For the last 30 years new apartment building construction has been almost non-existent in Canada a situation that started to change barely five years ago. Now there is a flurry of construction activity taking place in selective locations across the country as a healthy demand for rental and economic conditions merge to make purpose built apartment buildings viable.
In two cities in particular, Halifax and London, there are developers who have taken an interest in constructing new apartment buildings, which are primarily higher end luxury units, and they are running with the ball. There are other pockets of apartment development in Vancouver, Edmonton, Calgary and Ottawa where builders are willing and market conditions are favorable.
The surge in the construction of new apartments can be attributed to falling cap rates, low interest rates combined with CMHC financing, rising demand from population growth, immigration and changing demographics, and surprisingly, the strength of the condo market.
In London, Ontario, Tricar, Drewlo Holdings Inc. and Old Oak Properties, three locally based businesses, have all completed projects. There were more than 1,000 units constructed in one year in London according to Derek Lobo, CEO of ROCK Apartment Advisors Inc. a pattern that he expects will be repeated in other cities.
There is no single reason that the new apartment construction market is once again becoming attractive to builders – it is a cocktail of factors that have emerged over the past decade. Property Biz’s short form interpretation of why new apartment buildings make sense according to Lobo is ..
—- Cap rates have compressed. Interest rates have gone down. CMHC lending has taken them even lower and rents have increased. Pent up demand for rentals has created a ‘Class A’ tenant. As a result of all that a ‘Class B Builder’ with CMHC backing is seen as a reasonable risk by lenders. Builders have built. Tenants have rented. —–
This is a synopsis for a set of conditions that have been years in the making and there is really a lot more to the story. Lobo whose boutique commercial real estate firm is exclusively focus on the apartment industry also advises developers on new apartment development provided a more detailed explanation.
Cap Rate Compression
In the 1990s cap rates started to decline from the 9 per cent to 7 per cent range depending on the product. In 1998, a watershed year as Lobo described it the Province of Ontario removed the rental rate limit on newly vacated units. Cap rates started to compress to the point that what had been a 7 per cent lower limit became the new 7 per cent ceiling.
From 1998 through to 2008 cap rate compression continued finally leveling off at the 5 percent to 6 percent range depending on the building. From 2008 to the present apartment buildings have been the only asset class that remained steady at around 6 percent for most buildings and below 5 percent for premium assets.
Low Interest Rates
Interest rates are at near-historic lows and they are expected to remain stable until the economy starts to truly recover from the recession. “Five year money is now available below 3 per cent which is extremely low,” said Lobo. “Interest rates have dropped to the point that money is almost free.” Low interest rates coupled with CMHC secured lending has provided attractive financial proposals for builders to take to lenders.
Pent Up Demand
Next to cap rate compression, Lobo attributes huge pent-up demand for rental units through population growth, immigration and demographic change as the second most important factor driving the market. About a third of the tenants for new construction units are seniors, the remaining two-thirds are young professionals and both groups are in a position to rent in the luxury apartment market.
Condo Market Growth
Growth in the condominium market over the past 20 years is another trend that Lobo identifies as being instrumental in creating the new construction market for apartment buildings. While the prevailing notion in the multi-residential sector is that condominiums are bad for rentals, he thinks otherwise.
Prior to the condo boom there was no luxury market for apartments Lobo explains. The condo rental market has set a new higher standard for the quality of a multi-res unit when compared with the existing stock of apartment buildings.
A new luxury apartment is available at a slightly higher rate than a condo rental. Tenants are willing to pay a premium for ‘condo’ quality rental and furthermore for the security of knowing they will not be asked to leave due to an impeding sale.
“Condos effectively ‘incubate a renter’ to become a tenant in an apartment building explained Lobo. “Condos have created a luxury rental market.“
Developers Take Long Term View
The developers engaged in apartment construction are typically already apartment building owners and privy to the challenges of operating an existing rental property. While the resale value of an older apartment building is currently less than the replacement cost, a phenomenon that is unique to this asset class, the situation is changing.
“Since 1998 rents and values have been increasing and things are becoming more balanced”, said Lobo. A comparison to existing apartment buildings that takes into account depreciation of the older buildings and the associated deferred capital expenditures are all factored into the developers’ view of the market. Justification for proceeding with new construction is therefore closely tied to taking a long-term approach, ten years or more, with the assumption that there will be a sustained demand for rental over that time period.
New apartment construction is gaining traction across Canada, a trend that is surrounded by a complicated set of circumstances. Property Biz Canada will continue to track this topic in future editions of the publication.