Factors contributing to Canada’s confident real estate market

A ChAnging LAndsCApe for home BuiLders

Real estate & ConstRuCtion RepoRt JuLY 2015

Executives share their perspectives on a shifting market dominated by land scarcity and changing consumer preferences

For the last several years, Canada’s real estate market has been on a tear. According to the Canadian Real Estate Association (CREA), since January 2009, when the financial crisis shocked markets all over the world, real estate activity has steadily increased, rising 9.5% in the last year alone (on a year-over-year basis). In terms of prices, CREA indicates that the national average price for homes sold in March 2015 was $439,144, an increase of 9.4% on a year-over-year basis.

Several factors are contributing to this ongoing confidence in Canada’s real estate market:

1. From a high of 8.3% in 2009, Canada’s unemployment rate has steadily dropped as our economy recovered from the economic recession, and both full-time and part-time jobs were added as Canadian companies’ confidence in economic stability signaled the strong potential for growth. As of May 2015, the unemployment rate stood at a stable 6.8%.

2. Interest rates remain at historic lows, with no substantial increase in sight. In May 2015, the Bank of Canada announced that it was keeping its overnight lending rates at 0.75%, and economists and analysts alike expect rates to stay at current levels until 2016.

3. According to the Conference Board of Canada’s index of consumer confidence, national consumer confidence improved modestly in May 2015, largely because of a more positive outlook toward the labour market.1

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About BDO: bDo is one of the largest national accounting and advisory partnerships in Canada with over 100 offices nationwide. our professionals have the expertise to serve owner-managed businesses, large enterprises, public companies, the public sector, and communities and not-for-profit organizations in a broad range of industries. as a member firm of the international bDo network, we also have access to advisors around the globe with over 1,300 offices in more than 150 countries.

About BDO’s Real Estate & Construction Practice: Whether you are an investor, developer, builder, or contractor, the challenges and opportunities in the real estate and construction industry have never been greater. as the industry continues to face increased volatility and risks driven by economic factors, government regulations and evolving consumer tastes, executives in this sector are faced with the challenge of growing revenues in a difficult market. bDo’s Real estate & Construction practice team has a wide range of financial, advisory and industry experience across Canada and around the world. in over 50 countries, our dedicated team helps clients address their needs in key industry segments including commercial and industrial real estate development, construction, land development and home building, and real estate investments.

www.bdo.ca/real-estate-construction

1. The Conference Board Consumer Confidence Index® Increases,” The Conference Board, 26 May, 2015, https://www.conference-board.org/data/consumerconfidence.cfm.

Current interest rate, expected to stay level until 2016

0.75%

6.8%Stable unemployment rate, since May 2015

National consumer confidence improved in May 2015, largely due to a more positive outlook toward the labour market

Real Estate & Construction Report | A Changing Landscape for Homebuilders

As real estate analysts, economists and even the Bank of Canada try to forecast the future of the residential real estate market, BDO spoke to senior executives of residential developers and home builders in the Greater Toronto and Hamilton Area (GTHA), Montreal, and Calgary to get their perspectives on their industry, businesses, and changing roles. These are the common themes and insights that emerged from our discussions.

Competing for land

Although the executives we interviewed represent three very distinct real estate markets, a clear majority agreed that the competition for land is fierce and the number one market issue is a combination of land scarcity, regulation and new market entrants that are making land acquisition more costly.

In the GTHA, home builders have experienced a perfect storm of challenges, with land price, regulation and government red tape impacting development opportunities. The Greenbelt Act, which is now 10 years old, has had a significant impact on land availability as previous plots that were designated for development are now designated as Greenbelt land. At the same time, cash-strapped municipalities, unable to afford the cost of new infrastructure, are putting the brakes on approving these projects.

This is forcing some GTHA developers to consider sites and undertake projects that they would have rejected in years past. Some are even considering brownfield development, including redeveloping old parking lots, manufacturing plants and gas stations—opportunities they would otherwise pass on.

For Calgary home builders, City regulations are restricting access to prime development land. At the same time, the arrival of national and international competitors, combined with land scarcity, is forcing both horizontal and vertical consolidation.

In Montreal, some executives indicated that new players are driving up the competition and prices for land in downtown Montreal. Many also mentioned that the increasing costs have impacted their capacity to offer units to consumers at reasonable prices.

What are your top five market issues?

1. Land availability

2. land price

3. Government red tape

4. interest rate sensitivity

5. labour shortages

uBDO view

As land becomes scarcer, home builders need to search for new land opportunities beyond their normal comfort zone. The traditional land inventory model, where a developer buys a farm or other greenfield property, puts a syndicate of different home builders together to pool finances, holds the property until urban sprawl catches up, and then parcels it off in lots to individual companies, still offers growth potential. However, as costs rise across the board, having this much capital tied up in one asset while waiting for the municipality to develop the need for new residential housing can be a risky proposition. Similarly, brownfield development offers a number of opportunities to get an edge on the competition. Land costs may be lower and potential for imaginative developments higher. Yet, brownfield development comes with its own set of risks. In particular, soil remediation can open a Pandora’s box of unforeseen issues that can drive up the costs of an otherwise affordable property and erode already thinning margins.

6%Ceo

29%president

65%Vice president

participant profile Company profile

$0M -$49M

50%

$49M - $99M

30%

$100M +

20%

Real Estate & Construction Report | A Changing Landscape for Homebuilders

Changing consumer demands

For many homebuyers, the traditional days of getting married and moving to the suburbs are long gone.

In the GTHA and Montreal, the demographic known as Generation Y, make up a large portion of first-time homebuyers looking to get a toehold in the market. They want to be in the thick of the action—within walking or cycling distance to work, entertainment and amenities. Interestingly, in Calgary, despite what appears to be strong municipal support for a similar move towards urban development, this trend does not appear to be materializing.

At the other end of the spectrum, baby boomers are looking to downsize from their urban or suburban large, single family detached homes. This demographic is looking to retirement homes and assisted living facilities to live out their golden years. In the middle are young families who are looking to move back from the suburbs and into the city in search of better work-life balance. Overall, there is a shift away from large single family dwellings, in favour of smaller, more affordable, livable spaces.

In response to this demand, executives interviewed indicate a shift in the nature of home building toward urban intensification—using existing services and infrastructure to turn in-fill properties into townhomes, mid-rise and high-rise condominiums.

Across all regions surveyed, executives indicated that consumers are looking for higher end finishes and the use of environmentally friendly materials, and buildings that are conservation conscious and more energy efficient, with lower utility costs. Yet many buyers are not willing to pay a premium. A minority of home builders are meeting the demand by focusing on sustainable development, construction practices and materials. However, most are taking a wait and see attitude before investing in the development of sustainable buildings. They are more interested in appealing to the cost-conscious masses than a smaller segment of the “green” home-buying population.

Evolving the business

In a rapidly changing landscape, competition from new market entrants is of little concern to GTHA executives. Instead, their more pressing issue is how to evolve the business to sustain profitability and margins even as consumers demand more for less and the opportunities for prime land acquisition diminish. Calgary and Montreal executives tell a slightly different story, where, in addition to these issues, the emergence of new market entrants from the US and elsewhere is still key.

As developers and home builders evolve their businesses they need to establish different relationships with a greater diversity of subtrades to maintain efficiencies and project timing. They are also focusing on acquiring the right talent and implementing infrastructure to retain them, and diversifying the types of projects they pursue to keep teams working. As we mentioned earlier, GTHA home builders are looking at brownfield properties, while Montreal executives indicate that they will pursue public contracts to fill their order book, even at lower prices and knowing there are sometimes delays in payment.

Executives articulate that as the market changes so do funding models. Yet, for the right projects, with the right return on investment, funds are available. Smaller companies tend to rely on their own money to finance projects. Larger companies with good track records and a healthy mix of assets find that institutional lenders—Schedule A banks, credit unions, joint venture funding, REITs, and in some cases private equity money—are all open to providing capital.

In terms of their main risks, executives in all three geographies cited scarcity of land, market fluctuations, shifting consumer preferences, project timing, municipal policies, inventory balance, and labour shortages as their biggest concerns for long-term sustainability. Executives also indicated that due to red tape, they have to hold land longer, budget for increased carrying costs and ensure the project is still relevant to the consumers, when they are finally able to start building.

“Customers say they want environmental sustainability, but they don’t want to pay for it. Home standards are already strict for a good level of environmental sustainability, such as following ‘Energy Star’. We feel that’s as far as we want to go for now.”

– GTHA HomE buildEr

“Environmental sustainability is still a buzzword. it’s tough to place value on it.”

– CAlGAry HomE buildEr

uBDO view

In assessing the level of effort developers and home builders are willing to invest in meeting consumer demands, brand and reputation need to be considered. For many of the businesses we interviewed, their brand is synonymous with their name within the industry. In today’s digital age, where consumers’ first outlet for expressing their dissatisfaction is social media, developers and home builders need to weigh the risks and costs associated with meeting consumer demand, as well as the risks associated with choosing to ignore consumer demand, which could turn out to be more costly.

Main sources of funding for larger companies

2%5%

2%

9%

17%

29%

36%

offshore financing / foreign investors

Vendor financing

Reit

schedule a banks / credit unions

self-financing

Joint ventures

private equity

Real Estate & Construction Report | A Changing Landscape for Homebuilders

Do you have a succession plan?

Preparing for the future

Most of the executives we interviewed lead family-owned businesses where the value of their company is only as good as the number of projects they have on the go and their current land inventory. They don’t necessarily have a strategy to grow the business. Instead they are satisfied developing their current inventory and maintaining the status quo.

In the GTHA, many home builders we spoke with don’t seem to have a formal succession plan. For these family-owned businesses, there is an expectation that the next generation will learn the family business and then start their own businesses, buying properties with their own personal equity and learning as they go. So, as one generation winds down the current business, the next generation is building a new business upon which the family name and reputation—or brand—can continue.

Several Montreal executives talked of hiring and retention as a means toward building for the future. However, only a few admit to having a formal succession plan in place. Many suggested it was still too early to talk about it. Those that had undertaken succession planning tended to be family businesses that are now in their second or third generation.

In Calgary, companies seem to be more proactive, with some family-owned businesses in the process of sorting through their succession plans, while others already have fully-formed succession plans in place. One family business has taken steps to transition from a family business to an entrepreneurial enterprise complete with independent board to ensure the company’s long-term viability.

uBDO View

In a changing real estate market, dominated by rising costs and land scarcity, home builders need to be thinking about succession long before the time comes to hand over the reins. For companies in the GTHA, traditional succession, which is less about succession and more about the next generation starting their own business, there is often a shrinking of the combined family businesses. While the senior family members wind down, the next generation has yet to amass the capital base to maintain the same level of operations. As a result, rather than a straight line of growth over time, there is a diminishment in growth before the next generation business assumes its growth trajectory. For these generational businesses there is an opportunity to build a stronger business model based on the cumulative effect of multiple generations working together to build one combined business. Some companies in Calgary and Montreal seem to understand these advantages and have already taken steps to achieve it, either by inviting family members to lead different divisions within the same company or by creating an independent enterprise that can live on without family involvement, if need be.

uBDO view

Sometimes, the prospect of smaller margins leads companies to take greater risks. Although the real estate market has seen healthy year-over-year increases in activity since the financial crisis in 2009, any reversal of this good fortune could pose significant risks for developers and home builders, particularly as projects take longer to develop, and companies have to hold properties for longer before realizing any return. Low interest rates make it enticing for companies to take on additional debt to finance a diversity of projects to keep the pipeline flowing. However, those that take this route have to be confident that they can cover their liabilities if the market at best softens or at worst collapses.

Yes, we have one in place

36%

Yes, we’re in the process of implementing it

23%

no, but we’re thinking about it

9%

no, we’re not there yet

32%

Real Estate & Construction Report | A Changing Landscape for Homebuilders

The changing role of the CEO

Even as the business landscape changes for developers and home builders, many of the CEOs we interviewed indicate that when it comes to their role it’s business as usual.

In the GTHA, the role of the CEO varies from company to company. Some family-owned businesses have recently executed a succession plan that has seen the mantle of CEO transferred from parent to adult children. With a fresh set of eyes at the helm, some CEOs see changes in the operating model and infrastructure to hand day-to-day management to others so that they can focus on strategic planning. Other CEOs are in their prime and remain very hands on. Still others are looking to wind down and are taking a more hands-off approach. When asked where they see their role going in the next five years, the answers are just as varied—from getting more involved in community partnering to getting more involved in long-term strategic planning.

In Montreal, several CEOs shared with us that they are still very much involved in the daily operations. However, they would like one day to play a more strategic role. When asked about their main concerns, several mentioned still being worried about the economic situation in Québec, and Montreal in particular, as well as household indebtedness.

In Calgary, the CEOs we spoke with tend to see their role as more strategic. A majority indicated focusing more on delegation and strategic growth than day-to-day management. They expect this trend to continue going forward as many suggested their future goals were to position the business to achieve new growth targets, and to continue growing young talent to ensure the long-term sustainability of the company.

uBDO view

While the economy continues along an uncertain path, household indebtedness across Canada continues to rise, land scarcity increases and competition becomes more fierce, CEOs across the country should turn their attention towards strategic and operational planning directed at creating more agile organizations able to quickly adapt to changing market demands and less on the day-to-day running of the business.

As their role shifts focus, a well-constructed succession plan will become increasingly important. The earlier this plan is in place, the sooner CEOs can switch their attention towards strategic decision-making that puts them on a path to success in an increasingly mercurial market.

Despite the pessimism among economists and analysts about Canada’s faltering economy, our conversations with home builders in three large urban centres across Canada sound a note of optimism for the future.

Land may be scarce, yet reaching beyond the normal comfort zone of Greenbelt properties can yield surprising opportunities. Although changing demographics and the digital age have put consumers in control, there are opportunities to achieve a competitive advantage by associating a home builder’s brand with consumer demand. Yet, for all of the opportunities the future holds, home builders need to manage the risks and remain confident they can cover any liabilities they assume as they aim to reverse shrinking profit margins.

Ultimately, those that evolve their business models to adapt to land scarcity, economic uncertainty and changing consumer demands, and develop a sound succession plan that enables CEOs to assume a more strategic role, will position themselves to not only survive but thrive in an evolving market.

the changing role of the Ceo

How do you see your role evolving in the next 5 years?

How has your role changed in the last 5 years?

same

More hands on

less hands on62%

64%

27%

9%

10%

29%

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.

To learn more about how BDO can help your company with these and other challenges, contact your local BDO office or:

National Real Estate & Construction Industry Leader Dale Harper 604 443 4703dharper@bdo.ca

Montreal Chantal Cousineau 514 934 1127ccousineau@bdo.ca

Greater Toronto and Hamilton Area Tony Tartaglia905 633 4900 ttartaglia@bdo.ca

Frank DelZotto 905 946 2514 fdelzotto@bdo.ca

Calgary Matt Peron403 205 5768mperon@bdo.ca