“A Market within a Market”

The stability of the Canadian real estate market continues to attract positive attention from domestic and international investors. These market participants range from sovereign wealth funds to experienced local market investors. While the overall market could easily be described as “healthy,” the current real estate and capital market environment requires that each investment be carefully evaluated on its own merits. As one fund manager puts it: “The real estate market must be looked at ‘as a market within a market’—submarkets within cities must be reviewed to locate prime/central markets, all of which have different dynamics. The averages [e.g., cap rates, vacancies, IRRs (internal rates of return), etc.] can be meaningless within cities. The challenge is to understand the submarket in each area.”

Canada’s real estate market avoided the worst of the 2008 global financial crisis, and due to steady economic growth and a lack of oversupply it remains in a good position. The current level of economic growth will support the expansion of the real estate market across all property types. The Canadian real estate market could also get a boost from improvement in the U.S. economy. A stronger U.S. economy will continue to spur economic activity between the two countries, benefiting multiple industries across Canada.

The strength of the Canadian real estate market has made it very appealing to domestic real estate investors, but these investors are not limited to local investment. Canadian real estate investors are now the largest non-domestic investors in U.S. real estate. Canadian investors purchased $10.7 billion of U.S. properties over the last 12 months. This represents 28 per cent of all non-domestic investment in U.S. real estate. Canadian institutions, pension funds, and private investors are also active in Latin America, Europe, and Asia. The move to non-domestic investments is not due to any dissatisfaction with the local market, but reflects the sophistication of these investors as they search for diversified investment opportunities.

Yet there are signs that Canada’s real estate market will reach a plateau in 2014. “Canada is in a holding pattern,” says an interviewee. “Going into the downturn, there was very little construction. We were already seeing rents at near-record levels, and seeing vacancy rates at rock-bottom levels. So it is very difficult to see substantial improvement in fundamentals.” This year will be the year that investors in Canada look to the fundamentals of commercial property for “pure” yield in the form of cash flow, rather than relying on capital markets to boost real estate values. “Things will be tougher next year, but not a pitfall. It will be more of a ‘normal’ cycle. We’ll have to work the assets, [and] focus on fundamentals and adding value,” says an interviewee.

“While there will still be opportunities to acquire older properties and add value, competition for good assets will get tougher in 2014 along with increased competition for capital.”

Economy in Full Bloom

Some interviewees doubt that job growth in Canada will be sufficient to support continued demand for commercial real estate. Canadian jobs are tied largely to prices for commodities such as oil, potash, and precious and semi-precious metals like gold and copper—prices which have come down with a slackening of demand in China. Though the country has more than replaced all of the jobs it has lost since the recession, an average of only 12,000 jobs were created per month during the first half of 2013. “Job growth does not bode well for real estate right now. We are running at half of last year’s rate,” says an interviewee.

Canadian real estate investors hope to get a boost from the U.S. economy in 2014. Canada’s economy is tied to the U.S. economy through bilateral trade and investment. “We are waiting to see if the recovery in the U.S. is real. If it is, we will almost certainly benefit, and we will ride that tailwind,” says an interviewee. Canadians will benefit not only from the knock-on effect of U.S. economic growth, but also from the resulting rise in U.S. property values. Canadian investors who regard prices as climbing too high at home will invest in the United States, where they remain the largest foreign buyers of real estate.

Market Will Remain Strong in 2014

The Emerging Trends survey indicates that participants expect Canada’s real estate market to improve in 2014. The average “buy” rating is projected to slip slightly, from “modestly good” to “fair.” While this may seem to reflect falling confidence, it actually indicates that strength in the market has pushed up prices for the last two years to a level where investors are beginning to approach each transaction with a heightened level of caution.

The 2014 “sell” recommendation for the Canadian market remains in the “modestly good” range, suggesting that 2014 will be a year when investors could try to sell select properties. The combination of the buy and sell rankings suggests it may be a year when the market will function efficiently enough for investors to sell properties if they so desire. Finally, the “hold” rating nudged upward slightly, indicating that 2014 will still be a “modestly good” time to hold properties. This survey result would appear to reflect the general mind-set of most market participants. These indicators are consistent with sentiments expressed by our interviewees, many of whom felt that 2014 would still see a good number of transactions, but volumes will likely be down from last year. Buyers could be more discerning, paying top dollar only for the best properties. With prices strong, many interviewees also view this as a good time to reposition portfolios. It is timely to sell assets that may not be in line with current investment objectives.

Profitability Scenario without Losers

An efficient market across the full spectrum of property types in all major Canadian cities would clearly be good for business in 2014. The outlook for the profitability of companies will build on strong performance in 2013, with 69 per cent of survey respondents predicting “good” or “higher” prospects for profitability. Even more impressive, more than one-quarter of the respondents see the prospects for profitability as “very good” or “excellent.” There would appear to be no losers in this scenario, with only 10 per cent of respondents seeing the prospects for profitability as “modestly poor” or “lower.”

Such confidence is a strong indication that Canada’s real estate market will benefit a wide range of market participants, from lenders to fund managers to developers. In particular, the outlook would appear to be good for anyone who benefits directly from real estate investment.

Local operators scored the second-highest rating for profitability, which reflects a transition in the market from dependence on capital market movements for returns to more traditional asset performance. These Canadian investors indicate that they will continue to work with local partners as they explore new opportunities in search of higher returns.

The business prospect outlook for other types of market players is somewhat mixed. Commercial/multifamily developers are expected to have “slightly better” prospects than homebuilders. The outlook for lenders ranges from “strong” for banks to “lower” for insurance companies and commercial mortgage–backed securities (CMBS) lenders.

Among lenders, banks that are positioned to take advantage of higher interest rates have “slightly better” prospects than insurance companies and CMBS lende
rs as spreads on debt start to widen across the board in expectations of higher interest rates. The ability of banks to attract low-interest deposits that can be put to work at higher rates will boost their profitability. But CMBS lenders, who operate in a higher-risk loan environment, will be challenged by rising rates.

Top Trends for 2014

Cap Rates on the Rise

Survey respondents agree that capitalization rates will stabilize or rise in 2014 depending on specific assets. To some extent, this will be a function of higher borrowing rates. “We have seen an increase of 50 basis points across the board in response to increased interest rates,” says an interviewee.

Across the 11 property sectors surveyed, cap rates are projected to increase by less than 25 basis points in 2014. Suburban office space is likely to see the largest increase, at 25 to 50 basis points, followed by high-income for-rent apartments and research and development (R&D) industrial property. Expectations of softer demand for these property types are behind the projected increase in cap rates as investors demand a higher return.

The smallest increases in cap rates are expected to be seen in full-service hotels, moderate-income for-rent apartments, and regional malls. These assets are perhaps seeing the smallest increases due to their specific attributes. Full-service hotels and moderate-income for-rent apartments can raise their rents in a shorter time frame, allowing them to take advantage of a stronger market. Regional malls don’t have the same level of rent adaptability, but they do tend to offer a bond-like income stream. Survey respondents may be seeing the advantage to both these characteristics going into a faster economic growth environment. “Cap rates are starting to focus on quality and make distinction between good and bad properties,” an interviewee explains.

Capital Continues to Move into Balance

Based on 2014’s survey respondents, the availability and cost of capital for real estate investment are coming more into balance and the competition for capital will be robust. “There is debt and equity capital available. People will accept slight yield reductions,” says an interviewee. At the same time, there will be more “institutionalization of real estate” in deals that are likely to be structured with an eye toward managing loan-to-values by being conservative with the loan proceeds and valuations.

Equity capital for investing from a variety of sources is considered by over 38 per cent of the respondents to be in balance. This percentage is up from 32 per cent of respondents in 2013. While a rising number of respondents see the market as in balance, what may be even more significant is the percentage of respondents who view the amount of capital available being oversupplied has declined to 37 per cent from nearly 50 per cent two years ago. A balance of capital in the market will keep pricing more dependent on individual fundamentals and less on excess capital influence.

REITs Recede as Buyers, but Other Participants Eager to Take Their Place

In 2014, Canadian REITs, which represented about three out of 10 buyers as recently as July, may choose to be more selective about the assets they pursue. One of the reasons for their previous dominance in the acquisition market was that the number of REITs in the market increased significantly over the past three years. “They are no longer the dominant buyers,” says an interviewee. The reason is that REITs are sensitive to rising interest rates. “Their cost of capital has gone up so much, from about 4.5 per cent to 6.5 per cent. They were buying at cap rates of 5.25 per cent to 5.5 per cent, but now it’s hard for them to be accretive.”

The once-dominant, but now reduced, role of REITs as acquirers is quickly being filled by pension funds, which “never really went away but now are in full position,” an interviewee says. At the same time, private buyers, which historically were not as aggressive as REITs and not as exposed as REITs to interest rate increases, are becoming more active as acquirers. They tend to operate in different markets. Pension funds, which are driven by actuarial assumptions and are thus not forced to confront the impact of interest rates until year-end, were competing directly with REITs to buy the highest-institutional-grade properties.

Well-capitalized REITs will not have trouble accessing additional capital, but may choose not to due to the expected higher cost. Any additional capital raised must be redeployed at an expected rate that is accretive to unit-holder (i.e., shareholder) value. If REITs have decided to be more selective in the assets they pursue, they could need less capital in 2014. Consolidation could occur among small and mid-sized REITs, but consolidation will need to add to unit-holder value. There is some concern about the potential impact on REITs if valuations soften in 2014. “Weaker REITs may not have a choice, and will have to sell into a softer market to make distributions,” says an interviewee.

Retailers Spinning Off CRE Holdings as REITs

In what could emerge as a secular trend, some publicly listed retailers are spinning off their commercial real estate holdings as separately listed REITs in the hope that the value of those holdings will be realized in the form of higher securities prices on the stock market. The first such deal was struck by Loblaws, which in July raised $400 million in the REIT IPO while raising another $600 million in bonds. In October, Canadian Tire raised $253 million in an IPO. While retailers that are in a position to launch such IPOs represent “a limited universe,” says an interviewee, it will be interesting to see if similar deals are cobbled together by Canadian companies in other industries that have sizable real estate holdings across the country.

Development Will Remain Well Funded

Development is likely to be well funded, with 45 per cent of respondents seeing debt capital for 2014 development as being on the rise. In an indication that any project that receives development financing will still need to meet reasonable underwriting criteria, 40 per cent of the respondents see this category of debt capital as “undersupplied.” It should be noted that capital is expected to be available for high-quality projects that meet stricter lender requirements for both the project and the borrower. For example, high-rise condominium projects, and their sponsors, are now getting a higher level of scrutiny from traditional lenders. The best projects to the best borrowers will get capital, while those that do not meet these criteria will need to look for capital from alternative sources. Alternative sources of capital do exist, but will typically have a higher cost.

Borrowing Strategies

The expectation that borrowing will become more expensive does not appear to discourage real estate investors. Interviewees say they expect Canadian interest rates to increase 100 to 200 basis points by 2015. “Changes in the economy will likely result in change to the cost of debt,” explains an interviewee. The increase in rates, however, is not expected to lower demand for debt capital. “If you have a good strategy for long-term growth, regardless of the cost of borrowing, debt at today’s rates will still have a positive impact on bottom line,” says an interviewee. In response to higher rates, one interviewee believes that investors “should consider utilizing as much debt as possible” to lock in low interest rates while they still can. “There are signs that some pension funds are now taking this precaution,” he says.

This is an opportunity for lenders to segregate borrowers more aggressively, using credit quality as the main distinguishing factor. “To make sense of aggr
essive pricing, you need to have aggressive debt financing,” says an interviewee. “There is aggressive debt around for the right borrowers, who are easier to stratify in Canada than in Europe, where the difference between a creditworthy borrower and the next tier is almost indistinguishable.”

Capital Plays Hard to Get

Although survey respondents see both debt and equity capital as being available in 2014, they don’t expect capital to be easier to obtain. Our interviewees expect that owners of capital will only be looking to invest in the best projects and that they will be risk-adjusting their return expectations more so than in the last few years. “There is lots of cash available, but there is no place to put it. Mortgage lenders are going crazy,” says an interviewee. “Lots of cash is available for good projects, but banks are increasingly lending only to established builders with good balance sheets,” says another.

It is unclear whether equity underwriting standards are getting stricter in Canada. In 2014, 44 per cent of respondents expect equity underwriting standards to remain unchanged, while 44 per cent expect them to become more rigorous, which would keep capital from flowing into ill-conceived transactions. But it is clear that debt underwriting standards are getting tougher. The survey reveals that debt capital will be at least as difficult to obtain in 2014, with 50 per cent of respondents predicting that debt underwriting standards will be “more rigorous” and with 90 per cent of respondents predicting that they will be either “the same” as a year earlier or “more rigorous.”

Financing for new condominiums is a case in point. In general, Canadian lenders will not approve a new project until it is at least 70 per cent presold. The buyers are usually investors, and presale requirements are rigidly enforced. But in 2013, the stakes were raised even higher as banks started favoring established builders with track records and healthy balance sheets. Smaller developers—even ones that have established track records and were able to borrow as recently as two years ago—are increasingly being forced to seek alternative lenders.

“Bank underwriting has dried up for condo lending except for established relationships with strong, experienced local builders,” says an interviewee, predicting that banks will wait until the end of 2014 or mid-2015 to “loosen up” construction lending for condominiums. “They are concerned that it will be two to three years before the existing pipeline is absorbed, even though there is no real concern on absorption as rental demand is strong and rents are increasing,” the interviewee adds.

Non-bank Financial Institutions to Become Active Lenders

Except for government-sponsored entities (GSEs), all active providers of debt capital are expected to remain at least as active in Canada’s real estate market in 2014 as they were a year earlier. Non-bank financial institutions and mezzanine lenders are expected to see a small increase in activity due to improved market fundamentals, which will allow them to move toward higher risk/return strategies that can be enhanced with leverage in the form of debt and also as a response to tighter lending by banks to high-rise condo builders. Traditional players, such as securitized lenders, mortgage REITs, and insurance companies, will be as active as they were in 2013 or show a “slight increase,” according to the survey. The level of debt provided by commercial banks is expected to stay the same. GSEs are expected to provide “slightly lower” levels of debt capital as private players become more active.

Best Bets in 2014

Urban and Infill Retail Development. The outlook for retail is strong nationwide, but urban and infill retail could be exceptionally attractive in 2014. Retailers go where the customers are, and with the continuing trend toward urbanization more of those customers are moving to the urban core. Urban residential growth in multiple markets is well ahead of urban retail development. This has created a shortage of retail to serve a population that increasingly wants to live without using transit. Retailers see this as a growth opportunity not unlike the opening of the suburbs. As they develop formats to meet the demands of the urban market, retailers will need to find attractive locations. These locations are likely to be a combination of new development and redevelopment of existing properties.

Build mixed-use downtown. Mixed-use projects are soaking up investment dollars in one of the most rapidly-emerging investment opportunities in Canada’s major urban downtown areas. Combine condominiums with offices and retail stores to take advantage of a growing preference among reverse migrants and Millennials to live within walking distance of downtown areas.

Invest in commercial/multi-family developers. Commercial/multi-family developers are expected to have “slightly better” prospects than homebuilders in 2014. Multi-family developers may see more attractive opportunities in neighbourhoods that are seeking to increase the density of development within the urban core.

Lock in or refinance at low rates. Borrowers are locking in low interest rates on loans before they climb higher—and are negotiating longer-term loans. The cost of capital is expected to increase to 4 per cent from 3.5 per cent in 2014. Market participants could benefit from longer borrowing terms at fixed rates.

Look for underperforming or mismanaged assets. In a strong market, look for investments that are underperforming due to poor management. Use operational skills to improve the profile and attractiveness of the asset to take advantage of strong market fundamentals and growth.

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