Distressed developers: Soaring costs, fixed returns and public policy create perfect storm

Sam Billard of Aird & Berlis outlines causes and effects of these factors on addressing the housing crisis in Canada

Sam Billard, Partner and member of the Distressed Real Estate Group at Aird & Berlis, discusses the current housing crisis in Canada – specifically the Greater Toronto Area – exploring challenges arising from a surge in population due to immigration, the pressure to build more homes and the impact of rising construction costs on developers.

Controlling inflation v. building more homes

Housing is on everyone’s mind. Every level of government in Canada is making promises to build more homes faster: Ontario’s Ford government is in protection mode for having tried too hard; the Trudeau government is throwing money at the rental sector; and Toronto Mayor Olivia Chow is announcing new affordable housing projects. There are towers everywhere and yet there is an ongoing lack of housing at all levels. The Bank of Canada wants to chill demand in all markets by raising interest rates but the pressure to build is immense.

This article focuses on the Greater Toronto Area and condominium development in that area, as this has been the form that most new housing has taken in recent years for both ownership and rental purposes.

There are two significant competing forces at work: the need to control inflation and the need to build more homes. Bank of Canada governor Tiff Macklem has described the inability of interest rates to calm the housing market in Toronto as a “structural anomaly.” To understand why this anomaly exists, we need to consider immigration.

But first, the condominium development model.

The condominium development model

Most larger developers have a development cycle of five to 10 years from decision to build through land assembly, pricing, construction, occupancy, condominium corporation formation and payment. The developer assembles land, decides what it wants to build, designs it and seeks at least conditional approval. The developer then starts to pre-sell the anticipated inventory. Once the developer has a level of presales satisfactory to its lenders, it will use what is left of the presale proceeds, its own money and what is provided by its lenders to build the project. Once the units are fit to inhabit, they are occupied but not necessarily sold. Once a condominium corporation has been formed and all liens discharged, the developer can close the sales, pay its lenders and take its profit. Construction takes more or less time, depending on the size of the project. A realistic construction period for a fairly simple project would be two to three years but a larger and more complex project might take six years or more.

The key period is the time between pricing and payment. We call this the “Fixed Price Period.” During the Fixed Price Period, the developer is relying on debt to finance the bulk of its costs, and interest rates are a big factor. Any extension of the Fixed Price Period, any interest rate increase, or any other cost increase can be devastating to the profit of the developer and, in the end, the viability of the project.

Industry experts say that the key skills of a developer are negotiation and management. They must negotiate fixed-price contracts with the trades, manage the increasing demands of the relevant building department, communicate with purchasers, get everyone on and off the site on time and, crucially, finish everything and get paid at, or before the end of, the anticipated Fixed Price Period.

The COVID-19 pandemic, inflation and rising interest rates make all of that very challenging. During the pandemic, labour was sick, quarantined or worried, and supply chains were disrupted. Not only did these things raise prices, but construction really slowed down. Building inspectors were hard to find. Demand for construction materials and trades drove prices up. Now, interest rates have risen dramatically.

If a developer priced units in a development in, say, 2016 to 2018 to sell in 2019 to 2021, that building was likely not finished during COVID-19, while costs rose at an ever-increasing rate. It is very likely that all of these projects are now losing money. If the developer has other sources of cash and is willing to endure losses, these projects might be completed. But many have sought bankruptcy protection of one form or another.

Impact of immigration

Canada has the most open immigration policy in the G10 group of nations. The federal government has made immigration the focus of its economic policy. With stagnant growth and an aging population, bringing people to Canada from elsewhere seems like a cheap and effective solution.

Statistics Canada reported that the population of Canada grew by more than a million in the first nine months of 2023. That is the sum of immigrants, refugees, temporary foreign workers and international students. This significant population growth has been federal government policy since at least 2017. However, it has not been part of the federal government’s plan to address the consequences of having all of these new people living in Canada. It seems trite to point out that all of these new residents need food, housing, schooling and medical care. In addition, the growing demand strains all infrastructure – we see this problem everywhere.

Ontario accounts for between 45% and 55% of all Canadian immigration with British Columbia a distant second. The percentages vary by type of immigrant. Ontario gets a larger share of permanent residents that flow through the points system and a smaller share of temporary foreign workers and international students. Statistics were not available for refugees. While many refugees arrive in Ontario, immigration authorities may move them after processing in an effort to avoid concentration. It can be assumed that about half of them will end up in Ontario because there are more jobs and, likely, more familiar communities. This article assumes that at least half of Canada’s new residents end up living and working in the Greater Toronto Area.

It is important to note that most immigrants can afford housing. Permanent residents are chosen for their ability to be self-sufficient. They are not “your tired, your poor, your huddled masses yearning to breathe free.” They are the talented, the energetic, the wealthy, yearning for a nice house in Oakville. Temporary foreign workers are sponsored by employers that are likely to address the housing component, or they are very desirable workers who will be well paid. Refugees are the exception to the rule, but they are a small component of total immigration.

To provide context, Ontario received about 500,000 new residents in the first nine months of 2023. That is twice the population of Oakville. Let’s say that, on average, four people will share a dwelling unit. That means that, in the first nine months of 2023, the province needed 125,000 new housing units just to address newcomers. That does not take into account the backlog that already existed at the end of 2022 or the people displaced by the new residents. This new demand is bound to drive up the cost of housing for both owners and renters. This is the structural anomaly that has haunted Mr. Macklem in his fight against inflation and why he is reluctant to suggest that interest rates will fall.

Housing is a price-sensitive commodity and the price includes interest. A few basis points can make the difference between affordability and living in your mom’s basement. If the Bank of Canada reduces interest rates even a bit, housing prices could explode, especially if there is an expectation of more cuts to come. Taking inflationary pressure out of the Greater Toronto housing market will be very tricky.

Construction cost challenges

Mr. Macklem’s only tool in its fight against inflation is raising interest rates. This has, temporarily at least, increased the cost pressure on developers. For developers in the Fixed Price Period, here is a short list of other rising costs to developers, focusing on the condominium market:

  1. Interest Rates: Prime has moved from 2.75% in July 2020 to 7.20% in August 2023, an increase of 262%.
  2. Margins: Profit margins are thin in condominium developments; although developers aim for 15% to 20% margins on their investment, those rates are hard to achieve. The norm appears to be more in the 5% range. The return is fixed on pricing, so extending the Fixed Price Period means a lower return or a loss.
  3. Prices: Condo prices have also increased, but the market is starting to decline owing to the astonishing average cost of $1,547 per square foot (according to the Globe and Mail in August 2023) and rising interest rates.
  4. Building Materials: Costs are higher for many building materials (concrete up 7% in 2023 and 32% since January 2021).
  5. Labour: Costs are higher for labour (construction labourers received a 12.5% increase over three years in 2022). During the COVID-19 pandemic, there were reports that some in-demand trades, such as concrete formers, increased their pricing by up to three times because there were no alternatives. There was a lot of building going on with government pouring money into infrastructure, ongoing office tower and condominium demand and miscellaneous building and renovation projects. All skilled trades that wanted to work could work during COVID-19 and they could pretty much write their own ticket.
  6. Development Charges: Development charges in Toronto were $94,000 for a single-family or semi-detached home, per unit, in 2022. Toronto city council voted to increase those charges by 50% in July 2022. That increase is being phased in during 2023 and 2024. So, this year the development charge alone will be $141,000 per unit. For context, in 1986, the semi my wife and I bought in Toronto cost less than $90,000. If you wanted to build a replacement today, you would need to pay the city nearly 160% more than that house cost before a shovel could even meet the ground.
  7. Special Taxes: Land transfer tax is approximately 3.3% of the purchase price and likely to rise. This cost is not included in the StatsCan numbers addressed below. It does influence the price people can pay for a new home, however.
  8. Building Bureaucracy: Ever-expanding building rules and approval processes mean more time taken up by the process and more things to be dealt with as each inspector makes his or her mark. The Toronto Building Code, for example, requires two four-inch looseleaf binders and is more that 1,500 pages. There are also codes for plumbing and electrical matters. There are many rules for heating, ventilation and fire. It is all inspected by – usually – specialized inspectors. If by chance you run afoul of any of the myriad rules, plans will need to be updated, submitted and reviewed. Committee of Adjustment hearings may need to be called and attended. There are significant charges for all of this. More importantly, it all takes time, and time is money. Altus (a real estate analytics firm with a great deal of experience in the Toronto market) calculates that the costs of bureaucracy add significant cost to each project and has been growing by more than 15% per year since 2019. This problem is, in part, why the federal government insisted that municipalities simplify their approval processes to qualify for housing support. Bureaucracies are very difficult to change.

Statistics Canada publishes a Building Construction Price Index (Table 18-10-0276-01) which indicates that construction costs are up across Canada from Q1 2021 to Q2 2023 by 39% (11 major metropolitan areas including Toronto) and in Toronto by a staggering 80% since the fourth quarter of 2018, which is roughly when many condo projects now headed to completion were priced. Many believe these numbers understate the actual level of inflation.

Examining project challenges

There have been and will continue to be many insolvencies in this cohort. We have been involved in a number of proceedings under the Bankruptcy and Insolvency Act (the “BIA”) and the Companies’ Creditors Arrangement Act (the “CCAA”). They all illustrate the challenges that developers face when they are confronted by rapidly escalating costs during and extensions of the Fixed Price Period.

In some circumstances, the project has been underpriced so the best approach is to bankrupt it, use the proceeds to pay out such of the creditors as are unwilling to participate in the next phase, and reprice. This is best done under the BIA because that process will result in the discharge of any unpaid claims so the purchaser starts with a clean slate.

In other circumstances, the developer would like to retain its fixed-price contracts with its major building contractors while repricing the units to better reflect current markets. This is best accomplished under a CCAA process. The CCAA process is more complicated and all of the creditor groups need to agree at least to a certain extent. This can be time consuming and expensive. As we know, delay during the Fixed Price Period can be very difficult to manage.

The project known as the Highlight of Mississauga (4070 Dixie Road) provides an interesting example. It is a mixed residential development including a 14 floor condo tower and low-rise townhouses. Altogether, there are 261 residential units with parking spaces. Construction of the project was about 80% completed on filing, according to the developer.

The senior secured lender for Highlight of Mississauga was Meridian Credit Union. The monitor for Highlight of Mississauga is Grant Thornton and the quantity surveyor is Turner & Townsend.

Highlight of Mississauga, perhaps because this is the developer’s first property in the GTA, found it impossible to get many of the trades to respond, or to respond with enthusiasm, without increased compensation. That has led to the issuance of a number of material adverse change notes by the monitor under the CCAA plan. Also, although the units were repriced under a CCAA proposal at a price per square foot nearly 75% higher than the original agreed price (but lower than market), the project continues to struggle. The developer has been unable to sell most of the condominiums at the higher price.

A CCAA case study

Let’s look at a theoretical example based loosely on Highlight of Missisauga.

A developer has a project approved in the Toronto area. It bought the land for $7 million and has incurred expenses of $600,000. It wants a return of about 15%. The units were priced at the end of 2018 at $550 per square foot and the cost of construction was estimated at $100 million. There are 265 units with an average area of 640 square feet, so the estimated income is $93,280,000 for the units and a further $7,767,000 for parking and lockers. That leaves profit of $1,047,000. The total return is forecast to be 13.78%.

However, construction start was delayed by three months to September 2019 with an anticipated substantial completion date of April 2021. That did not happen. This is a mid-rise project, so not that complex, but the developer and the construction manager are inexperienced. There are delays; information is not being conveyed to the quantity surveyor, which means that the quantity surveyor cannot prepare its reports for the senior secured lender. It is impossible to get money from that lender without proper reporting. Co-ordination of the various trades is very hard and, in spite of injecting a significant amount of additional investor money, construction is not proceeding smoothly. Finally, in April 2022, the developer filed for protection under the CCAA.

The CCAA plan provides that the developer can reprice the units at $950 per square foot. The existing unit holders have an option to give up their units for the return of their deposits plus 12%, or they can sign up to purchase their unit at $950 per square foot without delivering any additional deposit. At $950 per square foot, the units are still priced at 20% below market, according to CBRE. The developer is surprised that more owners do not sign on, but interest rates are rising and many simply cannot afford to finance the additional debt. Only 40 of the original purchasers want to stay with the project. That leaves 225 units to sell.

The plan is implemented on October 20, 2022. Only 25 additional units have been sold under the approved CCAA plan. That leaves 200 unit holders that need their deposits repaid.

Meanwhile, construction limps along, requiring more funding. Building costs increase by 49% from December 31, 2018, when pricing was set, to March 31, 2022. However, under the CCAA plan, pricing is reset at $950 per square foot. Gross income is now a bit over $171 million and the new estimated cost to complete is a touch under $141 million, so anticipated profit is just over $30 million.

However, costs continue to rise during 2022 at 22%. The reports of the quantity surveyor continue to be slow and costs mount. There are major issues with core contractors who are not interested in working at rates that do not conform to the market, in their view. More expensive debtor-in-possession (“DIP”) financing is needed. As of September 27, 2023, the DIP lender had advanced – or committed to advance – a total of $41.5 million (up from $6.35 million). Ongoing inflation reduces anticipated profit to a bit over $19 million.

The deposits of 200 original purchasers have to be repaid with a 12% premium. The deposit insurer pays most of this, but the 12% premium and deposits paid for upgrades need to be financed by the developer. In the end, all of this money will need to be paid to get the deposit insurer’s liens to be discharged and the sales closed. Time drags on, so the lenders need to be paid more interest and the costs of the CCAA process continue to accrue. These increased costs are not contemplated by the budget approved by the senior secured lender, so limited new advances are available from that source. There are also commissions of 4% needed to be paid on the sale of the remaining 200 units. Then there is HST on the units which is normally included in the sale price. All of that leaves a shortfall of approximately $50 million as of December 31, 2023.

At that level of loss, neither the developer nor the DIP lender (who subordinated to the other secured lenders) get a penny. Both the senior lender and the insurer would get out if someone could be found to pay $50 million more to fund this project, and the units sell at the proposed price. That money might be hard to find.

This example is taken from the Highlight of Mississauga court proceedings, with rounded numbers, some guesses and no detailed analysis of the cost of the process. We do, however, have cash flows from the monitor that make some of the estimates pretty sound and, at this point, conservative.

Highlight of Mississauga is a little unusual in the extent of the delays, largely arising from the lack of experience of the construction manager and the developer, and perhaps some lack of experience on distressed projects on the part of the quantity surveyor. However, many other properties, especially those that elected to use the CCAA process, struggled to get a deal done with delays arising from many quarters. Please note that it is an open question if the repriced units can be sold at near top market pricing in today’s interest rate environment. This seems to be a big problem for Highlight of Mississauga. More centrally located properties may attract higher prices. One condo project was converted to a rental project. With the reduction in the HST requirements, this might be a strategy worth considering for other developers.


Some learnings:

  1. The development funding model is not capable of adjusting to delay, rapidly escalating costs and high interest rates. There is very high demand for housing but, at some point, it becomes unsupportable. This is a problem created by government and is not in any material way the fault of the developer in the cases we have observed.
  2. The core issue is demand created by immigration. That creates demand with restricted supply, which results in inflation. Controlling inflation requires high interest rates which exacerbate the problem. The federal government appears to have realized the issue, with the housing minister announcing on January 14, 2024, that immigration levels would be held at current levels until the housing problem is solved, and more recently that the number of international students will be reduced by 35%. Since the current levels of immigration are historically high, that strategy seems unlikely to solve the problem, especially if overall immigration levels are not reduced materially.
  3. If a project was priced before June 2020 and has not been repriced, it is probably insolvent. Repricing may help but may be difficult and time-consuming with the resulting higher price not necessarily being sufficient. In addition, it may not be possible to sell the units at the adjusted prices.
  4. It is very important to have a good quantity surveyor and construction manager/general contractor/project manager. If the existing advisors are struggling, the lender(s) should insist that they be replaced. A prudent cost-to-complete and construction schedule is essential to success. The trades need to be informed and must buy in to the plan.
  5. Look out for hints of trouble such as delayed reports and pricing that appears not to have changed over the life of the project. Flat costs are unrealistic, given the underlying financial currents, and probably mean that something is being hidden. It is a common theme in recent insolvencies that developers with multiple projects move available money around and/or cut deals with the contractors to pay them increases on the side. This is understandable but not helpful as it just digs a deeper financial hole.
  6. So far, senior secured creditors appear not to be impacted. However, at some level of exposure, that is not assured.

We continue to see developers with a portfolio of projects abandon, mothball or slow down their projects. There seems to be a new problem every week. These are not insignificant organizations or unrelated events. Details may differ but the underlying problems remain.

The demand for housing exists. It is probably cheaper to plug the holes in existing projects so they can be completed than to let them all fail. In Highlight of Mississauga, the DIP lender has continued to provide significant cash injections even though it has been advised that it is unlikely that the sale of the units will cover its debt at current levels, let alone the substantially higher levels proposed. The judge in his order approving the higher advances noted that the rate of interest was very high. A seasoned banker observed that the rate of interest is not relevant if there is no money to pay it or the principal.

A model where every party shares in the losses might be feasible if it can be managed, but it is not clear that the existing restructuring mechanisms are able to do that on their own. Some sort of government intervention may be required.

When the federal government manufactures significant demand and then insists that prices fall, there are going to be consequences. The tools are simple but very effective and the impact is immense. In this case, those consequences seem to be playing out in many areas, including the development sector in Canada’s busiest metropolitan areas.


Sam Billard is a partner in the Distressed Real Estate Group at Aird & Berlis. This team has a wealth of experience in successfully guiding clients through multiple real estate market cycles and uncertain economic conditions. We take a multi-disciplinary approach to distressed situations in collaboration with members of the firm’s Real Estate, Financial Services, Insolvency and Restructuring, Tax, Litigation and Construction Groups.