Inclusionary Zoning in Toronto: Game Changer or Deal Breaker?

Ontario’s Affordable Housing Taskforce recently released a plan to increase the supply of housing across the province.

One tool that Toronto and other cities are beginning to utilize is inclusionary zoning. Inclusionary zoning requires affordable housing units to be built as part of a new residential development, but what is being touted as a game changer could also be a deal breaker for many developers.

Market watchers are suggesting that development land may need to be repriced, but there are many factors at play.

Grant Chernenkoff is a Director with CBRE’s Valuation & Advisory Services group and runs the Land Valuation Practice with Vid Stambolovic. Grant has specialized in real estate, finance and development land for over 15 years and he recently explained how inclusionary zoning affects development proformas, how developers might respond to affordable housing requirements, and what impact inclusionary zoning will have on development land values.

What impact will inclusionary zoning (“IZ”) policies will have on underlying land values?

Without many test cases, the exact impacts are difficult to quantify. At this point, no potential development sites have been sold at a materially lower price point than would otherwise be expected in the wake of IZ bylaws. However, some logical assumptions can be made as to what’s about to happen. 

What factors currently determine the value of land?

Land values are fundamentally driven by what can be built and the type of use permitted on site. Not all buildings and uses are equally profitable. Profitability can be defined as the difference between revenues and the costs, which includes an acceptable level of to the developer. Some people question the need for profit, but developers assume huge risk and expend significant effort to deliver new housing units. If there is no profit, there are probably no units being built by a private company. 

Won’t profits and land values be maintained due to affordable unit cost savings?

Hard construction costs are relatively the same for both market and affordable units. Cost consultants indicate that components in affordable units are not significantly discounted compared to a market-priced component of a similar size.  While the level of finishes may be somewhat lower, the overall impact to a construction budget is quite limited and potential costs savings are outweighed by the overall reduction in potential revenues arising from the affordable housing component.

How does the new math impact development proformas?

There will less flexibility in development proformas as revenues fall and costs rise. That leaves three possible “relief valves” to ensure residential construction remains viable where there is inclusionary zoning:

• Higher pricing for the market rate portion of the project
• Lower acceptable profit margins for developers
• Lower overall project costs.

What path forward would most developers prefer?

The preference of most developers is to increase the selling price or rental rate for the remaining market-based units in a development as this would have the least overall impact to the development process. However, this assumes that the market will bear price increases and we all know that housing affordability is an issue for so many people. If not, it’s hard to see how development projects move forward.

What about adjusting profit margins to decrease costs?

Decreasing profit margins is an option, but development margins are not as large as some might think for high-density development projects to begin with. Typically, profits range anywhere from 10% - 15%, so it wouldn’t take much to reach a point where a developer wouldn’t see the financial incentive to build.

What about lowering overall project costs?

New mechanisms or incentives would be needed to change the math in any significant way because savings won’t be found in the construction process. New IZ legislation doesn’t currently include provisions for lowering municipal fees for the mandated affordable component, so there are no savings to be had there.

What’s left to reduce in price?

That leaves only one cost input that could be meaningfully reduced – the price of the underlying land.

The path forward is some combination of market pricing, profit margins and land values. However, it seems likely that pressure will mostly fall on land values as that is the only surefire way for developers to maintain acceptable levels of return for the risk involved with residential construction.

Will land prices actually fall?

Just because development underwriting supports lower land values does not mean that market participants will sell and accept lower prices. Entrenched positions could reduce liquidity in the high density residential land market due to a bid-ask spread.  This could lead to an even further reduction in new housing supply, which would put further upward pressure on new product pricing and rental rates, creating a vicious circle.

In short, IZ is no quick fix and could have unintended consequences.