This article is part of a six part series. Read the full series:
1. Government Policy & Rental Supply | Rental Housing Supply 1
2. Ottawa’s Historical Renting Data | Rental Housing Supply 2
3. Corporations | Rental Housing Supply 3
4. Individual Investors | Rental Housing Supply 4
5. Rent Control | Rental Housing Supply 5
6. Final Recommendations | Rental Housing Supply 6
Using the following IRR equation, where
“In general, businesses in a particular industry will choose the path of least resistance to best returns. When policies are enacted and they affect either the return or the path of a particular investment, the business will re-evaluate its alternatives which may involve a new path to an alternative return.”
– Christian Szpilfogel
Thus far, we have discussed the high demand for rental housing and the areas of policy that have affected the supply side of the equation. In the second article we broke down the statistical data, where we observed that demand for rental housing was rising faster than supply. Furthermore, the data identified two primary groups of rental housing supply providers: corporate investors and individual investors. In part 3 of this series, we will delve into the first of these groups, the corporate investor and rental apartment builders.
In the first article in the series, we identified that builders had alternatives to building purpose built rental housing specifically condominiums which were legalized in 1967 and new home construction for buyers that had purchasing incentives. In addition to condos being a new investment class, it is similar in process to the construction of purpose-built rental housing. When a merchant developer has a choice, they will gravitate towards the class with better returns.
Let’s begin with the pricing of housing units and focus on the Ottawa core. In the Centretown district condominiums were valued at $472,000 as of October 2019 (OREB) with a list to sold price of 100.1%. At the same time, brand new apartment units in the same area were being appraised at $330,000 per unit (Affiliated Property Group, AACI). So, on the face of it, a builder will get far more for building condominium units vs the equivalent number of apartment units.
For a builder there are other incentives to build condo units. On completion a condo will provide a higher yield and it will be faster. An apartment improves its yield over time due to the ongoing residual cashflows (ie. rent minus expenses). If you are in the business of building, then receiving that yield faster is preferred and the fact it is higher with condos is a big bonus. But there is also another more subtle impact that skews the business case in favour of condos, namely inflation and its interaction with the capital gains tax. Inflation is essentially just the devaluation of the purchasing power of the dollar. If we assume for a moment that a new building and property are well maintained and do not otherwise depreciate, the building and property would remain the same value in the future but adjusted for inflation. However, the capital gains tax introduced in 1972 does not take that into account so that same building and property are taxed in the future simply because of inflation even though the intrinsic value of the building and property have not changed. The implication is that the longer you hold an asset, the more tax you will pay simply due to the devaluation of the dollar (i.e., inflation). This again causes a business case analysis to favour a shorter completion time as the yield is not impacted by inflation.
Another incentive is that condos are often sold before they are built. This gives builders the needed seed capital to finance the construction costs. For apartments, the investors need to inject the initial seed capital to enable construction financing.
Finally, there is the aspect of HST. When an apartment building is constructed there is HST due and payable when it is complete even if the corporation building the apartment building intends to keep it for the long term. This HST is assessed at the market value on time of completion and if we use the above data then each apartment will be assessed $42,900 of HST. There is a credit offered via the New Residential Rental Property Rebate (NRRP) which is offered by the federal government but once applied, that still leaves $31,800 to be paid. Furthermore, in most businesses, HST paid usually acts as an Input Tax Credit (ITC) to partially offset the HST collected from customers. As such, residential tenants do not pay HST, thus the business must absorb the remaining HST as a form of soft cost. By contrast, the HST for the condo is passed onto the buyer of the unit and the buyer can apply for an HST rebate.
When a company assesses alternative business opportunities, comparative business cases are constructed, and key financial metrics are examined. One of the principal metrics used when comparing two or more opportunities on a similar timeline is called an Internal Rate of Return (IRR). Given the higher yield, capital investment requirements and taxes to be paid, the condominium project will almost always win. Thus, unless a company is exclusively focused on providing rental housing, they are much more likely to build condominiums.
When constructing a building, there are more costs than just simply the labour and materials, which are referred to as hard costs. The other category of costs are called (you guessed it) soft costs. These costs include all of the various fees, taxes and engineering support for the development application itself. Let’s look at an example of a typical six–unit apartment building to be constructed in Centretown. Let’s also assume that no zoning variances are required, disregarding the reality that in the downtown core, variances are almost always required.
Here is the typical breakdown of soft costs:
|Development Charges (Back/1BR)
|~ 15,000 per unit
|$12,000 + Miscellaneous Fees
|Site Plan Control & Supporting Documents
|Cash in Lieu of Parkland Fee
|~ 17,000 per unit
|Based on Land Value
|HST on Finished Price (including land)
|~ 104,000 (13% of 330,000)
|NNRP of $154,000
|Total Soft Cost = $321,000
As a general rule of thumb, excluding HST, the general formula is:
per square foot of soft costs
per square foot of soft costs
All levels of government are involved in these soft costs. The city controls the development charges and site plan control. The city also receives the benefit of the cash in lieu of parkland fee but it is mandated by the province. The federal government is responsible for the HST but in fairness they do give a partial rebate via the NRRP. The province could also help on this front as part of the HST is a provincial tax component.
There are some quirky aspects related to building code requirements and property tax laws. For example, with modern building codes, you need to provision for in-unit washer and dryers when added to modern conveniences (e.g. dishwashers, etc.) the electrical load will typically exceed 200 Amps at about 5 or 6 units. This then requires that the building be serviced with 400 Amp service and Hydro Ottawa requires that anything over 200 Amps must be buried cable. The net cost of implementing a 400 Amp service is approximately $50,000. Thus you get a large step up in construction cost at a lower unit count which spreads more cost across fewer units than before.
Another quirk in the system relates to Ontario’s property tax structure. Brand new apartment buildings generally benefit from a mill rate, similar to other residential housing. However, if an existing apartment building (Multi-Unit Residential, or MUR) is expanded to add more units than it does not benefit from the “New Multi–Unit Residential” property tax mill rate. However, if it is 7 or more units then it falls into the standard “Multi–Unit Residential” mill rate, which is approximately 40% higher. If you have, say, a 6 unit building and you wish to add a 7th or 8th unit to add more rental accommodation then your property taxes will immediately jump by 40% of the new value of the building, which typically offsets most of the revenue gain. To be fair to the city of Ottawa, they do recognize this issue and the MUR class is very slowly reducing this spread vs the new MUR class.
As a result, there is currently very little incentive to build apartment buildings with between 7 and 10 units. Thus, if the zoning does not support at least 10 units, then the business case will generally stop at 6 units. It is clear between the additional infrastructure requirements and additional property taxes that adding density to existing low rise apartment buildings usually doesn’t make for a good business case vs other uses of the capital to be invested.
There is a clear imbalance between the incentives to build, which has a direct bearing on the creation of new rental housing units. A key consideration for governments would be to look at balancing the equation where incentives can be created to justify increased focus on rental housing.
In the 1960’s and early 1970’s, when the majority of the large rental housing apartment projects were completed, builders had several government subsidies, including capital cost write offs, for the purpose of building rental apartments. Construction of apartments soared, and vacancy increased to about 6%. It is typically considered a balanced market when there is about 3% vacancy rate, so the environment at the time gave a very favourable environment for tenants to negotiate a sensible rent. In the 1970’s these subsidies disappeared as the government shifted its focus towards home ownership, propagating the implementation of capital gains taxes without consideration for inflation, ergo resulting in a tax for the devaluation of the dollar.
This interplay between the new condo regulations, loss of federal government tax incentives and the introduction of the capital gains tax, precipitated a rapid decline in the construction of purpose-built apartment buildings from approximately 30,000 – 40,000 in 1972 to around 5,000 in 1975. Vacancy rates began to drop quickly as early as 1972, resulting in increased rents. This in turn increased the imperative for the provincial government to react, leading to the introduction of rent control in 1975. It is not clear in the Ontario example whether rent controls had a direct bearing on the vacancy rates. Tenant advocates will claim that it had more to do with the significant tax changes. Landlords at the time claimed it was a significant contributing incentive to not create purpose built rental housing, but there is no doubt it is highly correlated. As we will discuss in a subsequent article surrounding rent controls, other jurisdictions that had only a rent control effect did indeed see a negative impact to vacancy. Even in Ontario when rent controls were applied to new construction activities in 1992, we observed a drop in new rental housing construction.
Creating more incentive (enough to overcome the condominium business case) to build rental housing is one clear opportunity to moderate rents. This could include targeted solutions such as what was done in the 1960s. It has been suggested by Haider-Moranis  (amongst others) that indexing capital gains cost base to inflation could also be a powerful tool, as it was done in the UK, US and Australia. This would better level the playing field for the long-term hold of rental buildings versus the short-term yield of building condos.
In the next part of the series, focus will turn to the other major demographic of the Individual Investor.
 CMHC Housing Market Insights, July 2017, Rental Ownership Structure in Canada
 National Residential Rental Program (NRRP)
 City Of Ottawa Development Charges
 The interesting history of capital gains tax in Canada — and its significant impact on real estate
Murtaza Haider and Stephen Moranis, Haider-Moranis Bulletin
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