Property Biz Canada

Institutional buyers: Calculated risk or foolish gamble?

In May of this year, two real estate investment trusts (REITs) joined forces to purchase Bank of Nova Scotia’s landmark red tower in Toronto for $1.27 billion, the highest price paid to date for an office tower in Canada.

Scotiabank is but one example of a growing trend in which institutional buyers are throwing their weight around and, as a consequence, dividing the commercial real estate market into two categories. First, there are those properties valued under $10 million, which represent the majority of the stock on the market and, due to their size, are primarily of interest only to local buyers with specific objectives and investment criteria. Second, there are those properties of higher value which, increasingly, have been snapped up by institutional buyers from outside of the region or even the country. These buyers are not concerned by how far afield they must go for investment opportunities provided they are of high value and generate reliable revenue streams.

Institutional buyers are pension funds, REITs and any other entity that buys for an investment fund or group of investors. Economic conditions have led them to become increasingly active in the Canadian market in recent years as their need to grow and sustain cash flow becomes more urgent. Pension funds in particular have become desperately underfunded. But how is this impacting asset values, capitalization rates and the market’s long-term outlook?

Prices are being inflated

The math here is simple – the more you pay for real estate as an investment, the longer it will take to see a return. Nonetheless, institutional buyers are paying premium prices that have been inflated by their own demand. Take for example, Scotiabank’s Toronto tower; while the final price tag was $1.27 billion, most analysts had expected between $1 billion to $1.2 billion.

In addition to the need to generate cash flow for unitholders, this buying trend also suggests many institutional buyers have large sums of capital to place. And those who sell are in need of new investments to offset capital gains taxes.

This is compressing cap rates

As a result, many institutional buyers have bought with capitalization rates of only five to seven per cent. Smaller local and private buyers are seldom interested in buying at these rates.

The higher the purchase price in comparison to Net Income, the lower the cap rate. For example, let’s say a building that was purchased for $1 million produces $100,000 in annual positive net operating income (NOI). NOI is the amount left over after fixed costs and variable costs are subtracted from gross lease income. Divide 100,000 by one million and you are left with 0.10, or 10 per cent. If the NOI remains constant, it will take 10 years to recover the purchase price. If we ran the same calculations using a purchase price of $2 million, the cap rate ends up being five per cent, meaning it will now take 20 years to recover the purchase price, without considering a return on investment.

Which creates long long-term risk

In other words, the lower the cap rate, the greater the risk of a poor or negative return on the investment. Institutional buyers know this, and yet they are still jumping into transactions that leave them with historically low cap rates. I can only assume that they are banking on increased rental rates which will drive up NOI.

The other gamble which they are taking relates to the periodic need for reinvestment. All classes of real estate need reinvestment in the form of retrofits, upgrades and other improvements to maintain prestige in the market, attract and retain desirable tenants, keep up to code and, most importantly, sustain rent payments. Anything other than a building that is brand spanking new will need some measure of reinvestment within the medium time horizon of 15 to 30 years. In many instances, institutional buyers who are taking on such low cap rates must be banking on needed reinvestments being decades away.

Lastly, low cap rates mean that capital is tied up in a property for a longer period, which prevents investment in other, perhaps more lucrative, opportunities that may come along.

What does it all mean?

Are institutional buyers taking reasonable risks by committing to such low cap rates? Are they making unwise assumptions? It is difficult to say and the answer, in many cases, may not be obvious for some time. Many things can happen to impact rental rates and other variables which have a bearing on NOI. Even Ottawa, arguably one of the most stable markets in the country, has endured its share of ups and downs over the years, most notably the public cuts by the Liberal government of the mid-90s, which saw some properties change hands for only 10 per cent of their historical market value.

About John Clark: With over 30 years of experience in the national real estate appraisal and valuation industry, John Clark (BA, AACI, P.App., FRICS, Chartered Valuation Surveyor) is a leading expert on real estate matters that impact the value of commercial, institutional, residential and other special use properties. He joined The Regional Group of Companies Inc. in 1988 and has served as Vice-President of Valuation and Consulting since 1990. He is a Fellow of the Appraisal Institute of Canada and served as its National President, 2001-2002.

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