Missing Middle Condos Pt. 1 - Start with Why

With the Missing Middle Summit in the rear view mirror, I'm really excited about what's possible for our development industry - there are opportunities for small developers to scale up, or for large developers to build smaller projects, because neither have to deal with the time and uncertainty of rezoning applications on as-of-right projects.

Exclusively for Linkedin (and anyone with the internet, or who gets a printout from a friend), I wanted to share an expanded version of my presentation from the Summit on developing condominiums, with some additional notes and ideas I didn't have time to share. I expect this to be a 7 part series, but I may have to break out a few points between multiple articles - so stay tuned!

Whether you're developing a fourplex or a 60 unit complex, registering the building as a condo is an exit strategy to consider. I know, I'm a condo developer lawyer and I should be pumping the gas on every building going condo, not giving you tepid statements like "an exit strategy to consider". More fees for the firm! More billable hours! But that would be bad advice - fundamentally, some projects will pencil better as rental, especially factoring in government incentives - so I have to be tepid to be intellectually honest.

That all being said, here are the main reasons why you would choose condominium as your development exit strategy:

Defined Exit

Condo, especially when you've sold units pre-construction, gives you a defined exit. You know, subject to default risk, who you're selling to, how much revenue you're receiving and when you expect to have your construction lender paid back. This gives a lot more certainty to investors, and your construction lender, than embarking on a rental program on completion, and either refinancing (on terms that may not be knowable at project commencement, given our recent interest rate history) or selling the whole building.

This is a big consideration if you're interest in moving from project to project, rather than holding and letting it cashflow. If you do want to hybridize the options, registering a condo allows you to sell some units while retaining others; you'll just have to work out with your construction lender how the payout will function, and you'll generally lose most of the government's incentives for purpose-built rental.

Buyer Pool and Marketability Premium

You can, of course, have a defined exit on an apartment building of any size, by selling the whole building. Unfortunately, the buyer pool for a whole is small, and gets smaller as the building gets bigger. Retail investors could be interested in buying a fourplex, and even living in one of the units while renting out the other three, but as you get larger, your buyer pool shrinks to capital heavy institutions. The smaller the buyer pool for your asset, the more risky it is for any buyer to buy - because it's harder, if they need to sell the asset in the future, to find themselves a buyer.

Condominium units are (present market aside!) a much more tradeable asset - there are potential purchasers among investors as well as end-users. Because they can transact more easily on the open market, they each carry a premium (all other things be equal) against the building as a whole. To oversimplify, consider a truck full of Bublys. My wife won't let me buy the whole truck (apparently, we have no where to put them), but if I did, our cost per Bubly would be much less than we're paying buying them by the case, retail. I'm sure Pepsico would love if each truck sold as a straight multiplier of the case price (or even better, than can price), but there are only so many buyers in those quantities, so they get a discount to move the product.

The marketability premium is also affected by market sentiments. Some people simply value ownership over renting a property, and are willing to pay a premium above the equivalent rent for that privilege. Anywhere that rents fall below the deadweight cost of ownership (i.e. mortgage interest, realty taxes, maintenance costs, common element fees) there is good prima facie evidence of a marketability premium.

Upselling

Speaking generally, rental buildings want standardization. The more similar the finishes and features are between suites, the easier it is to maintain, buy appliances, paint and parts in bulk and otherwise operate a building. Whether you're renting out the building yourself or selling a whole building, standardization is desirable.

Individual unit ownership changes the calculation. Unit owners may want to customize their space with unique countertops and backsplashes, or move into a unit with upgraded appliances on day one. With each desired customization comes a premium that would otherwise be inaccessible in developing a rental building.

Deposits as Equity

When you sell pre-construction condominium units, your purchasers will be putting down deposits. Under the Condominium Act, those deposits have to be held in trust unless insured, but if you do obtain deposit insurance, you'll have access to a source of capital that isn't from an investor expecting part of your equity, or a lender expecting a high rate of return. The insurer will charge you a small premium to use the deposits, and the Act requires payment to the purchaser of interest at a statutory rate, but deposits are still likely to be the cheapest capital you can get.

I say likely, because there are startup costs to deposit insurance - the insurer will need to do due diligence on you and your company, and register security on your property. That all comes at a cost, and the fewer units you're developing, the fewer units you have to amortize the cost.

Who wants to be a landlord?

Right now, fewer and fewer retail investors are interested in being a landlord. Ontario has always had relatively tenant-friendly rental legislation and a landlord-tenant board tasked with seeking equity over strict justice. Frankly, as a policy position, this is one most landlords can live with. As long as you know the rules of the game, you can decide whether or not to invest in a rental property and go from there.

The state of affairs prior to the pandemic was never perfect, and I'm sure many landlords have a much more negative opinion than I do about the status quo - but the onset of the pandemic was nothing short of destructive to the Landlord Tenant Board. The Board was shut down for some time and, for various reasons, never seems to have caught up. A report by Tribunal Watch Ontario is nothing short of damning. Reported delays can exceed a year and even on successful eviction, the landlord can be left with no realistic ability to recover rent for that period.

With a smaller building, the risk of defaulting tenants is magnified. In a building with 100 units that has budgeted for a 5% delinquency rate, the owner can, in theory, afford for 5 of the units to have rent go bad for some period of time. You might develop a pro forma with the same delinquency rate for a 4 unit building, but if any tenants stop paying their rent, it's a 25% hole in revenue, not 5%. That's catastrophic.

So should I go Condo?

I am a good lawyer, I hope, so I will give a good lawyer answer. It depends.

I've listed some factors in favour, but I think it's worth modeling the different options - operating a rental building, selling a rental building, and registering and selling a condo unit - before making up your mind on your exit strategy. Keep in mind that recent government incentives - the full HST rebate, MLI Select insured mortgages, Toronto's garden suite DC deferral - all target purpose built rental and those incentives can be really powerful on the margin. Another big factor is disparity between rents and ownership prices - the ratio is different across the city, and whether or not to go condo may come down to that premium.

Once you've done your modeling, come back for part 2 (June 5, or earlier) and prepare to be regulated like you've never been regulated before.

And, before I forget - please comment! Tell me what I got wrong, or right, or didn't consider about rental or condo for your missing middle project.

Legal disclaimer: This article, and any reply in the comments, are for general information purposes only and arenot legal advice. If you are seeking legal advice for your project, please reach out at [email protected]