Over the past three years, KSV has been appointed to act on numerous distressed real estate mandates. We have closed dozens of transactions totalling hundreds of millions of dollars. Most of the activity relates to residential development projects, but there have also been commercial and industrial mandates. We have been involved in mandates across the country, but the majority have been in Southern Ontario.
Given the rise in property values of GTA real estate in recent years, the level of distressed activity may seem surprising.
The Globe and Mail recently reported that Toronto currently has 104 active cranes, which is by far the highest number in North America (the next highest city, Seattle, has 59). Another indicator is the tightness of supply in both the industrial and office markets with vacancy rates of 1.7% and 2.7%, respectively. However, in 2018 approximately 30% of the insolvency filings in Ontario were classified as real estate by the Insolvency Insider.
So why is there such a high level of distress in real estate? We have noticed several common themes, four of which are discussed below.
1. New Entrants into the Industry
Like most growing industries, real estate is attracting new entrants who believe it’s easy to be successful in the sector. (How many times have you heard “the value of real estate always rises”?) With low barriers to entry and expectations of high returns, real estate development has been very attractive to both local and foreign investors. With limited experience, new entrants underestimate the time and capital required to purchase a development and take it through the development process, which can last several years.
The process to develop a site is taking longer than ever, especially in the City of Toronto. Obtaining site plan approval can take longer than construction. Developers need to have the skill to navigate the approval process either through their experience or through engaging quality consultants. For example, on several of our mandates, the developers only had capital sufficient to fund one year’s development and debt services costs, when project approval required several years.
Lack of real estate experience by new entrants is a major factor causing real estate distress.
2. Rising Costs
Developers have seen construction costs skyrocket. A leading real estate cost consulting firm estimates that construction costs in Toronto have increased 10% to 17% per annum since Q4 of 2017. Also, development charges, which are collected by municipalities from property developers when a building permit is issued, have increased significantly. In Toronto, by November 2020, development charges for single family homes will have nearly doubled from their levels in May 2018 (from approximately $40,000 to $80,000).
In addition, due to the high level of construction activity in the GTA, the lack of availability of quality trades and manpower impacts construction schedules, which leads to delays and a significant impact on costs. Using inexperienced or sub-par trades further contributes to cost issues down the road due to deficiencies and repairs.
To compensate for the skyrocketing construction costs, developers have raised their selling prices but, in the case of pre-sales, the developer has locked in the selling prices while construction costs continue to rise during the life of the project. When the development process is taking longer and longer to complete and costs rise significantly, it can be difficult or impossible to advance a pre-sold project. Builders who are accustomed to seeing returns in the 15% range (or more) can see these returns reduced to the single digits. The reduced returns not only call into question whether the risk/reward is justifiable but also if the project can be financed.
We have had a number of projects where the construction costs coupled with delays rendered the development not viable.
3. Unsophisticated Investors
A great deal of capital has been raised from unsophisticated investors, including through syndicated mortgages (“SMI”). In one of our mandates, a developer, with several projects across Ontario, raised nearly $100 million through SMI’s from “mom and pop” investors, as is usually the case when using a SMI structure. The investors believed their investments were fully secured by real property. They were sold on the idea that the investments were income generating assets when in fact they were early stage, speculative development properties. The disclosures regarding the projects were misleading. Up to 33% of their invested dollars were paid up-front to brokers and professionals, not leaving sufficient capital to develop the project. These fees are paid at the outset.
In order to raise funds from investors, developers sometimes used appraisals that reflected the property “as developed” versus a traditional “as is” appraisal. The “as developed” appraisals assume a completed development. In one of our cases, an “as developed” appraisal was based on a twelve-storey building, but the maximum zoning permitted by the municipality was four stories! Moreover, the intended development did not even fit on the property.
Unsophisticated investors have lost hundreds of millions of dollars through syndicated mortgage investments. When these deals go south, they have little opportunity to fully recover their investments.
4. Poorly Capitalized
Developers, experienced and novice, can take on too many projects at one time. A delay or increased costs on one project can trigger a cash crisis, which then impairs the developer’s other projects. This leads to increased financing costs sourced from opportunistic lenders willing to accept greater risk – but also willing to use the mortgage as a means to own the property. Although each of a developer’s projects is independently financed, cash flow problems on one project can affect others, particularly if mortgages or other loans are cross-collateralized against several projects. The fact that there can be numerous lenders on each project also presents a problem at the time of distress because lenders have competing interests when a development goes sideways.
Increasing interest rates will also impair the feasibility of projects. Increased property values are partially attributable to inexpensive and easily accessible capital. During the real estate boom, lenders have been competing for developers’ business, driving down the cost of capital. Since January 2018, the Bank of Canada has increased its policy interest rate by 75 bps, increasing the cost for borrowers, including real estate borrowers. Even a small further increase in interest rates could cause teetering projects to fail.
Being well capitalized with access to reasonably priced capital in the event of an urgent need is an important element in real estate development.