Brandon Donnelly — Daily insights for city builders. Published since 2013 by Toronto-based real estate developer Brandon Donnelly. — Page 1308

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In yesterday’s post I made a remark that we have antiquated tax policies here in Ontario that encourage the building of smaller new construction condominiums. There seemed to be a lot of interest in that comment, and so I’d like to talk about that today.

Some people thought I was referring to development charges, but I was actually thinking of the GST/HST New Housing Rebate in Ontario . 

The way it typically works in Ontario is that when buy a new construction home, the price you pay is inclusive of HST (harmonized sales tax) and net of any applicable rebates, such as the rebate program mentioned above. 

This means that the price you see on your agreement is usually the price you pay. I say usually only because there are ways that you could disqualify yourself from the New Housing Rebate program. But that’s a different post.

So what does this mean in practice?

Let’s say you went out and bought a new construction condo for $368,200 (there is a reason I’m picking what seems like an arbitrary number). If there was no such thing as the New Housing Rebate program, then the sales tax owing on this home would be the full 13%. And that would mean that the price paid before any taxes is actually $325,841 (x 13% = $368,200). This is an important number because it represents revenue to the developer.

But since there is a New Housing Rebate program, the effective tax rate actually works out to be 5.20% for this particular sale price, which means that the price paid before any taxes is now $350,000 (a nice whole number). And so because of rebates and because they are now paying less HST, the developer’s revenue number has increased. It has gone from $325,841 to $350,000.

The way this logistically works is that purchasers usually assign the New Housing Rebate benefits to the developer who then processes all the paperwork. This is what I mean when I say that the “sticker price” is inclusive of HST and net of any rebates – it already factors in the possible deductions.

So far things are looking good. And I want to be clear that I don’t have concerns with the New Housing Rebate program in its entirety. In fact, it’s a hugely important part of the new home industry. Without it, many projects would simply not be feasible to build.

However, as the price of the new home increases (which typically happens as the home gets bigger), the rebates start to fall off. The federal portion of the rebate maxes out at a base purchase price of $350,000 (which is why I chose that number) and the Ontario portion maxes out at a base purchase price of $400,000.

What all this means is that as the unit sizes get bigger and more expensive, the effective tax rate is no longer at 5.20%, as was the case in the example I gave above. It increases. And if you hold prices constant for the purchaser, it means that the developer’s revenues now start to drop.

To illustrate why this matters, consider the following chart:

In the first scenario, the developer builds and sells 2 units for a price of $368,2000. This translates into revenue of $700,000. However, if the developer instead decides to combine those 2 units and sell the larger single unit for $733,100 (roughly double the price) then the effective rate of HST goes up and revenue drops by $30,000.

The second scenario is similar to the first one except that instead of 2 units, it’s 3 units which then get combined into one. Here revenue drops even further – by $50,000.

Now, you could argue that there are some cost savings associated with building fewer suites, but I don’t think it would offset the differentials shown above, especially if you multiply those revenue numbers across an entire project. So what this all means is that it can be more profitable for developers to build smaller units priced below the thresholds mentioned above, as opposed to a smaller number of larger units. 

Again, I’m not saying that HST rebates are bad. They’re critical to the industry. I love them. But I do believe we should be thinking about the possible implications that the current set up could be having on what we’re building and in particular on unit sizes.

If you’d like to learn more about how the rebates work, check out this PDF from the Canada Revenue Agency. I tried to keep things simple in this post.

Pre-sales are a big part of many condominium markets. The way it typically works is that developers sell suites in their building before construction has even started and then uses those purchaser deposits (which are held in trust) to obtain a construction loan to actually build the building. Part of the reason this is done is that it, in theory, reduces speculative overbuilding.

Nobody really knows the exact number, but here in Toronto many suites within a new building often end up getting sold to investors. And in some locations and some buildings, it could be most suites.

On the one hand this is a good thing. Because in a way they provide the short-term money that gets new projects off the ground. And if they end up holding onto their suites, they also become landlords for new rental housing. Here in Toronto condos have been almost the only new rental stock built in this city for decades. (Purpose-built rental is now starting to come back though.)

But one of the potential negatives is that buildings could be getting designed more around investor needs as opposed to end user needs. And that is happening because many end users – particularly when it comes to larger suites – find it difficult to make such a big life decision 3-5 years out. Doing that means saying to yourself: Okay, I’m going to buy this 3 bedroom condo today because 4.5 years from now when it’s complete I expect to be married and have 1.5 kids. Life doesn’t always work that way.

We also have antiquated tax policies in Ontario that encourage the building of smaller suites. And I believe they should be modernized. (This topic deserves a dedicated post.)

So if we are to think of these condo suites as products , then you could say that there are two broad customer segments: the investor and the end user. There are obviously sub-segments within each, but let’s assume that those are the top of the funnel.

The challenge now facing developers creating new product is that the system we have put in place arguably privileges one customer segment over the other. And it’s a problem that is somewhat unique to the real estate industry because it takes so damn long to bring new supply to the market. (If you sell jets or yachts, maybe you have a similar problem.)

Now one way to solve this might be to create lots of flexibility in the product. That is, you could allow people to adjust and combine suites to fit their current needs. And that’s what great products do: they meet specific needs and solve problems. In this scenario, perhaps the single person could “add-on” to their suite as they enter a new life phase. And indeed, this is something people are experimenting with by way of things like “ knockout panels .”

But the problems with this are twofold. 

Firstly, this requires an adjacent and suitable suite to come on the market so that you can buy it. And that may not happen 6 months before the baby comes. 

Secondly, most Toronto condominiums are built using something called shear walls. These are structural reinforced concrete walls that cannot be removed without compromising the integrity of the entire building. And most purchasers like these walls between them and their neighbors because they’re worried about noise. So combing suites isn’t always as straightforward as we might think. There are many constraints.

One way to mitigate these problems is through smaller projects. That reduces the lead time between purchase and occupancy. But I am sure there are probably other creative solutions that we could come up with to better align product and customer needs.

Earlier this month The Washington Post published an article called, There’s no such thing as a city that has run out of room .

And what it was really about was that when we say there’s no more room (I guess people are saying this), we are really saying that we just don’t want to allow anyone else to become our neighbor. Because the reality is that urban population densities vary widely around the world. So how can you really call a place full?

I’m not sure I feel this pain point as much as the author, but I always find population densities to be a fascinating topic. And accompanying the article was a tool – using data from Demographia – that allowed you to compare the population densities of various cities.

Here are are two scenarios I ran:

It’s important to keep in mind that these numbers are averages for the entire economically contiguous region. So it tells you nothing about the potential spikiness of certain areas. That’s why the population density of New York (which includes portions of New Jersey and Connecticut) probably seems low to you.

Still, it’s fascinating to see how extreme some cities – including some first world cities like Hong Kong – can be. Clearly many cities have a lot of room to become a lot more dense. And I think that would be a good thing.