that’s moving into that space, they will tell you that you can’t look at those developments as a one-off development with a going-in yield that’s going to be a homerun,” Morassutti recounted. “They are executing on the strategy, not necessarily the individual deal. I think they all feel confident that they are creating brand new rental product in a sector that they all want to be in. Ten years from now, 15 years from now, they will own great quality product with rents that will have grown, and they’ll be in a very good space.”

Barbara Carss is the editor-in-chief of Canadian Property Management.

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