Shahab Valaei Sharif, Dawn Cassandra Parker, Paul Waddell, and Ted Tsiakopoulos
Executive summary
In recent years, the Greater Toronto Area (GTA) housing market has experienced drastic shifts in prices and market trends, representing shocks to the housing system that have led many residential developers to pause or cancel their projects. These supply frictions can have significant ramifications for housing affordability. To explore these dynamics, we formulated a standardized "proforma" financial model for a hypothetical high-rise condominium project in Toronto, scheduled between 2019 and 2023. The model evaluates the combined effect of market volatility and developers' price expectations on their development decisions. Ultimately, the study identifies the key drivers of development decisions and evaluates how expectation formation regarding construction costs, sales prices, and interest rates impacts the financial feasibility of potential developments. It also explains why the cascade of recent condo projects has occurred. To create publicly accessible tools, we produced Python code blocks that model the proforma and alternative expectation formation strategies, which could be utilized by any modelling team to develop their own pro-formas, or to represent expectation formation in agent-based market models.
Key findings
Primary Drivers of Project Profitability
Recently, there have been lively debates about how municipal development fees and planning charges impact housing supply and project viability. While our analysis confirms that these upfront costs do affect a project’s bottom line, we found that their impact is actually dwarfed by other, more volatile factors tied to project financing—specifically, loan interest rates, the amount of equity funds required, and the loan repayment period. Furthermore, variables that carry a high degree of market uncertainty, such as shifting construction costs and fluctuating unit sales prices, have a larger impact on overall feasibility. Ultimately, when construction costs or interest rates spike, even projects with minimal municipal fees can quickly become unprofitable.
“Boundedly Rational Expectations” and Project Cancellations
Developers—like the rest of us—can't perfectly foresee the future. Instead, they use heuristics or algorithms to form a “boundedly rational” assessment of future conditions, when they make development decisions. Our research shows that while heuristic approaches might work in stable times, they fail during periods of economic instability. Since these heuristics and algorithms mostly rely on historical data to predict future trends, they fall short of accurately capturing significant shifts in key profitability factors—such as construction costs, sales prices, and interest rates—especially when unexpected economic shocks hit the markets.
As a project moves forward, developers constantly update their financial calculations using the latest market data. When developers rely on boundedly rational expectations to update their expectations about whether a project is still profitable, they may fail to account for the effect of unexpected economic shocks—such as a sudden jump in construction costs or a spike in interest rates. As a result, a project that looked highly profitable in the pre-construction phase can suddenly seem like a massive financial loss after revisiting the financial calculations. This shift in profitability perceptions helps explain the cascade of project cancellations in the Toronto housing market resulting from recent shifts in construction costs and interest rates.
Conclusion and Policy Implications
By understanding how housing market shifts influence profitability perceptions, policymakers can better navigate the complexities of the housing landscape and address supply shortages. The paper highlights several key policy implications for planners and government officials:
- Planners require a thorough understanding of developers' expectations and decision-making processes, particularly during volatile market conditions, to effectively influence construction activity.
- Policymakers can design interventions that align developer profit incentives with affordable housing goals by utilizing localized policies such as inclusionary zoning and density bonuses.
- Delays in development approvals and opaque zoning constraints significantly increase uncertainty and financial risk for developers. There is a clear mandate for policymakers to streamline planning processes and formulate policies that create a more predictable environment, which will contribute to a more attractive investment landscape and facilitate consistent housing supply.
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Citation
Valaei Sharif, S., Parker, D. C., Waddell, P., & Tsiakopoulos, T. (2023). Understanding the effects of market volatility on profitability perceptions of housing market developers. Journal of Risk and Financial Management, 16(10), 446. https://doi.org/10.3390/jrfm16100446.