The real estate market in Ontario – What’s really going on?
The media is filled with articles and commentary concerning the “red-hot” residential real estate market and the current environment of sky-rocketing housing prices, bidding wars, supply shortages, and rent increases. Both nationally and internationally, there are continued warnings of a “bubble” in the Canadian housing market, the level of consumer debt, and the potential dire consequences if the “bubble” bursts.
The Toronto Real Estate Board reported average residential home price increases of 17.3% in 2016, and year over year to May 31, 2017 price increases averaged 29%. The Toronto skyline is filled with cranes, and Zoning Application signage for new condominium and other projects is posted throughout the city. Vacant land is scarce and development outside Toronto in areas such as Hamilton, Stoney Creek, and Milton is robust. Rental apartments are in short supply and all the above factors recently caused the Ontario Liberal Government to, among other measures, amend Rent Control legislation and introduce a foreign buyer tax of 15%.
On the other hand, over the last two or three years there have been several high-profile insolvency proceedings of developers and, in certain instances, associated financing entities across various asset classes and involving different financing structures. Some of these insolvency proceedings in Ontario, which are in the public domain, have included:
- Hush Homes Inc. – Residential developer
- Urbancorp Inc. – Developer of low and high rise residential
- Mady Development Corp. ( certain projects) – Residential and commercial developer
- Titan Equity et al – Financing and development
- Tier 1 et al – Syndicated mortgages and development
As well, the effects of the recent high-profile OSC investigation of publicly traded Home Capital has served as a warning of how jittery the public and investors have become, as they remember the sub-prime meltdown in the US.
Given the robust real estate market, it seems counter-intuitive for entities of this magnitude and presence in the market to have encountered such financial difficulties. Upon reflection, however, the common themes below emerge, which should serve as lessons to developers, lenders, and investors alike.
With the frothiness in the real estate market, the development and related financing markets seem to have become inundated with new names, all with slick marketing materials promising quality product at “reasonable” prices, and for investors, above-average market returns relative to other available products.
Peel back the “onion” however, and with some proper diligence you may be surprised at the level of expertise, infrastructure and the experience, or lack thereof, of either the developer or promoter of the financing product.
Little or no direct experience in development or financing will likely lead to trouble down the road, particularly as these markets get more crowded and the supply of product (land held for development) at reasonable prices dwindles, in the context of the proposed development.
A development business usually starts off as a single-purpose entity with a specific project to be built out. Often though, a development business, like other businesses, does not remain static. New opportunities are presented or arise and growth-seeking entrepreneurs are attracted to such opportunities. But, growth inevitably changes the dynamics within an organization – financing, planning, staffing, and other resource requirements change and must be monitored accordingly. Projects and assets within different classes must be managed to diversify risk to the organization. Too often as the business grows, project requirements, timelines, and financing needs change and if not managed and planned appropriately, can wreak financial havoc throughout the organization. Profitable projects, including the notional equity that may exist, are used to finance other projects which may not be performing as planned, thereby potentially draining an organization’s financial and human resources.
The range of available financing alternatives and structures has grown and changed as the real estate market has flourished. For well-established developers and for projects meeting traditional lending criteria, capital is readily available. For others, who may be new to the market or who don’t meet the funding criteria of traditional structures, alternative financing structures and sources have become common place, such as: alternative high-interest and mezzanine lenders, Mortgage Investment Corporations, Syndicated Mortgages, and private REIT vehicles. Some of these investment vehicles themselves have run into financial difficulty and tarnished the reputation of others in this marketplace, as everyone became “painted with the same brush”. Difficulties have resulted from a lack of financial management experience and oversight and inappropriate expansion. Several high-profile business failures of developers with improperly structured financing at unsustainable interest rates, given a project or the overall business status, have also occurred.
Projects generally start with a vision, budget, and timeline to completion. The execution of a project may falter, however, for a variety of reasons including lack of development experience, expansion at too rapid a pace, time delays, or insufficient or improperly structured financing. Delays cost money and can lead to a never-ending downward spiral. At times, project equity or unencumbered development assets are required to be pledged or liquidated to keep projects moving forward, which has the effect of hobbling future activity and growth. From an investor’s perspective, repayments may not be made on time or at all; there is an inability to obtain credible information and promises are continually broken. What started as a simple investment in a single-purpose entity or project may have morphed into a drastically different investment and risk profile.
In today’s social media filled world, it is all too easy for a company’s reputation to be publicly tarnished. Once that happens, doing business in the normal course becomes difficult. Management’s attention gets diverted away from daily activities necessary to lead the business. This problem is exacerbated if regulatory bodies such as the OSC, FSCO or Tarion are obliged to make public disclosure of facts, or take action, that impact either a developer or an investment vehicle or its principals, which are subject to regulation. Loss of reputation can cause a development business to come to a grinding halt as constituents lose faith in management.
While developing and investing in real estate can be rewarding and lucrative, developers must ensure that management expertise, systems, financing, and controls are in place and suitable given the nature of current activities as well as future plans. Lenders should ensure projects are being executed according to plan and on budget, either directly or with the help of cost and other consultants. Growth in the business and financing structure should also be assessed regularly to obtain a complete picture. Investors should assess their risk appetite, an investment’s structure and risks, and the manager’s experience and history over time prior to deploying funds. In this way, unexpected surprises and financially devasting consequences can be minimized or avoided altogether.