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Build or reno: getting max value from apartments

  • First National Financial LP

After a lack of new construction for many years, market conditions have set the stage for a fresh wave of apartment development, according to Canada’s largest non-bank mortgage lender.

“We’re in a position for the first time in a very long time where you can say that it actually makes sense to build new apartment buildings,” says Andrew Drexler, Assistant Vice President, Commercial Financing at First National Financial. “That is because returns are starting to look more attractive when you compare them with buying older apartment buildings.”

There was a time when investors could expect a 9 per cent return on an apartment building. But the low-interest-rate environment has driven up the cost of these buildings, as it has with all types of real estate. And as buildings age, expenditures increase, further driving down return. CBRE Research has reported that 79 per cent of Canada’s existing rental stock is more than 35 years old, meaning that big repairs — and big expenditures — are on the horizon.

“What's happening now is we're down to a 3 or 4 per cent return on existing buildings,” Drexler says.

He says investors should be looking not only at net operating income, but also at net cash flows, which are better in new buildings because they don’t need new roofs, balconies, windows or other major repairs. “You can buy an old apartment building at a 3.5-to-4 per cent unleveraged return on paper, but in reality, the actual return will be much lower when you factor in the capital expenditures. Alternatively, you can build your own apartment building with a true 5-to-6 per cent return.”

A new building also comes with 25 years of depreciation, which is a big tax benefit. And new, more energy-efficient buildings help keep costs down, which further enhances your returns.

Another factor, driven in part by new condo development, is that today’s urbanites have become more sophisticated in terms of what they want in an apartment rental. They expect high-end finishings, quality appliances, balconies and lots of light.  Amenities such as swimming pools, yoga studios and a 24-hour concierge are preferred, and they are willing to pay higher rents to have their expectations met.

Jon Bester, CFO of Shiplake Properties in Toronto, confirms this trend.

Shiplake Properties is a third-generation family-owned business with deep roots in the rental business.  Its newest project, Balliol Park, is a 521-unit, two-tower apartment building in the Davisville area of Toronto, available for occupancy in June. One bedrooms rent for an average of $1,600 a month, two-bedrooms for an average of $2,250.

With all the must-have bells and whistles — rooftop pool, indoor lap pool, movie screening room and two gyms — the development has attracted significant interest since the leasing office opened in February. This isn’t surprising given that vacancy rates are low in Toronto, as they are elsewhere in Canada’s major cities.

“It’s important to ensure that you have the right location, the right layouts and the right amenities,” Bester says, as well as the right mix of apartment sizes. “If you have a good location and are on the subway line in this market, it makes it easier to lease your property.”

But that said, building a new apartment complex is not easy or risk-free.  “A successful apartment development takes a lot of precision,” he adds. “All facets of the development need to be closely managed — development planning, construction, leasing and property management.”

One challenge for would-be apartment builders is the high cost of land in desirable areas. This means that the easiest deals to make work are the ones where the developer already owns the land, as did Shiplake, which demolished 21 aging townhomes to make room for Balliol Park.

Another challenge is qualifying for construction financing, especially for the uninitiated, according to the First National’s Drexler. “Construction loans pose greater risks, so as a lender you want to make sure that you're dealing with someone who has a sophisticated builder or who has successfully built themselves. And ideally somebody who has experience in apartments, or has a partnership with someone experienced. After all, leasing a new building is just as important as building it on time and on budget.”

While new construction can be a daunting task which requires deep pockets, the right market, excellent relationships and significant expertise in building and leasing, adding value by renovating older buildings might be a good alternative for some. But as with all investment decisions, it pays to do due diligence. “You have to know how much of a premium renters are willing to pay before you borrow money to put in new kitchens or knock down walls,” Drexler says.

His advice to landlords is to renovate several units at a time upon turnover. That way, they can keep their subcontractors busy and can gain valuable insight about how much of a rent increase the market will bear as the renovations progress.

Over the years, Shiplake Properties has had positive results upgrading its existing buildings in Toronto, Bester says. It continues to see good returns, for instance, on renovations of a 575-unit apartment building built in the 1970s just south of Yonge and Eglinton.  “We complete about a dozen renovations annually in this building. Renovations include new kitchens and new countertops and we have been able to get rent increases that make the investment worthwhile”

When deciding whether to build or renovate, the first question to ask is whether you can enhance your return by bringing in new rental stocks.

“It’s all about understanding the market that you're in,” Drexler says. “Adding new rental stock is feasible now, but it’s got to be the right borrower with the right experience in the right market.”