by Sandy Mandel
In a previous edition, Winter 2000 of Skyviews, I outlined a method of 'Measuring Upside'. This analytical method was devised to measure what seemed to be an unrestrained upward rent trajectory. The pendulum has swung the other way and a 'rental-supply-shortage' mind-set that developed over twenty-five years is giving way to the realization that the affordability of home ownership and the continuing delivery of investor-purchased condominium units are imposing a degree of equilibrium on the traditional apartment market. In this new market context, three types of rent structures have emerged:
Firstly, many buildings continue to have long-term tenants whose rents remain suppressed by the lingering effects of the previous rent control system. While the Liberal government's intention to repeal vacancy decontrol seems clear, this structure provides the capacity to absorb guideline rent increases to offset increases in operating costs. Depending on the degree, this rent structure may be able to absorb above-guideline-increases. Of course this structure is the most desirable. A recent sale of a rather average 41-suite building in the 416-suburbs with this type of structure reflected a capitalization rate of only 6.7%. A half point premium may apply to buildings outside the GTA.
In an 'at market' rent structure, rents for incoming tenants roughly match those for the existing tenants. While there is no rental growth, or erosion, a building with a flat rent structure is exposed to net income erosion as operating expenses rise. Expected increases in utilities are of particular concern. Recent sales of buildings in Toronto with this type of rent structure have reflected cap rates in the low to mid-7% range. Once again, a half point premium may apply to buildings outside the GTA.
Many landlords were adept at managing buildings under the soon to be repealed Tenant Protection Act. In addition to rent gains achieved under vacancy decontrol, above-guideline-increases were achieved under the operating expense and capital recovery provisions of the Act. While their rent trajectory was impressive through the late 1990s and into 2002, these buildings are now exposed erosion as the rents for incoming tenants fall below rents for existing tenants.
The question is: How do you determine which type of structure a building has? As an appraiser, I have devised the 'Internal Comparison' tool for profiling rent structures. It compares the total monthly rent to rent levels that have been achieved on recent apartment turnovers.
To illustrate this point, take three identical, 1960's walk-up 'brick boxes' that are found in clusters in may established neighbourhoods. Each building has 10 1-bedroom and 10 2-bedroom suites. Buildings A, B and C have total monthly rents of $16,500, $18,000 and $19,000 respectively. In the past six months, several one and 2-bedroom suites have been rented at $850 and $950 respectively. If all tenants turned over at these 'market' rates, the total monthly rent would be $18,000. On this basis, building A has upside of about 9%, building B is 'at market' while the rent structure at building C is exposed to erosion by about 5%.
These scenarios are more pronounced in the GTA where rental growth has been sharp in the past several years. The rental growth curve has not been as steep outside the GTA as such; the exposure to erosion is typically less. While these points set out a general valuation context, the parameters of value will be specific to each building.
This 'Internal Comparison' presents the ability to profile a building and determine the degree to which upside, or erosion exposure exists in the rent structure.