Emerging Trends in Canada
The United States could learn from Canada. The govern ment has kept a lid on spending and slowly recovered from huge early-1990s budget deficits. Higher taxes help pay for health care and infrastructure improvements, and regulators clamp down on banks, discouraging high-risk lend ing. A wealth of natural resources–gas, oil, and water–helps buttress the nation’s economy, too. The conservative, careful approach to managing government and markets pays divi dends now for Canadian real estate players. Sideswiped by U.S. fallout, they experience a manageable market correction mostly from slackened tenant demand rather than a full-blown credit crisis-precipitated market meltdown. “Canada’s prob lems are like Bud Lite compared to the United States.”
Mild Recovery. Canadian interviewees exhibit little smugness about the relative lack of distress in their regions since some suffer big losses in U.S. real estate investments– pension funds in particular bought into the south-of-the-border froth. But Canadians take comfort and satisfaction in “steady as she goes” local markets, even if they are “boring, incestu ous, and parochial, with lending activity governed by cautious bank credit departments and little trading of prime properties even in the best of times.” For 2010, expect “flat to modestly improved” operating performance, after top-to-bottom value declines ranging from 10 to 20 per cent for most investors. Softened markets generally avoid distress, except for “small pockets of condos,” built by undercapitalized developers.
Little Opportunity. Relative market stability in Canada’s “safe haven” removes the opportunity for most timing play bets in a moderate– “okay, not stellar”–cyclical upswing, which should get underway before 2011. Canada’s dominant institutional investors implement core-style, buy-and-hold strategies, controlling most Class A downtown office buildings and fortress regional malls. This “handful” of companies and pension funds prizes income over short-term buy-appreciate-and-sell gambits. “Real estate retains its attributes; it’s not commoditized like in the U.S.” Canadian investors seek portfolio pop the old-fashioned way by developing projects or heading into foreign markets–Brazil and India are current favourites. “It’s too soon to go back into the U.S.”
Minor Distress. Most owners resteasy– “they won’t face negative leverage” and major markets entered the downturn with record-low vacancies and limited new supply (except in Alberta). Defaults and foreclosures will concentrate in smaller properties in secondary markets and outer suburban dis tricts– that’s where any vulture investors congregate. “There won’t be forced sales in primary markets.”
Cross-border Concerns. Interviewees raise cautionary signals about the parlous state of the economy in the United States, Canada’s principal trading partner: “We may look good by comparison, but we’re very dependent on U.S. markets for our job growth.” The auto industry collapse bleeds into Ontario’s important manufacturing sector and lower demand for energy products knifes at western Canada’s gas and energy centers. “We can catch U.S. pneumonia very easily.” Sound federal and provincial government fiscal outlooks and stable financial institutions form the cornerstone of recovery. “We have minor government deficits compared to the U.S.–it helps not paying for wars.” The big Canadian banks grow North American market shares and avoid any need for bailouts while the country’s natural resource bounty hedges against higher commodity prices. The potential for rising interest rates, triggered by U.S. fiscal problems, “could stall out our recovery, but that’s not all bad for real estate since higher rates place a governor on development and new supply. That’s what usually gets us in trouble.”
Improving Mood. The Emerging Trends 2010 investment barometer forecasts a relatively stable transaction market, slightly better for buyers than sellers. According to surveys, average cap rates will increase modestly by year-end 2010, ranging from about seven per cent for moderate-income apartments to 9.5 per cent-plus for hotels. Power centers and central city office will register the sharpest increases. Hotels, malls, and neighbourhood shopping centers will record the smallest bumps. “Nothing comes cheap–we should see value increases by the end of the year after a period of slowing declines.” Hotels and secondary retail suffer the biggest depreciation–off as much as 30 per cent–while Toronto office loses 10 per cent from peaks. A sizable bid/ask spread should narrow, if tenant demand picks up as expected and nervous banks increase financing to buyers. “A growing confidence lifts the market psyche”–some borrowers can obtain more credit, REITs have raised capital, owners aren’t distressed, and the number of bids on deals shows slow improvement.
Construction Time-out. Developers must curb activity in light of softened demand as bankers rein in construction loans. Condo projects stall out until residential prices firm up in Vancouver and Toronto. Concern grows about Calgary office builders–a supply splurge meets waning demand from deflated energy companies. “Developers got ahead of themselves in Edmonton, too, stockpiling land for inventory.” In Toronto, where some smaller developers got in over their heads in residential construction, bigger players with more experience and lender relationships take over struggling projects.
Capital Reticence. Banks and large pension funds took their licks in the world economic crisis, but remain solvent and well capitalized. Real estate lenders pull back out of caution and Emerging Trends surveys anticipate that debt markets will remain undersupplied in 2010. Bankers favour established borrower relationships– refinancing should not be a problem. But they temporarily shut doors on developers and unproven investors. “Healthy” life insurers maintain their whole-loan business, somewhat offsetting the loss of securitization markets. Equity markets retain their share of reasonably capitalized and cash-rich investors. REITs “got whacked, now bounce back”–they will be early cash buyers, followed by “in-for- the-long-haul” pension funds. Plan sponsors may suffer value declines on their prime holdings, but will ride out the rough spots since “they’re not interested in selling.” High-net-worth families, buttressed by lender ties, will focus on acquiring “workout product” in secondary markets. But “disappointed” foreign investors may shy away. “They don’t see enough big gains”–a five per cent return with low risk isn’t compelling enough compared to what’s coming in the United States and the U.K. The big Canadian institutions prepare to increase foreign allocations, too. “Canada isn’t as attractive even to Canadians–we’ll find better returns elsewhere” in recovery. “Why buy Vancouver at a six cap when you can buy in London at a higher rate?”
Markets to Watch
After a hot-growth wave, western Canada–especially Calgary– cools down. Plummeting natural gas prices take a “brutal” toll. Eastern Canada girds for more potential fallout from manufacturing woes–automaker bankruptcies and slack U.S. consumer demand inflict pain in Ontario, “the real engine of the country.” Development prospects drop from coast to coast, although most markets stay in relative equilibrium–vacancies increase from low levels and rents continue to soften, especially in office and industrial.
Vancouver. A classic barriers-to-entry story, this metro area’s constrained property market always trades at “surprisingly” high price points, “defying gravity.” Cap rates for prime properties “stay in [the] mid sixes” when “everywhere else is 7.5 per cent.” Interviewees wonder what happens after the Olympics–will the city take on “global darling” status or endure “a big sucking sound?” Don’t bet
against the market– “It does bloody well under any circumstances.” Condo development decelerates–banks and developers anticipate a demand slowdown after the Games. Prohibitive replacement costs and few land sites shut down office development. Most institutionally owned properties don’t trade and outsiders can’t find many investment opportunities.
Ottawa. Sentiment improves for this low-key national capital. Like Washington, D.C., when recessions strike, investors seek refuge in government centers. Unlike Washington, a thin market doesn’t offer much cover or opportunity. But at least owners of existing property won’t notice much turbulence.
Toronto. Canada’s global gateway is the country’s “place that matters.” Glistening new condominium high rises and office tower projects adorn downtown streetscapes, raising concerns about too much construction in a problematic economy. More than four million square feet of new Class A office space will spike downtown vacancies from comfortable five per cent levels. “Tenants in older Class A space will move into new projects, leaving hard-to-fill holes.” Affected institutional owners sport “deep pockets, can ring-fence issues, upgrade, and get by.” Over the past decade, the city grows into North America’s biggest condominium market. Now, banks wisely pull back funding on larger projects– “they see too many cranes.” Weather– “people don’t like shovelling snow,” and driving-related costs–gasoline, time lost in congestion–spur more vertical, in-town living. An immigrant influx–about 100,000 annually–helps keep apartments full. Single-family home and condo buyers surge to make deals before a new harmonized sales tax (HST) takes effect on July 1, and developers fear a demand drop-off afterward. The HST will add eight per cent to the purchase price of a new home to the extent it exceeds $400,000, and will not apply to resale homes; this perhaps will create a market bias in favour of smaller, lower-priced new homes, and provide a boost to the resale market. Warehouse markets stumble–rents decline 25 to 30 per cent. Blame the U.S. car companies. “It’s not Ontario’s finest hour” and “a really tough leasing market.” Watch for “further weakening on the demand side.”
Edmonton. The provincial capital of Alberta dips with declining energy business fortunes–you can squeeze only so much out of oil sands and from gas extraction when volatile prices turn down. Developers didn’t go overboard, so the demand drop won’t hurt dramatically. “It’s more steady as she goes and boring”–not so bad.
Montreal. Built up and around the mighty St. Lawrence River, Montreal stands out as one of North America’s most beautiful cities, but companies find “no particular reason to be here.” The real estate market sleepwalks through a boring equilibrium– measured development and limited demand growth. “It’s a good place to live, but nothing’s happening.”
Calgary. Alberta’s largest city suffers the biggest rating decline for any North American market in Emerging Trends surveys. About six million square feet of mostly speculative office comes online at just the wrong time. Condos and housing are overbuilt, too. Only higher natural gas prices can bail out developers. “It’s a boom/bust market in a bit of bust phase, but good for the long term.” Time to buy land–prices slip.
Halifax. Local developers and owners do well, especially in multifamily markets, but the Maritimes stand well off the beaten track and don’t attract much interest from institutional investors.
Other Markets. Saskatchewan and Manitoba sustain housing booms / Detroit’s problems infect the adjacent Windsor industrial corridor– “it’s hard to see a comeback” / Quebec City doesn’t register much interest.
Property Types in Perspective
For 2010, Emerging Trends surveys rate only fair investment outlooks for most property types and predict generally poor conditions for development. Limp demand threatens to soften property cash flows across all sectors and most markets. “Fundamentals will get worse before they get better, people shouldn’t be fooled.”
Apartments. Steady immigration and move-back-in trends bolster moderate-income multifamily properties located in or near metro cores. Properties close to mass transit lines almost can’t miss. Condo building in most major cities takes the edge off higher-income apartment product.
Office. Stick to the prime downtowns and avoid the suburbs. People and business favour urban cores for convenience and multidimensional environments. Vast underground passages, which link to subway stations, help workers avoid dealing with too much winter chill. New construction dampens rental rates in downtown Toronto and could plaster Calgary. Confronting weak demand, landlords will prefer to keep face rents high and maintain income streams, making capital concessions like tenant improvements to retain tenants.
Retail. Consumers didn’t overload their credit cards, so retail spending “never got frothy.” Overbuilding and overstoring aren’t problems, but slackening demand arouses concerns among shopping center owners and developers back off. So far, sales slow (off five to 10 per cent) to levels “better than imagined.” Steer clear of “malls in secondary cities with shrinking, aging demographics.” Sound familiar? Shopping activity will concentrate in infill areas in major urban markets. Grocery-anchored retail is pretty stable, but power centers could be a weak spot if any more U.S. big-box chains go belly up.
Industrial. Problems center in Ontario, where rental rates “drop like rocks on rollovers.” Some property values “could lose 30 to 40 per cent.” But “well-capitalized” owners should weather the downturn. “Quebec must be happy since the province doesn’t have as much auto exposure as it used to.”
Hotels. Travel from U.S. tourists and business goes south. High-end hotels suffer the most– “their profits are way off.” Sellers can’t find takers, but most owners don’t have leverage problems–they can manage through the tough times.
Housing. While low mortgage rates help homebuilder sales, prices correct modestly as buyers turn cautious and bankers tighten already stringent underwriting. Financial industry regulators haven’t been asleep at the switch and lenders couldn’t adopt exotic U.S.-style mortgages. “We like down payments here.” Interviewees don’t expect defaults and foreclosures to increase dramatically– “well-underwritten loans help most borrowers stay current.” That Ontario sales tax could “hurt the high-end market” and the British Columbia government moves to follow suit with its own version of the HST.
The preceding is a portion of the Emerging Trends in Real Estate® 2010 report, released by PricewaterhouseCoopers LLP and the Urban Land Institute (ULI). Reprinted with permission. The Urban Land Institute ( www.uli.org)is a non-profit education and research institute supported by its members. Its mission is to provide leadership in the responsible use of land and in sustaining and creating thriving communities worldwide. Established in 1936, the Institute has more than 33,000 members representing all aspects of land use and development disciplines.
• Sell low-yielding Canadian assets, and buy in the United States when markets hit bottom.
• Prepare to buy distressed assets in secondary markets– “that’s where you’ll hear small owners and developers scream uncle” and then trade out in the up cycle. “No such opportunities exist in prime markets.”
• Purchase new apartments near primary urban cores– “It’s a good defensive play–you don’t have capex issues and immigration flows help fill them up.” Stable, secondary government/university markets like Halifax also make sense.
• Buy nei
ghbourhood shopping centers, anchored by state-of- the-art supermarkets in infill areas, for secure income streams.
• Grab full-service center city hotels at cyclical lows, but don’t plan to hold forever. B