Rental Housing Supply not likely to improve short term as developers adjust to higher interest rates

An adequate supply of rental housing is essential to restoring affordability in Canada. According to one of our recent studies, it would require an investment of at least $1 trillion to achieve this. In this context, the private sector plays a crucial role.

Nonetheless, over the past few years, the wavering economic environment characterized by higher interest rates, construction costs and development fees has put the financial feasibility of numerous planned rental projects to the test. These more restrictive financial conditions have limited the flow of private investments into new purpose-built rental housing, resulting in a decrease of planned projects and further fueling the affordability crisis.

Research conducted earlier this year showed that most of the recent purpose-built rental housing stock in Canada is owned and developed by the private sector. In order to launch the construction of new rental development projects, return expectations by investors need to be met. As a result, larger-scale developers with the deepest pools of capital and a greater ability to source upfront equity have been playing a significant role in the development of new rental housing.

Rental developers adapt their strategies to face increasing financial challenges

Purpose-built rental developers in Canada are facing an increasing number of market challenges including:

• significantly higher construction costs (+ 50% between 2020 and 2023)
• large government fees (such as development charges)
• higher lending rates

Under these circumstances, developers have adjusted in several ways; by either reducing the potential future supply of rental housing or adapting their strategies to move along new construction projects. Our Canadian Rental Housing Construction Survey (PDF) conducted in early 2023 results indicate that given the current environment:

• Most developers, especially smaller developers with larger financial indebtedness (typically between 60 to 70% of debt loans on average) were more likely to pause their new projects or reduce the number of future projects. Approximately 40% of residential developers indicated to reduce the number of future projects while over 30% indicated they would put their new projects on the back burner.
• Those with deeper pools of capital and longer-term investment horizons are likely to be active in purpose-built rental projects since these projects require significantly more initial equity than condominium projects. Purpose-built rental projects achieve positive returns over their longer period.
• Only 10% of projects are expected to be developed under a "develop to sell" or “build to sell” strategy (historically at 25%). This strategy aims to maximize the value of the property prior to selling to another investment entity.
• In parallel, more than 50% of this strategy is developed around a "build to grow" with the intention of retaining and operating the new rental project for a longer term (10 years and more).

For most rental projects planned in 2022, the limited return premiums have motivated the decisions to pause or cancel projects. Other developers who decided to move along projects saw the need to raise rents to offset increasing borrowing, construction and development costs. It is worth mentioning that developing a multi-family housing project requires several years and the timeline may vary across different cities, with some taking longer than others.

Research suggests that important financial adjustments needed to be made to ensure financial viability. These include, increasing rent prices, using lower quality materials and/or reducing the square footage of units. In this context, economic and financial conditions are contributing to the deterioration of future rental affordability.

Large rental developers have a significant impact on potential affordability

Larger-scale developers (1,000+ units) should be responsible for more than 3 out of 4 new rental units among survey respondents in the coming years. They also represent 9 out of 10 respondents who are leveraging public sector funding, such as CMHC programs, hence incorporating a greater share of affordable housing units into their portfolios. That said, market rent was mentioned as the most common product strategy.

Partnerships between larger institutional investors, such as pension funds and public companies (that is, REITs), and private developers can allow for reduced upfront cost and greater access to alternative financing. These partnerships were mentioned to be increasingly leveraged to build new rental housing.

Larger scale developers are seemingly putting more focus into creating affordable housing opportunities. Collaboration and partnerships between different development typologies and investors will be foundational in the future rental housing development ecosystem.

Recent legislation and policy changes brought forward to address financial challenges in the industry

Most developers access private capital and traditional lending to fund their investment. That said, the recent economic environment has hindered the availability of conventional credit, reflecting a diminished risk appetite by traditional lenders. In fact, developers perceived an important shift in the financial availability and the cost of financing to develop new residential construction projects.

In this context:

• Two thirds of respondents mentioned that operating in the current financial market was increasingly difficult.
• More than nine out of ten respondents indicated that purpose-built rental projects are no longer feasible with conventional debt financing.
• More than half of the survey respondents have made use of the CMHC Mortgage Loan Insurance (MLI) Select program. The prevalent response to building affordable housing seems to result in the increased use of CMHC products and programs.
• CMHC programs, notably MLI Select, may be a critical opportunity to help redefine the market approach to the development of purpose-built rental housing in Canada; and despite the increasing use of alternative financing, such as low-cost CMHC products.

In response to this increasingly restrictive financial context, the federal government has recently introduced new legislation and policy changes to stimulate the construction of new rental housing.

The enhancement of the Canadian Mortgage Bond (CMB) program: the government has announced unlocking 20 billion dollars in low-cost financing for multi-unit rental construction, which should result in building 30,000 more apartments per year.

The removal of the Goods and Services Tax (GST) on new purpose-built rental housing: this new legislation introduced in September 2023 aims to incentivize the construction of rental, student and senior housing. For instance, for a two-bedroom rental apartment valued at $500,000, the full GST rebate now available for rental housing would provide a tax-relief of $25,000.

The Canadian Rental Housing Construction Survey (PDF) is an important tool: it allows us to gather data and insights from the industry. This survey is helpful because knowledge gaps persist that prevent a comprehensive understanding of what is needed to build more rental supply.

The 2024 edition of this survey will be launched in January and target active rental housing developers and investors in the current Canadian ecosystem to continue address these gaps.

Source : Interest rate hikes impact rental housing construction and supply | CMHC (cmhc-schl.gc.ca)