Do developers know something the rest of us don’t?
Or have the giant pension funds and real estate holding companies just decided to diversify, and perhaps take a long-term approach to investing, rather than a large short-term gain?
The recent media reports would have us believe that constructing purpose-built rental apartments spells doom for the condo market, but aren’t they forgetting that fewer condos being built makes for shorter supply?
I remember a presentation I did in Grade 12 “Economics,” back in 1997.
The task was simple: come up with a “question” that will lead to discussion and debate, and we would be judged on the response of the rest of the class, or lack thereof.
Students came up with most boring answers, and some of were illogical. One of my buddies asked, “Do you think stocks are good for the economy?” That didn’t make any sense, whatsoever.
My question was simple: If you had $10,000 to invest in an “all or nothing” venture, and there were four outcomes, which one would you take:
a) 90% chance of $11,111
b) 50% chance of $20,000
c) 25% chance of $40,000
d) 10% chance of $100,000
The class debated this for the rest of the period. People were fighting to get a word in.
Of course, there really isn’t any right or wrong answer.
This is just a simple example of “expected value,” in that every single one of these options has an expected value of $10,000.
My teacher was smirking the whole time. He even winked at me as I fielded questions; listening to people give their reasoning, when all the while, there really wasn’t a right answer.
In the real world, investment opportunities are not this simple.
But your expected value does play into your decision, along with future value, cost of debt, inflation, and a host of other variables.
Over the past, say, two decades, we’ve seen nothing but condominiums being built in the city of Toronto. Very few true “rental buildings” have been constructed, as was the trend in the 60’s, 70’s, and even into the 80’s.
In the past few months, we’ve seen a lot of press about developers starting to build rental towers again, and it’s come with this bizarre notion, in my opinion, that this says something negative about the condo market.
Here’s an excerpt from an article called “Rental Renaissance” in last week’s Globe & Mail that shows the statistics involved:
There were nearly 24,000 rental units under construction across Canada in the second half of last year, up 52 per cent from a year earlier, according to commercial real estate brokerage CBRE Group Inc.
Across Canada’s six biggest cities, rental starts are double their five-year average. In Toronto, there are 21 rental apartment buildings under way, up from 12 two years ago.
Now bear in mind – I am not the CEO of a multi-billion-dollar pension fund, nor am I a math genius, or investment banker. I’m not qualified to get in depth here.
But I can tell you that the newspaper articles about the condo market “being in trouble” because developers are electing to build rental towers instead of condominiums are incredibly misleading.
It goes back to that Grade 12 example, doesn’t it?
Call it “risk versus reward” if you want to.
Or simply suggest that different investors have different goals in mind.
If I’m more conservative with my money and want to put it in something “safe” that pays me 5%, as opposed to the gunslinger that wants all his money in gold and biotech stocks, trying to find one that will DOUBLE, then does that make me better, or worse?
Building a condominium versus building a rental tower doesn’t say anything about “the future of condominium prices.”
Instead, it speaks to the investor, and their goals.
Let’s say that an investor purchases land for $5,000,000, and it costs $10,000,000 to build a condo tower.
Let’s say that the condos are sold for $35,000,000, and the developer makes $20,000,000 in net profit.
Now let’s say that instead of selling those condos for $35,000,000, the developer was able to rent those units out, for a net profit of $1,000,000 per year.
So after twenty years of renting those units, the developer would have the $20,000,000 in profit that he would have had by selling the units as condos. AND…..now he gets $1,000,000 per year, every year, forever. (I know this assumes rents don’t go up, but just work with it…)
What’s the right call here?
Simple example, I know.
And there’s a LOT to be discussed.
That $1,000,000 net profit in Year #20 isn’t really $1,000,000 by today’s standards. It could be more like $700,000 after inflation.
And what’s the opportunity cost of having all that money tied up in the apartment? You have $15,000,000 tied up (the $5M price of the land plus the $10M to build) for twenty years! You could have used that money for other ventures, or even made basic interest.
Condos come with that “walk away” feature, whereas apartments come with that “constant management and maintenance” headache.
But ultimately, it’s up to the investor to decide which path to take, and there are thousands of variables to consider.
Earlier this month, Canada Pension Plan bought a portfolio of student housing in the United Kingdom for $2.1 Billion. The portfolio had 40 residences, with room for 16,700 students.
This deal likely took several months, if not a year, to come together, and there were probably dozens of people at CPP that worked on it, not to mention consultants, investment banks, etc.
CPP clearly sees an opportunity here – university applications are up, student housing is in short supply, rents have potential to increase, etc.
But they chose to spend $2.1 Billion on rental units.
So does that mean the real estate market in the United Kingdom is going down?
No. No it doesn’t.
But the articles in the Globe & Mail, National Post, Toronto Star, et al, all seem to suggest that because more and more rental towers are being built in Toronto, that there’s some sort of indication that prices are headed south.
I would agree that if every condominium developer started to construct purpose-built rental apartments rather than condominiums, then perhaps their 5-year outlook for the rise in values of condominiums has changed.
But not every condominium developer is building rentals; just a couple. And that’s just one “perhaps,” and on the flip side, it could simply mean that there’s more money being pumped into real estate in general, just in a different way.
If a pension fund wants to put $2 Billion into “rentals,” because they like the long-term play associated with owning real estate, and collecting rent, then they probably aren’t going to purchase $2 Billion worth of condominiums, are they?
Instead, they’re going to buy purpose-built rental buildings, ie. the student residences in the UK.
So if a condominium developer thinks he can get more money from building an apartment, and selling it in one, two, or ten years to a pension fund, REIT, or another investment group, then I say again – this doesn’t signal a pending decline in the price of condominiums on the whole.
I guess the point I’m trying to make here is that people (especially the bearish media….) need to remember that condominiums and apartments are not as similar as they would have us believe. They attract completely different investors, and the type of investment is drastically different.
Condos are individually owned, and together, they form a corporation. They’re usually sold off one by one, by the developer, to individual investors.
Apartment buildings can be sold as a whole, to one investor, and they’re easier to manage, and the ownership structure is completely different.
So it could be argued, rather than “developers are building more apartments, so maybe the condo market is about to weaken,” that developers are building more apartments, so big financial institutions and fund managers are attracted to Toronto real estate even more so than before.
Maybe that’s my positive spin on things, but do you think that CPPIB would have spent $2.1 Billion on 16,700 individual condominium units scattered all over the UK? Or did they buy the lot because it constituted ONE investment?
One final thought on this, while we’re at it…
The basic laws of supply and demand dictate that when supply goes down, and demand remains the same, then prices increase. Correct?
So if developers start building more apartments, whether they hold these themselves (which most don’t) or sell them to larger investment funds, that means there will be LESS condominiums built.
If there are less condominiums built, then won’t prices increase?
If anything, they won’t go down.
So alas, I don’t understand the take-away from the media coverage that suggests “developers building rental apartments suggests the condo market is weakening.”
The laws of supply and demand wouldn’t agree.
And what the media coverage doesn’t mention is that most of these developers are looking to sell the apartments when they’re completed, not keep them and manage them.
Condominium developers develop condos; they don’t manage them, or rather most don’t.
Companies like Cityzen, who recently built The Berczy at 55 Front Street, aren’t just developers – they build condos, apartments, sub-divisions, retirement communities, and they own and manage many of the projects they build.
But that’s a rare case, and most Toronto condo developers are looking to get in, get out, and get paid. That means holding a purpose-built apartment for 30-years isn’t the goal.
I sure don’t want to come off as a real estate cheerleader here, but the media are dying to see a real estate decline, and have been for a long time. And it really bothers me when they draw an inference from something as basic as “hey look, there are more rental buildings being built,” to suggest a decline in the real estate market.
Just look at this guy and his prediction that Canadian real estate will drop 40-50%. And what does he do for a living? Oh right, he’s a financial adviser. So I guess we should sell real estate, and put it into his fund?
“When The Bubble Bursts” will sell.
But a book called, “Everything Is Fine Here, Folks” probably won’t get a look…