Question: What Rents Can New Rentals Get?

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Choosing asking rents for new purpose-built rentals is one of the key tasks which developers need to get right if they want their new rentals to be successful, both in terms of being absorbed into the housing supply in a timely manner, and in terms of generating the highest possible rent revenues. If your rents are too low your building will lease-up quickly but you will forgo revenues; if your rents are too high, you’ll maximize rent revenues but may struggle with the initial lease-up and with ongoing leasing. So what’s the best way to choose rents?

During my fifteen-plus years working as a consultant in the rental housing industry, looking at rents on a daily basis across multiple markets in Ontario and meeting with a variety of clients, I’ve seen several methods used for setting rents. Some of these methods are more useful than others and some are best avoided. In this article I list these methods, rank them from least complex to most complex, and provide comments on the advantages and disadvantages of each. At the end, I suggest the method I think is best.

(1) ROLL-THE-DICE. Choose whatever rents you want and trust the huge gap that exists between demand for rentals and supply in Ontario to ensure that your new rentals are fully leased. This sounds like a crazy method, but, in most markets in southern Ontario (with a few notable exceptions like London), most developers could probably get away with this approach, asking and getting high rents, as long as there were no other new rentals to offer competition. However, this approach could easily backfire after leasing begins when prospective renters have to assess the real-world value proposition offered by your new rentals—even with demand exceeding supply, renters aren’t so desperate that they’ll pay wildly high rents. And because this approach to choosing rents doesn’t incorporate an understanding of market positioning, your new rentals won’t be positioned to compete if/when new rentals enter the market in the future: no developer wants to make large adjustments to their asking rents when competition heats up. It’s best to choose rents carefully rather than “roll the dice”.

(2) APPLY A GENERIC RENT PREMIUM. Identify rents asked by leading rentals in the host city and add 10% or 20% (or some other generic rent premium) to your new rentals across-the-board to reflect their newness and the greater desirability of new rentals compared to old rentals. This approach has the advantage of being easy to implement, but it’s too simplistic for today’s rental housing market since new rental units should be individually priced, not priced the same using a single rent premium. This method could easily leave money on the table if the generic rent premiums are too low, or it could make some units “good deals” while making others “bad deals”, creating leasing challenges. Generally speaking, it’s far better to choose rents carefully and individually after studying the market, rather than using a one-size-fits-all approach.

(3) COPY-AND-PASTE RENTS. Find new rentals in the host city and/or other cities and adopt their asking rents for your new rentals. This is a relatively simple method and in a way it recognizes that asking rents among new rentals are often similar from city-to-city and are seemingly independent of other factors, leading some to think that rents can be transposed from building to building, or market to market. However, this apparent similarity is largely coincidental and rents are not universally applicable.

(4) BENCHMARK OFF OTHER CITIES. Find cities and towns with similar characteristics as the host city (using measurements such as population growth, rental supply density, household incomes, etc.) and use rents in the comparison cities as a guide to setting rents for new rentals in the host city. This method is based on the assumption that new rentals in cities which have similar demographic and housing characteristics will have similar rents. That’s rarely the case, though, since even cities which seem similar “by the numbers” have a bunch of local factors that differentiate them. However, if these shortcomings are kept in mind, this method can be useful when there aren’t any local rentals in the host city that can be used as comparables, or when local comparables in the host city are not reliable or not relevant. There are two ways to approach this method.

(a) Benchmark Off CMHC Average Rents. Calculate the percentage difference between CMHC average rents and asking rents in new rentals in other cities, then apply that percentage difference to CMHC average rents in the host city to calculate rents for new rentals in the host city. This approach is used when the host city contains no new rentals but contains enough old rentals to form a reliable statistical sample from which CMHC can calculate average rents. The problem is that CMHC averages rents are calculated using rentals from buildings of all ages and quality levels, most of which are not comparable to new rentals.

(B) Benchmark Off Old Rentals. Calculate the percentage difference between asking rents in old rentals and new rentals in other cities, then apply that percentage difference to old rentals in the host city to calculate rents for new rentals in the host city. This approach is used when the host city contains no new rentals but contains a supply of old rentals which that can be compared to rentals in other cities which contain both old and new rentals. The key here is that the host city has to contain a large enough and sophisticated enough supply of old rentals to form a sufficiently ‘mature’ functioning rental housing market so that its rents can be relied upon. If the host city’s supply of old rentals is small in quantity, poor in quality, or otherwise not constituting a functioning rental housing market, then this approach won’t be of much use since a distorted housing supply means distorted (and unreliable) pricing.

(5) BENCHMARKET OFF OTHER NEW RENTALS. Identify the newest rentals in the host city and ask higher rents to reflect newness (but make sure that the new rentals offer superior quality offering than existing rentals otherwise this won’t work since renters will quickly see that your asking rents are not justified). This is a sound approach and pretty much the way a consultant will approach market positioning and rent selection, although most consultants will also consider additional variables such as depth-of-market, upcoming projects (the development pipeline), and asking rents in the best old rental buildings because in some cities the newest rentals aren’t necessarily performing as well as they could and thus relying on them exclusively as benchmarks could mean selecting lower-than-optimum rents. This method doesn’t require much analysis and it’s relatively safe to use because the newest rentals almost always achieve the highest rents.

(6) BENCHMARK FROM CONDOS-FOR-RENT. Obtain asking rents for new and recently built condominiums-for-rent and houses-for-rent in the host city and add a rent premium to reflect the professional leasing and operations of purpose-built rentals. This method is ideal for cities which have no new rentals but lots of owned dwelling units being rented out by their owners (which can be defined as pretty much any owned house, townhouse, duplex, or condominium being leased with or without leases, but not including holiday rentals or short-term rentals like AirBnB, etc.). In many larger cities and towns in southern Ontario this supply of non-purpose-built rentals can match or even exceed the purpose-built rental supply, although usually it’s a close second. This means that in cities such as Toronto, Mississauga, Richmond Hill, and Ottawa, which have experienced large amounts of multi-unit condominium development, non-purpose-built rentals need to be considered when choosing rents for new purpose-built rentals. When using this method you need to be aware that non-purpose-built rentals are being offered by individual owners who don’t have much rental market knowledge and often copy each other’s rents, so their asking rents typically aren’t maximal.

(7) WORK BACKWARDS FROM CONSTRUCTION COSTS. This method reverses the approach normally adopted by market surveys—which is to determine what rents the market will accept and use those rents to decide if development is justified—instead, first determining what base rents are needed to meet construction and development costs, then choosing whatever rent premiums are needed to ensure profitability. There are two possible approaches to this method.

(a) Calculate the minimum possible base rents to achieve financial break-even, then add on whatever rent premiums are needed to achieve your desired profitability. However, this approach more or less ignores the market and relies on demand exceeding supply—which in most areas of Ontario it does—and assumes that prospective renters will be happy to pay almost any rents.

(b) Calculate the minimum possible base rents to achieve financial break-even, then compare these to current asking rents among existing rentals in the host city to see how large a rent premium can be added which achieves profitability and which will likely be accepted by the market.

Which method is the most useful, or makes the most sense?

I think the method which offers the most utility is the last one: work backwards from construction costs to calculate break-even base rents, then achieve profitability by adding rent premiums based on an analysis of what rents the market will accept (method #7b, above). Not only does this method follow the most logical decision making process, both demanding and providing far more clarity than any other method, it also has the advantage of incorporating an early-stage feasibility test, which, if passed, gives the developer a measure of confidence his or her project will be profitable. If your project passes this test—i.e. if your minimum base rents are low enough that they’re likely to be absorbed into the market without question—then you know your new rentals will be profitable and you can determine just how profitable they could be.

What’s the best way to choose rents?

Here’s the best thing you can do to answer that question: HIRE A CONSULTANT TO CONDUCT A MARKET SURVEY. For most developers, especially those without a lot of experience with rentals, this is the smartest method to use. Why? Because I have found, in my experience, that developers typically do not have as good a handle on potential achievable rents as they think they do, compounded in many cases by an unwillingness to tour comparable buildings to see the competition as renters do, or even make a few telephone calls to ask about rents. No matter how closely developers think they follow the rental housing market, it’s a good idea to get an outside opinion from experts who study the rental market on a daily basis and who are able to provide you with objective, disinterested rent recommendations based on detailed and thorough market surveys. On a related note, I have also found that appraisers, who analyze rents when preparing valuations, often do not conduct market surveys as thoroughly as they could, sometimes leaving out key comparables or casting too large a geographic net when choosing comparables. (I fully understand that market surveys are not the core business of either developers or appraisers, so my comments here are simply intended to be observations, not criticisms.) Hiring an independent consultant not only helps you to avoid bringing your own biases to choosing rents, but it also provides you objective analysis and independently chosen rents in a report which you can use to satisfy your lender’s requirements. Outside consultants aren’t cheap—be prepared to pay a few grand—but they’re usually worth the money for the reasons I’ve stated. Developers need to keep in mind that they can’t be experts at everything, so it’s smart to seek out those who are experts on what you aren’t, and use them.