The impact of housing affordability on commercial real estate

It’s no secret that housing affordability is a widespread issue in many parts of the world – especially in those regions which see an exceedingly high demand for housing, despite having a limited supply of housing to meet that demand. This predicament famously plagues major cities like New York, Los Angeles, San Francisco, Vancouver and Toronto; in fact, Toronto and Vancouver were recently ranked among the top 5 least affordable housing markets in the world, a category reserved for markets with a price-to-income ratio of 5.1 or more.

The negative implications of a housing affordability crisis are, of course, well understood and often the subject of debates between political leaders and industry experts – but this impact is not exclusively felt within residential real estate. A housing affordability crisis also has a significant ripple effect into the world of commercial real estate and can negatively impact future commercial and residential development.

When housing becomes less affordable, it can change employment trends. These patterns limit economic growth and affect the demand for rental properties, including commercial properties. In a recent episode of the CRE Exchange Podcast, Aviva Fink, Vice President of Global Marketing at Altus Group, welcomed experts Peter Norman, Vice President & Chief Economist at Altus Group, and Omar Eltorai, Director of Research at Altus Group. Peter and Omar offer a US and Canadian perspective on housing affordability, its effect on commercial real estate, and their predictions for how things may play out in the short to medium term.

After the dust settled: Post-pandemic ramifications on housing affordability

Housing affordability is a multi-faceted issue that means different things to different segments, depending on how you look at it, and how you measure it. “First and foremost, housing affordability can be measured by looking at flow metrics, such as what your housing payments would be on a mortgage on a typical house versus your income,” explains Peter. This is a reasonable, rudimentary way of measuring whether the housing market is affordable or not, and this same approach can be applied to the rental market. “We tend to measure these things relative to income, and income is something that can be easily measured. But realistically, what we want to think about when we're thinking about affordability is where does housing sit in the pantheon of needs and goods that an individual or household needs to spend on?”

Everyone, of course, needs to spend on their shelter, in addition to food, and some other categories of goods and services. “And the more expensive homes are, the more expensive rents become, and that inevitably begins to infringe on one’s ability to spend on other things,” Peter notes.

Many of the factors that drive up the cost of housing, whether it’s rented or owned, have been undeniably exacerbated by the pandemic. “Right now is a pretty unique time, in the sense that we are getting hit with a number of trends that started during the Covid era, inflation being a big one,” explains Omar, adding that beyond the obvious implications on home ownership and rent costs, it now costs more to operate a building. “Multifamily is one of the more expensive buildings to run in terms of overhead costs related not only to utilities, but also marketing, personnel, and more. Ultimately, it's a thinner margin business, so when there is inflation, operational expenses increase, and owners look to offset those costs.”

At the same time, we recently transitioned from an economy in which money was free – or at the very least, incredibly cheap – to an economy in which money costs something again. “When money was practically free and people could move and work from anywhere they wanted, we saw the ‘flight to the suburbs’ trend emerge,” notes Omar. “All of a sudden, a lot of people were willing to spend their income on a limited supply of housing, and this invariably drove prices up. Now that borrowing has become costly again, everything is reversing, and those hoping to buy may no longer be able to reasonably afford it, and may be stuck renting for longer.” As prospective buyers halt their search for a home due to economic uncertainty and borrowing costs, rent costs are likely to continue on an upward trajectory.

The impact on commercial real estate as an asset class

“When you're thinking about all of your asset classes and you're thinking about a community, there’s always going to be a need to build out developments in a mixed-use kind of way,” explains Peter. “But when housing affordability issues arise, it also has an important impact on the mix of uses you need and can viably build in your community, and how assets are going to perform across different types of asset classes. So in a market where housing affordability is starting to get more and more constrained, like San Francisco, New York, Toronto, and Vancouver, etc., you have to consider what kind of an impact that is going to have on your ability to build out and maintain other types of assets.”

There is a significant budgetary impact to be considered across markets struggling with housing affordability. The longer households are spending more on housing, the less financial bandwidth they may have to allocate to other categories, such as retail. “If you own a number of retail assets in a given market, you probably want that market to be one with affordable housing, as that lays the foundation for a well-functioning community,” explains Peter.

Similarly, the office market thrives in areas with strong economic development. “I think it’s fair to say that economic development and housing affordability are very strongly linked,” shares Peter. “In a market that becomes too constrained, you're simply not going to have the inflow of the labor force that you need to build jobs, fill offices, and create that kind of demand.”

The most obvious solution to a housing affordability crisis, Peter notes, is to fix the supply side of the problem by building more housing. “If only it were that easy – but in many cases, building new housing (and building it quickly) can mean being more flexible with some of your other assets.” The office market, in particular, is soft right now in many North American markets post-pandemic as we go through something of a transcendental shift in terms of office demand, but we also have lots and lots of B and C class buildings that are ready to be converted into housing projects. Even class A needs to be considered. Class A buildings may not be the best candidates for conversion, but stress in the office market now in most cities means there’s very little need to build more, and lands set aside for new office should now be considered for housing. “And yet, we still have a lot of jurisdictions where governments are not fully on board with this concept. In Canada we've got some cities with zoning by-laws that make conversion or redevelopment for residential uses very difficult or even impossible,” Peter explains. “So, we see this obvious opportunity to transform some assets into other property types which could, in turn, positively impact the affordability issue by injecting more supply into the market where new development rates can’t keep up. Unfortunately, policy constraints sometimes stand in the way of making this sort of thinking a feasible reality.”

Expensive housing, expensive money

If multifamily is one of the most expensive asset classes to maintain and manage even without turbulence in the market, what happens when cost of capital increases significantly? Where does this leave the industry?

“If you’re looking at it from a development standpoint, I think that it can become pretty clear – looking at your financing options is math, right? Inflation has also really rocked construction, in the sense that materials and labor costs are still high, and they’re never in deflation,” Omar notes. “They’re never getting cheaper, the long-term trend is that they’re more expensive, but just at different paces. So right now, we're very much in an environment where costs really do constrain whether or not a development project can get off the ground. You also have to consider the political hurdle, in the sense that navigating red tape (permits and other regulatory barriers) comes with a time cost as well.”

It's also important to recognize that the overall net operating income (NOI) margin of multifamily is relatively thin when you consider it against other property types; moreover, owners and operators typically can’t pass down those expenses to anyone other than the occupants. These trickle-down costs, paired with inflation, create an environment largely unequipped to ease the affordability pains being felt in various markets. “When overall prices trend up, the property type will often keep adjusting,” notes Omar. “But there is a concern that if you can't keep your rent growth – whether it's a deflationary effect or due to expense increases – you can't get positive rent growth, and that’s when you start to see your margins collapse pretty dramatically.”

The Government’s role in housing affordability

General affordability, Peter explains, speaks to the idea that a typical family (working class, middle class, etc.,) should be able to find housing that's appropriate to their income. “But there are also families who are in need of deeply affordable units, and each market needs to have a sufficient amount of those deeply affordable units to ensure – from a social policy standpoint – that you're providing shelter to those who need it,” he shares. “So I think policies need to be cognizant of both sides of the coin at the same time, and work to address it. We like income support schemes for families that are in need because you can design them in different ways, but shelter allowances for families in need can then allow them to participate in the open market and to be part of the supply and demand of housing on an equal footing.”

Ultimately, governments should be directly involved in the provision of deeply affordable units within the markets they serve, but not at the expense of other housing, Peter adds. “I think the government needs to plan for communities in a comprehensive way that provides an adequate range and mix of housing for the expectations. If you've got policies that have the wrong mix of housing between, for example, apartment projects and single family, compared to what the market is looking for, that will create a market imbalance.” Market imbalance, as you might have guessed, leads to affordability issues. “So we like to see planning policies that reflect what the future needs of the community actually are.”

In Canada, specifically, the market finds itself gripped by foreign buyer bans, ushered in by the notion that it was foreign investors contributing to the burgeoning affordability crisis. “In reality, foreign investment was actually helping to create supply, and the bans that have since come into place are one of the issues now exacerbating the affordability crisis,” explains Peter.

Inclusionary zoning policies are another hot button issue impacting the housing sector, Peter notes, explaining that these policies aim to provide subsidized housing by mandating a certain number of deeply affordable units in any proposed development project. While this may sound great on paper, these subsidies are coming from the other units in the project, rather than from the government. “So you’re effectively inflating the price of market housing in order to subsidize the deeply affordable units,” he explains, once again reiterating that deeply affordable units should not come at the expense of other housing. “Predictably, a lot of these projects simply don’t work, or if they do, they push up the price of market housing and exacerbate the affordability problem. So, I’d like to see more strong planning, subsidies going directly to those in need, and an adequate supply of the right range and mix of housing.”

Paving the path to affordable housing with incentives

Omar notes that, in the US, there are agencies that are very active who recently had their scorecard updated. “Their regulator essentially tells them, this is the amount of money we want you to put towards these missions, and it effectively broadens the scope – which is a good thing,” he shares. “The jargon in the US is Capital A versus Lowercase A. Capital A refers to properties where, let’s say 30%-50%, of the properties will qualify for some of government program.” Another program that has proved helpful in the US, he adds, is LIHTC (Low Income Housing Tax Credit), which offers lower taxes to support investment in low incoming housing. “The success of these programs and structures, at least in the US, should point us in the right direction of how greater affordability can be achieved through financial incentives.”

However, more emphasis is needed on development financing. “The issue really is supply, as Peter pointed out, and while there are some programs that do support development, it really requires the project sponsors to jump through a lot of hoops, and often extend timelines,” he explains. “It could be easier, and affordable supply could hit the market faster.”

The good news, Peter notes, is that multifamily (and just residential as a whole) is by far the largest real estate or built space, and it's the one that typically matters the most to politicians and constituents. “Royal Bank also puts out an affordability index that is monitored on a quarterly basis, you can keep an eye on that, as well as the CMHC on the north side of the border, and HUD on the south side of the border,” he shares. “And just keep watching Altus. We're in the business of trying to monitor policy, trying to advise governments and the private sector about how best to navigate this space, and how best to use that data and tools and services that we can provide to in order to get more housing built.”