#16 - Condo To Rental Conversions
It's like building an airplane while flying it
Condo To Rental Conversions
Rental housing is a big topic in Canada these days. Unlike in the US, rental housing is not the predominant form of multifamily construction here. Condominium has served as the main form of entry-level urban housing and also the de facto supply of rental apartments for around 40 years. There are many reasons for this, but these days all levels of Canadian government are trying to make professionally managed rental housing more economically feasible. And many condo developers are now considering converting some of their projects from condo to rental.
Let’s run through some of the main issues surrounding these conversions.
Why would you do it?
This is a tough time to be a condominium developer in Toronto.
Last I checked, pre-construction sales were down 81% from the 10-year average. In Canada you typically need to sell ~70% of your condo units before you can get a construction loan. With no demand for pre-construction units, you get no construction starts. And no construction starts means that developers are having to pay the carrying costs of projects that they can’t build. This can get very expensive. In many cases developers will need to pay for interest payments on land loans, for property taxes, site security, and other costs. If the developer is using investor equity, there may be a preferred return accruing in the background, which reduces the chance that the developer will see any promote (extra compensation based on financial performance).
This is going to be very stressful for a condo developer, its lenders, and its investors, to put it mildly.
For the last couple of years, condo developers have generally continued to take their pre-development projects through the planning process, even as demand for condo units has collapsed. The hope has been that the market will recover, and these projects will be able to advance once their approvals are in place. This has been perfectly rational. But the recovery has been slow. Many condo projects now have approvals in hand, but cannot get construction financing.
No demand → no pre-construction sales → no loan → no construction.
At the same time, the federal government has construction financing programs with very favorable terms that are only available for rental housing. It’s only natural that many of these condo developers are investigating this option for their stalled projects.
But there is a big problem.
There has been very little rental development in Ontario since the mid-1970’s. The relatively high number of deliveries over the past few years is only a small fraction of what Canada produced half a century ago. Because there have been so few rental developments, there are very few experienced rental developers. This is a problem for Toronto’s housing industry in general, and for these condo projects in particular. I could write an entire book about this, but I want to provide just a few examples of why this process can be fraught with risk for anyone trying to building rental housing, especially for a developer who is really good at condominium.
A condo developer may be more likely to make certain mistakes, compared to someone who is just getting started, because the way that condos are designed and approved is often contrary to how you’d develop a rental building. These professionals have (rightly!) earned a lot of confidence by being successful in the condo business. However this confidence won’t serve them well if they try to apply the same rules to a different game.
Let me explain.
Condo Is About Sales — Rental Is About Operations
First, the business of condo development is fundamentally different from the business of rental development. At its core, condo development in Canada is about selling most of your units before they’ve been built, at a much lower price than the remaining units that you sell at the end. This dynamic happens for two reasons. First, recall that you need to sell 70% of your inventory before you start construction. Second, people are generally not willing to pay as much for something they can’t see and touch; most (but not all) “end users” don’t buy a condo unit until construction is complete. This makes sense. A typical buyer can’t/won’t have their money tied up for three or five years until construction is complete. For these reasons, pre-construction purchases are generally made by investors who plan to make a profit by re-selling the units after construction.
If you are mostly selling a project before it’s built, that means you are mostly selling a story, not a building. Your buyers are mostly investors, looking at units on paper. They are experiencing an off-site sales center. They are thinking about the financial incentives that you’re providing, and about your reputation insofar as it impacts their future buyers. They are not really responding to the quality of construction, the convenience of getting in and out of the building, the quality of service, or how long it takes for an elevator to come to a given floor. This emphasis on story sets the incentives for condo development, which tends to, on average, focus much more on sales and marketing than on construction and operations.
Rental housing, on the other hand, is almost entirely “sold” (leased) after it’s built. Just think about your own purchasing behavior — would you ever rent an apartment without looking at it? If so, how much cheaper would it need to be, compared with an comparable apartment across the street that you could visit in person? 20% cheaper? 30% cheaper?
Renters also tend to move more often than owners. In a non-rent-controlled, Class A building in Toronto, around 25-35% of residents might move each year. That means that a typical apartment needs to be leased every three years, and your customer will be examining the apartment in person… not based on drawings that they see in a sales center. And if you think about it in a slightly different way, every single unit in a rental building must be sold every single year. This is because a renter can leave at any time, after the initial lease term has expired, if they find a better deal — a better location, a better price, or better service. You need to convince your current residents to stay put! In fact, my favorite KPI for measuring how I’m doing against my competitors is how much of a rent increase I am gaining on renewed leases. If my competitors are earning 1.5% and I’m earning 2.0%, then I know that I’m doing something right.
All of this means that rental developers tend to be much more focused on how a building operates, and they will tend to make very different decisions over the course of the development process — going right back to the beginning.
First Contact
When I get a call from a condo developer who is considering a conversion to rental, the project has usually gone through some significant part of its entitlement process already. Sometimes its zoning is complete and it is going through site plan approval (SPA), and sometimes SPA is complete and the site is “shovel ready”.
Usually during our first meeting, the condo developer will present their drawings and proforma, along with a project schedule. They will explain that they intend to raise additional equity, then submit an application for CMHC financing (usually MLI Select) and then break ground in six months or less. This puts me in a slightly awkward position, because I need to explain that just raising the equity and finalizing joint venture documents could easily take six months. Then another few months to line up MLI financing (these things cannot be done concurrently). Plus their condominium design will not work for rental. And they are missing a couple million bucks in mandatory costs like operating deficits, supplies, furniture, and equipment.
Obviously, they do not like hearing any of this! But in 100% of the cases they have been open to recasting a more realistic schedule, a more accurate budget, and making substantial changes to make their design more livable and operationally efficient.
Resident Experience
Because you need to sell a rental unit over and over again, you really need to think about the experience of your customer. You need to choreograph this experience for them — from the moment a prospective resident walks in the door to the moment they sign a lease. But your responsibility doesn’t end there. As we saw earlier, you also need to sell that rental unit to that same resident every single year because they can always move in search of better value.
Condo developers (along with architects, engineers, sales & marketing people, etc.) never need to think about this. In fact, because thinking like this doesn’t improve the bottom line, a condo developer who thinks like this will probably underperform their competitors. Here is a small sampling of some very common design choices that I see in condo projects, which would destroy a lot of value in a rental building:
Unpleasant things like loading docks, garbage rooms, utilities, and pet relief areas are located near the building entrance, amenity areas, or residents’ front doors.
Difficult or unpleasant access for move-ins and loading.
Requiring interior access to residents’ apartments for things like exterior window washing.
Amenities spread all over a building, which makes touring and accessing them difficult.
Amenities next to apartments, which creates issues with security, noise, smells, etc.
Finishes that don’t last. Wood veneers, mitered corner details, lack of corner protection, glazing in locations with lots of salt/water.
Rental Proforma
This is another topic that could fill a book, but I will give just a few examples of issues I see over and over when helping condo developers pivot to rental. On one hand, I’ve generally been impressed by the rental proformas that condo developers bring to me. They tend to be incredibly detailed and have strong justification for their various inputs. On the other hand, even among larger, well-established builders I see a few common mistakes. It’s a simple matter of experience.
Lack of capitalized operating deficits in the development proforma.
No budget for building start-up (i.e. cleaning supplies and equipment).
Meager budget for FF&E. Think about furniture longevity, and whether your furniture matches the level of product you’re signaling to the market. Would you want to sit on Wayfair furniture if you’re paying $3,500 per month in rent? By selecting the cheapest furniture, you also guarantee its frequent replacement, which will annoy both staff and residents, and might even cost you more money in the long run.
Aggressive operating assumptions. CMHC will let you underwrite 28% for operating expenses, but your competitors are spending 30-35%. Stress test your proforma and see if you would do this deal with a higher expense ratio.
Incorrectly modeling flows of funds. Make sure you understand and accurately model the timing of your sources and uses. Being fastidious with this will save you lots of time and brain damage, and it will make you look good to your investors. When can you ask for your first construction draw? What qualifies as “stabilization” and when does that happen? When do you achieve breakeven NOI? What is your peak equity, and is it different from your minimum equity? What are the requirements for conversion to term financing, and when will you realistically achieve them? Are you tracking cash deposits or Letters of Credit in your cash flows?
Rental Design & Operations
I will never forget one conversation I had shortly after moving to Toronto from Washington. I was touring a construction site with a developer, a construction manager, and an architect. This project was the first or second rental building that each of these men had ever built, but each of them had had a long career in condo construction.
When the right moment came, I asked my companions if any of them had ever visited one of their projects more than five years after it opened, to speak with building staff and ask how they could improve their product.
Not a single person had ever done this before!
Rental operations is a key lens that a rental developer needs to bring to building design. Here are a few common design choices that would be mistakes in a rental development:
Lack of storage for “attic stock” of building finishes and appliances. This means if a resident needs a stove replaced, they will need to wait until the property manager can order and deliver a new one — this can be weeks or even months. A competent manager will have spares at the property.
Lack of shop space for maintenance staff and vendors. This should have a commercial washer/dryer, 240V circuits for appliance repair, supplementary high-volume exhaust, a waterproof floor, a mop sink, and work benches.
Lack of well-located office space for leasing and/or management staff. This will increase the time it takes to meet walk-in prospects, and will create an awkward sales experience when it comes time to negotiate and sign leases.
Poor building access. This one is huge. Move-in day is a stressful, emotional experience for most people, and it’s a resident’s first real impression of living in your building. If you want to get a bunch of 1-star Google reviews and tank the value of your building, having a painful loading/move-in experience is a good way to do it.
Poor acoustics. This will likely be the second or third most common complaint that residents have when moving out of your building. Hiring a consultant is not good enough. As an owner you need to be personally checking these details — they are very easy to get wrong, and they have a huge impact on the quality of your residents’ experience. I have personally audited the length and color of screws that the drywallers were installing to make sure they were following our acoustical details.
A Playbook For Rental Conversion
If you’ve made it this far, I hope you have an appreciation for how different a rental building must be, compared to a condo building. If you’re interested in converting your condo project to rental, please get in touch. Imprint can help you work through each of the key steps.
Construction Financing. Unless you have experience with rental construction and term financing, I generally recommend using a broker or advisory firm. This person will provide valuable feedback on proforma inputs.
Equity Raising. You will usually need more equity for a rental building, and you will be drawing from a different pool of investors. These groups are not very active today, and they have a lot of projects to choose from. You may want to engage a broker. Forming a joint venture will probably take several months (at minimum, if all goes very well), so plan accordingly.
Design Review. Unless your architect has done many rental projects with many years of stabilized operations, you should hire someone to do a comprehensive review. There are only a few experienced rental developers, and most of them don’t do outside consulting.
Marketing. Let the public know when you will open your doors, and start to build awareness about your product offering and value proposition. How are you different from your competitors? What level of service can your residents expect?
Property Management. You want to have this company lined up before you start construction, and ideally before you submit for permits. That doesn’t mean you need your property management agreements signed. Many property managers will provide feedback for free, or for a reasonable fee, depending on the scope you need.
Staff Up. At minimum, 3-4 months before first occupancy you should have your general manager identified, and your senior maintenance person/building engineer. We would develop a staffing plan, and use the time leading to building launch as a training period for your team.
Pre-Leasing. My advice is usually to avoid a lot of pre-leasing. At the same time, pre-leasing is a great way to train your staff and get the team to gel before opening day.
Regulatory Compliance. Each city is a little different, but make sure you understand what it means to be a landlord in your jurisdiction before you open your doors.
One final note about the risk of mistakes in rental versus condo.
Your profit in a condo deal is, roughly, your total revenue minus your total costs.
Your profit in a rental deal is, roughly, the present value of the future cash flows at stabilization, minus your total costs.
Making poor design decisions in a condo building is only likely to impact your asking prices for the units you sell after construction. Making poor decisions during design and operation of a rental building can easily shave $0.25 or more from your monthly rents, forever. If you assume a 4% exit cap rate, every $0.25 that you lose is approximately $5 million in lost profit.
That’s why it’s so important to seek help from seasoned rental professionals who can help protect your investment. Click below to start this conversation.
That’s a wrap.
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Thank you for reading. Wishing you all a peaceful and joyous holiday season.