By Ted Tsiakopoulos
Senior Economist
Drastic shifts in costs, revenues and housing market trends in recent years have led some highrise residential developers to pause or cancel housing projects. By now you have heard about One Bloor – an 85-plus storey highrise development in the heart of Toronto that has gone into receivership. It is one example of what could go wrong when market volatility and uncertainty become the norm and not the exception. Other developers having faced similar challenges include China’s Country Garden and Evergrande. In larger urban housing markets where more housing supply is critical, these supply frictions can have significant ramifications for affordability. Canada Mortgage and Housing Corp. has estimated that Canada needs housing starts to double on an annual basis to restore affordability by 2030.
Builders price housing projects today and lock in their revenues. However, long project production runs could cause significant changes to construction costs and could make projects less economically viable in the future. Volatile macroeconomic conditions as well as regulatory constraints lead to uncertainty and volatility in new housing supply decisions. This uncertainty heightens the investment risk for developers and investors, which can increase the required return on investment to offset the perceived risks.
This article examines three critical questions that are informed by a research report[i] recently released.
- What role do builder expectations[ii] play in the supply decision?
- What market and regulatory factors have a more notable impact on a project’s[iii] yield?
- How can policy makers create more certainty and contribute to better outcomes for housing supply and affordability?
The role of expectations
Developer expectations for construction costs, interest rates and market prices are critical drivers on the decision to initiate a housing project. When developers rely more on current information known as boundedly rational data of market trends to shape their expectations, this can alter profitability perceptions particularly when market conditions experience significant shifts. Our research findings suggest that boundedly rational expectations can fail to accurately capture market trends in volatile market conditions and sometimes lead to overly optimistic projections. When relying on boundedly rational expectations, updating the profitability perceptions after project initiation can cause striking changes in the expected project yield. This change in profitability perceptions can explain the cascade of project cancellations in the Toronto housing market in the past few years.
Factors affecting the project yield
Developers use a financial analysis tool called a “proforma” to assess the profitability of a new development when deciding if, when, and where they should begin new high-rise projects. A developer’s decision to proceed with a project is dependent on the estimated financial return from the project exceeding a reasonable minimum threshold of return on investment. The Minimum Attractive Rate of Return (MARR), which may also encompass a risk premium, is defined as a reasonable rate of return on other competing alternative projects. A development project is not financially justified unless it is expected to return at least the MARR.
Through formulating a sample highrise condo proforma in the GTA, we explored the primary factors influencing the profitability perceptions of housing market developers. Our findings suggest that factors related to project financing and loan terms (such as equity funds and interest rates), property taxes and factors that involve a degree of uncertainty, such as construction costs and unit sales prices, can substantially influence the project yield making them important factors in development decisions. These factors have shown unexpected volatility in recent years, resulting in an unexpected shock to the housing supply system.
Besides market factors, regulatory factors also add substantial uncertainty to the feasibility and yield of a development project. Uncertainty surrounding zoning combined with long planning/lender approval times can restrain revenues and can add to development costs. This could easily increase MARR, through the risk premium channel, or can set a higher bar for a project to meet which often leads to a project not commencing and housing supply not materializing.
How can policy makers help?
It has been widely documented what impact forward guidance on interest rates had on consumer, investor and builder expectations following the COVID-19 outbreak. Comments that interest rates would remain low for an extended period was built into consumer, investor and builder expectations especially if a “boundedly rational” expectations approach was applied. The aggressive rate tightening cycle that followed to combat run-away inflation caused profit expectations to adjust dramatically – exerting downward pressure on housing supply. The highrise market was impacted most by the shock to the cost of capital as lower appraised prices and lower potential yields prevented investors from closing resulting in a delay or cancellation of new highrise projects that rely on pre-sales. Cancellation trends in condominium and rental development projects can exacerbate Canada’s already severe housing shortage and further intensify its affordability crunch. Given the unpredictability of random events like a pandemic, limiting the interest rate guidance window to a shorter time horizon and building in potential risks that are data dependent would enable consumers and builders to make more informed decisions.
In less volatile financial environments, delays in development approvals caused by planning processes such as negotiations with city planners regarding density bonuses and inclusionary zoning requirements, can increase uncertainty and risk for developers. Opaque zoning constraints and requirements for applications of zoning amendments can further increase uncertainty. This view supports a mandate for policymakers to formulate land use policies that create a more predictable environment for developers, which can contribute to a more stable and attractive investment landscape that facilitates housing supply.
Developers factor in risk premiums to mitigate potential losses stemming from unforeseen market and regulatory shocks. These premiums, cited as part of MARR earlier, could act as a financial cushion, helping to absorb losses and maintain a healthy financial position even when significant shifts impact the market. When policy is more certain and aligned across all levels of government, risk premiums are likely contained and this sets a lower bar for a project to meet to commence construction. Risk premiums have trended lower in recent years as the increase in risk-free government of Canada bond yields have increased more than capitalization rates on highrise projects. But this has come at a time when market and regulatory risks have increased suggesting developers/investors were not compensated for taking on additional risk. With central banks expected to cut overnight rates over the next year, the risk premium should begin to normalize. In addition, new government programs such as the Housing Accelerator Fund are geared to break down structural supply barriers, encourage government policy alignment, reduce builder uncertainty with the end goal to support more private sector housing investment.
Ted Tsiakopoulos is a senior economist, linkedin.com/in/ted-tsiakopoulos-b8335113. The opinions expressed are exclusively those of the author.
[i] Sharif, Parker, Waddell, Tsiakopoulos (2023) – Understanding the Effects of Market Volatility on Profitability Perceptions of Housing Market Developers, Journal of Risk and Financial Management
[ii] Our study applies a theoretical approach examining empirical models. How builders set expectations in practice will be further examined in future research
[iii] Condo development was the focus of this research, but some findings also apply to purpose-built rental development
