The Rental Shortage

The Tyee has had an interesting series of articles on the housing market of late and the latest in their installment is The Path to New Rental Homes: One Broker's View by guest poster David Goodman. I encourage you to read the post as it highlights some of the technicalities surrounding building rental housing in the Vancouver area. Certainly it seems, on the surface, to be a bit of a quagmire.

First he starts off by setting the scene:

During my 26 years in apartment sales, I've heard on at least 50 separate occasions developers commenting that "even if the land is thrown in for free, we cannot make the numbers work on a new rental building." As a result, the Vancouver vacancy rates stands at 0.5 per cent, the age of the average purpose-build rental is 50 years plus, and local developers attempting to produce new rental housing are likely to lose money.

So developers cannot "make the numbers work"? Sounds reasonable. But I don't really get it. The vacancy rate is low, apparently signaling low supply. I would expect rents to increase to compensate for the low vacancy rate. I wonder why rental rates aren't increasing -- maybe the vacancy rate isn't as low as he is citing? He continues:

Things changed considerably in the early 1970s when the strata condominium was introduced to the market. This new concept provided buyers, including tenants, the opportunity to purchase and own their own suite rather than pay rent. Prices paid for condominiums were soon much higher than rental apartments. As a result, land quickly increased in value to reflect the fact that building condominiums was significantly more profitable than building rental apartments. Accordingly, except for very few special situations, the construction of purpose-built rental properties ceased. This situation has not changed much since the 1970s.

Ahh now we get to it. The reason purpose built apartments have not been built is because building condos is more profitable. It certainly seems that, given the horrid price to rent ratio in the city, any developer would be batshit crazy to build something with cash flows unlikely to cover debt repayments and other carrying costs (except with a large downpayment of course! haha).

Over many years, the developers of condominiums would assemble single-family lots in apartment-zoned areas or seek to rezone former industrial sites. Unfortunately, we have almost exhausted the conventional source of residential development land throughout the Lower Mainland. As a result, the cost of multi-family zoned land and the resulting new condominiums have increased much further in Vancouver compared to other parts of Canada. This is one reason why we have all heard of some prime Vancouver sites selling at over $200 per square foot gross buildable at the recent peak of the market.

The old faithful "running out of land" argument. Can we be so sure about this? Maybe it seems land supply is tight because there are so many projects under construction? The population didn't suddenly explode in the past 5 years and hit the buildable land brick wall. It is entirely possible what we are witnessing is underutilisation of existing housing and speculation. If we were truly land constrained wouldn't real rents be increasing as well? Strange how they are not.

I have learned to appreciate the important real estate concept known as "highest and best use" in considering the value of real estate.

Developers and value investors share this philosophy. But the difference is what "value" means. For the developer it's a very simple and short term calculation: build within one or two years and sell, pre-sold or on spec, to someone else, likely a speculator (in one form or another). This dude either occupies it, using the full brunt of his ownership premium, keeps it dark for a flip, or rents it out at a yield a developer wouldn't touch with a ten foot barge pole. Value investors, on the other hand, look at "highest and best use" more on what cash flow is possible. It may mean re-development but only because doing so generates higher rents to compensate for the construction costs and delay in occupancy. I have no clue the thought patterns of Mr. Goodman's current clients though I would expect, given they are the "dudes" buying the bags, it's not exclusively a value play.

Purpose-built rental housing is not being built because of more profitable alternatives to the developers, namely selling it to someone else to deal with. I laugh when I realise the rental vacancy stats Mr. Goodman cites don't include small time landlords to whom his developer acquaintances sell. I am sure regulation plays some part but give me a break -- even if we remove every shred of red tape surrounding rental units it still wouldn't make sense UNTIL THE RENTS CAN COVER THE THE CARRYING COSTS.

It is laudable Mr. Goodman's suggests to streamline the ability to build purpose-built rental housing again but to think doing so will suddenly swing developers into the rental camp again is a bit too "rich" for me, at least until land values drop or rents increase to where it makes financial sense. I encourage him to keep priming the pump for such an eventuality.