No shocks and few surprises. So reads the first sentence of the Canadian section of the 2015 Emerging Trends in Real Estate report. So much for publishing in October and being the first out of the gate.
Within the last six months we have seen oil plunge by 60 per cent, a retail superstar miss its target, and a Bank of Canada rate cut with potentially another to come. We do indeed live in interesting times.
Within that backdrop, there are a host of issues further complicating the picture and while we can’t address all of them, we hope this morning we can provide you with some context.
There are two main factors that are critical to the health of a real estate market and to pricing: market fundamentals, most notably supply and demand; and the cost and availability of capital, both debt and equity. Of these two factors, the cost and availability of capital invariably trumps fundamentals although it rarely receives the headlines.
Since 2010, as we came out of the last recession, the Canadian industry has been spoiled, with market fundamentals and capital tightly aligned and overall conditions as good as they can get. We are now beginning to see these two hemispheres decoupling and frankly it’s a little nerve wracking. Of course, the pertinent question is, what does this mean to our industry?
Let’s break it down and start with the capital stack.
On the buy side, no one has stepped away from the table although there is, understandably, a heightened level of caution amongst buyers. Cap rates are diverging. The demand for super-prime assets appears to be insatiable and returns have dipped further in response to the scarcity of these assets and the cash flow security they provide. This is very much a global phenomenon. Conversely, buyers are very discerning when it comes to assets with any sort of leasing or market risk attached to them. In uncertain times, this divide only widens.
Looking at pension funds, a recent BMO research report estimated that the average pension fund allocation to real estate was 12.0 per cent versus a target allocation of 12.8 per cent. It doesn’t sound like much, but this represents an under-allocation of approximately $4.5 billion. Given the paltry returns associated with fixed equities, it seems likely that these allocations will increase given the desire to secure strong, stable returns. At the same time, there are few quality assets to buy. The spot price of oil doesn’t change that equation.
REITs remain a very attractive asset class in a low interest rate environment and are in good shape regardless of the metric applied whether it is AFFO spreads over 10-Year Canada Bonds, discount to NAV’s, or discount to U.S. REITs. Their cost of capital has been lowered and we expect REITs will continue to be selective buyers in 2015.
Private investors were the largest buyer profile in 2014. They remain nimble, tolerant of risk and with financing at historically low levels, it seems unlikely that their appetite will diminish in the coming year.
Cap rate spreads over 10-Year Canada bond yields, which were already quite healthy, have widened dramatically. 10-Yr Canada bonds now stand at the lowest level in 60 years. The spreads reflect the uncertainty and perceived risk in the market and also suggest that there is a sizable cushion to absorb an increase in interest rates.
Conventional wisdom was that rising interest rates were the greatest risk to the investment market. It certainly appears that this threat is off the table for the foreseeable future and we may in fact see an extension of this bottom for some time – perhaps years – with measured increases at worst. If rates do go up, it would likely be on the back of improved economic activity, which of course would boost fundamentals and net income.
The buyers that have traditionally been the most heavily geared to interest rates are the REITs. Even if you do believe interest rates are going to increase, CIBC calculated the effect of refinancing all REIT debt maturing in 2015, 2016, and 2017 at 100 bps higher than the rates of mid-December 2014. Their conclusion was that the impact would reduce FFO (funds from operations) by less than 1.0 per cent per year. That’s a pretty negligible impact.
Debt is still readily available at historically low rates with most lenders reporting unfulfilled allocations. Underwriting remains disciplined, particularly with regard to energy-based markets and we are beginning to see the emergence of interest rate floors, which speaks to how incredibly low rates have fallen. On the capital side of the ledger, things look good – attractive and abundant debt from disciplined lenders and all buying groups active.
Pivoting to market fundamentals is where things get considerably less rosy and the centre of the storm is unfortunately Alberta. As we all know, the energy sector is reeling. And while no one should be surprised when an incredibly cyclical market actually acts cyclical, the speed at which all this occurred caught everyone off guard. To date, the biggest casualty has been the office market which is suffering not only from weakened demand and a wave of sublets, but also from imminent new supply.
The most vulnerable markets are Calgary, and for slightly different reasons, Edmonton. It’s going to be a tough year to be a landlord in Calgary where approximately 60 per cent of the largest tenants in the market are energy related, but let’s keep this in perspective.
First of all, we have been down this road before, six times in the last 30 years to be precise, with oil prices declining 54 per cent on average. And there are mitigating factors. Capital spending on major oil infrastructure projects that are already underway cannot just be stopped. Yes, the amount of sublet space has swelled substantially and will impact the pricing of direct space, but that is also a characteristic that Calgary is familiar with and most of the initial losses in the process are borne by the tenant and not the landlord.
Remember also, that the majority of new supply does not come on stream until 2016 through 2018. Poor comfort perhaps, but it does give us a bit of breathing space.
Edmonton is primarily facing a supply issue, which will take many years to work through, but this is mainly a function of the inventory being very small to begin with and relatively modest annual demand. And while there does seem to be a tendency to always default to an armageddon scenario, what we are currently seeing in the oil patch is a slowing of momentum rather than a dead stop.
Outside of Alberta, the biggest threat to the office markets is economic contagion and the resulting impact on job growth, demand, and overall confidence. Office fundamentals are further complicated by the on-going drive towards space compression. Keep in mind, this is not simply about squeezing the size of cubes but fundamentally about how the nature of the work environment is evolving.
In a CBRE study of 20,000 workers around the world, a clear theme emerged. While in the office, people spend less than 50 per cent of their workday at their desk. Essentially, people spend about half their time working independently, while the other half is spent working with others, either face-to-face in a meeting or virtually.
CBRE’s new downtown Los Angeles office is a good example. The company downsized from 61,000 sf to 48,000 sf. In the old, traditional office, there were 191 seats for 191 people. There are now 168 seats for 210 people. Density increased by over 30 per cent. Where there used to be three distinct places to work, there are now 16. And through aggressive digitization, they went from 1,500 file drawers to 300 file drawers. Employee satisfaction is through the roof.
The new office buildings are filling up because the math works for the tenants and it allows organizations to establish these new workplace standards. The challenge to the older buildings is obvious. Whethe
r it is price point, renovation or innovation, older buildings need to respond to these changes. The legacy Class A buildings in Toronto are excellent examples of how spending capital can effect change and competitiveness. The alternative is to become a pure price play option and a slow spiral down in tenant quality, relative rent levels and increasing vacancies.
Not every tenant will adopt these standards. Many feel that the pendulum may actually swing back, but a comparison of leasing activity from our most recent waves of office development in downtown Toronto is telling.
If we look at pre-leasing activity from the last round of development, tenants expanded by 31 per cent. In the current cycle, they are giving up more space than they are taking. And if you factor this trend into weakening demand in general and new supply, you have a sector that without an expanding economy will see rising vacancies and downward pressure on rental rates.
Turning to retail, the biggest recent story has been the spectacular crash and burn of Target. The causes of Target’s misfire in Canada have been well discussed and I won’t rehash the details except to emphasize that the exit of Target from Canada was entirely a Target problem and in no way should be misconstrued as an indictment of the Canadian retail landscape.
It’s still a little early to determine how the economy will affect consumer spending, especially in
Alberta, but retail remains solid. Look at the remarkable consistency in occupancy of the major retail REITs. Whether the point of reference is the 10-year average, how we fared during the recession or where we are today, occupancy has consistently been over 95 per cent.
Target-anchored malls in less than stellar locations or older power centres may languish and they will face liquidity challenges, but this is nothing new. Retailers fail and retailers die and new retailers emerge. Consumer preferences change. It is real estate Darwinism. It wasn’t that long ago that Eaton’s anchored almost every major mall in Canada. And as the memory of Target is already fading, others have plans to expand. And to a large degree this is to be expected. Retail is by far the most dynamic of all asset classes, and it is ever evolving.
The question of how e-commerce will affect bricks and mortar, as if the two are entirely separate from each other, has become quaint in the same way that we used to ask ourselves, do you think LEED will catch on? It has become clear that digital has converged with physical. Retailers with bricks and mortar locations are already starting to use their stores as mini-fulfillment centres, and buying a product online and picking it up within a few hours is becoming increasingly common.
Given this symbiotic relationship between conventional retail and logistics, it is becoming increasingly difficult to distinguish between where the world of retail ends and logistics begins. In other words, you can’t discuss one without the other.
And given the importance of the retail supply chain, the catalytic effect of e-commerce on the industrial sector has been profound. The lexicon of the ever expanding logistics sector has evolved from: warehouse to distribution centres, to distribution and fulfillment centres, to mega distribution and fulfillment centres.
In many of these new facilities, the technology takes longer to install than the building takes to build and is often worth just as much. Buildings are not only getting bigger but clear heights are climbing, column spacing is widening, truck courts are deepening and site coverage is shrinking.
In time, technology may play an even larger role in the industrial sector. According to a recent report from Boston Consulting, advanced robotics are changing the calculus of manufacturing boosting productivity and enhancing the growing trend of manufacturers moving production back to North America – commonly referred to as reshoring. Canada is well positioned to be a fast adopter of this technology and aligned with a low Canadian dollar, it could prove to have a dramatic effect on manufacturing assets as we get back to actually making what we consume.
Industrial has a shorter development cycle than any other real estate class, meaning the supply tap can be shut off relatively quickly. It continues to perform with less volatility than any other asset class, other than multifamily.
Twinned with industrial for its stable returns is the multi-family sector, truly the epitome of the perfect child. No traumas, good fundamentals, favourable immigration patterns and housing affordability concerns all speak to the continued demand for apartment product. Rental growth in Alberta; however, will be tempered and we are already seeing evidence of rents decreasing.
Outside of Alberta, existing fundamentals do look solid, but there is a level of uncertainty hovering over the entire market that exceeds anything we have seen in recent years. The market faces very real economic headwinds and I’m not trying to downplay them, especially the potential contagion of weak resource pricing on the broader economy. That’s a very real threat. The true measure of the impact of low resource pricing is not just how much it has fallen, but how long it will last. That remains a story which has yet to unfold.
At times like this, I think it is very important that we keep things in context and I think it is instructive to consider the underlying strength of the industry in Canada.
Consider the following:
- The Canadian REIT industry didn’t exist prior to 1992 and has since evolved into approximately 100 entities, bringing with it public market discipline and generally excellent management.
- Payout ratios are declining as REITs move to a more conservative total return model and now average approximately 79 per cent vs 97 per cent in 2008.
- Some REITs have moved out along the risk curve and have ramped up their development activities but only because they have the scale to allow for it. Most are allocating less than
- 10 per cent of their balance sheets to development and, in the unlikely event that a development were to completely blow up, their dividends are covered.
- Canadian pension funds are amongst the most sophisticated capital in the world and allocations to real estate have increased every year and continue to move up.
- Pension funds, either directly or indirectly, are responsible for the largest developments in the country and they have the ability to weather market volatility much better than the highly levered private entities of the past.
- Industry leverage is conservative. Loan to fair market value ratios for REITs average approximately 50 per cent. LTV ratios for private buyers are well within historic norms and there are virtually no players of any consequence who are levered up to their eyeballs.
- For the most part, the addition of new supply is disciplined with stringent pre-leasing requirements across the board. Yes, we have pockets of concern, notably in the office sector, but it is nothing like what we’ve seen in the past.
- The supply/demand imbalance between quality assets and capital looking for a home is growing wider. The competition for a finite supply of core real estate is unlikely to change anytime soon and will probably intensify.
- And in markets like Vancouver and Toronto, land constraints provide inexorable upward pressure on everything.
When you put all of that together, you end up with an incredibly strong foundation that allows our industry to absorb external shocks, like a sudden plunge in oil prices, better than at any other time. It also means that a great degree of the volatility that we used to see in real estate has been permanently removed.
It does not mean that real estate is no longer cyclical nor am I being dismissive of some of the real economic challenges that we face, but the wild gyrations in rents and prices that we have seen in the past are likel
y over. And it means that we have better resilience as an industry than ever before. To put it another way, a healthy 25-year old with the flu is much less vulnerable than an 85-year old with a cold.
For the best evidence of this, think of the last recession. An unprecedented global financial catastrophe and, relatively speaking, Canada skated through it. We had a period of extreme illiquidity but there was virtually no distressed selling, no blood on the streets.
Looking forward, here are some thoughts on 2015:
- Don’t expect to see fire sale pricing in Alberta. Instead, we expect liquidity will be impacted, with deal flow curtailed at least for the time being
- Capital will remain readily available and cheaper than ever
- The west’s pain is the east’s gain – momentum of capital will shift back to the east – don’t be surprised to see cap rates tighten further for good assets in Central Canada
- The strong get stronger, the weak get weaker. It is very much a two-tier market and bifurcation appears to be a permanent feature.
- Watch for a continued evolution of the retail landscape. Retailers will need seamless omni-channel strategies or face extinction and power centres will be re-imagined as consumer preferences evolve. Watch for malls to offer more dining, entertainment and ‘experiential’ elements that cannot be replicated digitally.
- The suburbs are far from dead but there will be winners and losers going forward. Transit hub-oriented development is where most of the winners will be found and we will see more evidence that intensification is not just a downtown phenomenon.
- And finally, expect the unexpected.
In summary, when we move beyond the headlines and take a dispassionate view of the market based on actual facts, things don’t look that bad. The regional balance in Canada is shifting from the west to the east for the first time in years but the sky is not falling. The sky is cloudy, but it is definitely not falling. I think my colleague in Calgary, Greg Kwong, CBRE’s Regional Managing Director for Alberta, put it best when asked about the sense of doom and gloom in the province: he said, “There is no doom, just gloom. No one who was long on Alberta has changed their opinion”.
And we believe the same is true for the rest of Canada. After all, when you consider the alternatives, commercial real estate remains a very good place to be over the long term.
Over the short term? Well, there is a truism in economics that states if you have to forecast, forecast often. I think that will definitely apply to 2015. Thank you very much.