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Apartment sector update: Demand grows, but some questions remain

While purpose-built rental apartments have performed well through the pandemic, SVN Rock Advisors...

IMAGE: Derek Lobo.

Derek Lobo is the CEO of of SVN Rock Advisors Inc. (Courtesy SVN Rock Advisors)

While purpose-built rental apartments have performed well through the pandemic, SVN Rock Advisors Inc., Brokerage chief executive officer Derek Lobo believes there’s still some uncertainty in the market.

Lobo hosted a July 6 webinar to update various aspects of the apartment sector, noting an influx of building owners and developers from other asset classes because multifamily has traditionally been recession-proof and, recently, has also proven to be virus-proof.

“Buyer demand was strong before the shutdown and it’s strong now,” said the industry veteran, discussing buyer and seller sentiments.

“There are always more buyers than sellers. I can’t think of a time that I’ve been in the business where that hasn’t been the case.”

Lobo said apartment owners have had a great run over the past 30 to 40 years with an incredible bull market that should have earned them strong financial returns because suites have risen considerably in value. As many buildings and individual owners grow older, however, it may be time to consider selling.

Lobo believes this to be especially true for second-generation apartment owners who are getting older and whose children aren’t interested in the business.

However, apartment property prices are expected to continue to rise, as they have for the past 20 years, so owners may hold out to see if they can take advantage of increases.

Income taxes take a big bite out of the profit from selling an apartment building and the tax rate is expected to rise, which may make it a good idea to sell now rather than later.

“The people that have a vision are going to stay in the business and the people that don’t have a vision are going to exit,” said Lobo.

He especially believes there are good apartment acquisition opportunities in Alberta due to higher capitalization rates and quality product for sale.

New apartment construction

There are record numbers of new apartment construction permits and sites under construction across the United States and Canada, according to Lobo.

“One caution we have is that the spreads may be narrowing between the development yield and the exit yield due to increased construction costs,” he said.

“You always want to make sure that your projected rents are solid and I think that’s even more important now with the spread shrinking because of increased construction costs.”

Lobo said new apartment units are five to 10 per cent larger now than in recent years and he’s not sure if that’s a result of the COVID-19 pandemic or just a sign of increased suburban construction.

While rent per square foot is generally higher in smaller units, Lobo has seen the rent per square foot for large suites rise in some affluent neighbourhoods.

Construction costs are lower per square foot for larger units than smaller ones, so Lobo said the profit sweet spots for apartment owners are in smaller units and larger units in wealthy neighbourhoods.

Lobo has seen plenty of recent apartment development applications in several Canadian cities, most for larger and more capital-intensive buildings being built by major institutions or joint ventures.

He’s surprised there aren’t more smaller apartments being built. He said there are approximately 22,000 apartment buildings of six units or more in Ontario and about 18,000 are under 150 units. Many of those smaller apartments were built in the 1950s, ’60s and ’70s.

Capitalization rates

Capitalization rates were low in 2019 and Lobo thinks they’ll be lower in 2021, due largely to low interest rates, but there’s still some uncertainty in the market about that. Cap rates for Toronto apartment properties are around three per cent.

The spread between the national average cap rate for all real estate asset classes and the 10-year Government of Canada bond yield was 409 points in Q1 2021.

“The bigger the spread there is, I think the more uncertainty there is in the marketplace,” said Lobo. “There’s still uncertainty in the marketplace.”

Lobo thinks intergenerational family apartment owners may be looking to sell this year after going through the pandemic, which could bring more product into the marketplace and push cap rates up.

Affordable housing

“The affordable housing movement is going to increase dramatically across Canada and in America,” said Lobo. “There’s now interest from governments, from pension funds, from industry and from the public to see more affordable housing built.”

Municipalities and provinces often have different regulations for providing affordable housing, but Lobo thinks the federal government is going to make it a bigger priority, investing more money to encourage developers to build.

“I think there’s a will here and all three levels of government are moving towards policies that are more cohesive and will result in more developers building apartments,” said Lobo.

Developers should think of affordable housing as apartments with rents 10 to 20 per cent below market – but governments will offer incentives to build: “You can put less money into the deal, so your returns are better.”

Repositioning C-class apartments

Lobo is an advocate of acquiring and repositioning C-class properties in Ontario, noting this activity has created strong financial returns.

Those considering this strategy should research the prospects for property intensification and seek buildings with larger units and balconies, which are easier to reposition.

“The danger of buying C-class buildings in good areas in Ontario is vacancy decontrol,” said Lobo. “You buy a building and half the units are paying below-market rents. When that tenant moves out, you go in and fix the unit up and you can charge a much higher rent.

“If you can raise the rent by $400, you might raise the value of the unit by $100,000 even if you only spent $30,000 to renovate the unit. There’s a big delta there.

“The danger is that if the government changes the vacancy decontrol laws, or tenants don’t move, then you don’t get the opportunity to pick up that latent value.”

The turnover rate in apartments has gone down dramatically in the last few years and is now 10 to 12 per cent or lower – less than half of what it used to be, according to Lobo. He pointed out that a C-class building full of students will turn over quicker than one with other types of residents.

Other purpose-built rental topics

Lobo believes the greatest threat to the apartment industry is regulation and government interference.

Rent controls and regulations could be a future challenge if landlords are forced to spend on improvements to units and buildings for environmental, social and corporate governance purposes but can’t raise rents sufficiently to cover those expenditures.

He said new purpose-built rental apartments should include a fitness centre, social activity rooms, space for storage lockers and package deliveries, and pet facilities. In smaller buildings where such amenities aren’t feasible, Lobo suggested including a lobby lounge as an attractive addition.

When asked about the prospects for single-family rental homes and build-for-rent housing, Lobo said they’re more of an American phenomenon.

“I think it’s difficult to make it work in today’s housing market where housing prices are so high.”

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