The recent Toronto release of the REALpac/IPD Canada Quarterly Property Index was followed by a panel of four commercial real estate executives challenged with answering the industry’s most pressing question: How long can the good times last?
Marco Ding, director of real estate investments at the Canada Pension Plan Investment Board and someone who admits to taking a long-term view, sounded a note of caution.
“I’m glad to see that the returns are moderating after a very strong period. The 10-year return for IPD Canada is still around 11 per cent and that is pretty amazing if you think about that as being an unlevered return,” Ding said. “If you compare the same period to stocks and bonds, (it’s) nowhere close. If you assume 50 per cent leverage at five per cent interest rates, that 11(%) turns into 16-17(%) levered return.
“So that is really the number you should be comparing to stocks and bonds and the question we should really be asking ourselves is, ‘Is that sustainable going forward?’ ”
The CPPIB executive, who at 11% came closest among the panelists in predicting REALpac/IPD’s 2013 return of 10.7%, concluded that “caution is the word” for Canadian commercial real estate.
Ding, who joked that he likes to think on a quarterly basis that is 25 years long rather than three months, was consistently the most conservative executive during the hour-long panel discussion.
Plenty of money
The panel’s moderator, REALpac CEO Michael Brooks, questioned how there could be near-record asset trading in 2013 amid gloomy headlines of rising interest rates and a pullback in real estate company stock prices. The REALpac/IPD 2013 study found new acquisitions were the second-highest on record at $6.7 billion and disposals hit a record $7.85 billion.
The answer, the panelists agreed, is that there is a huge stash of private money looking for safe havens, including real estate.
“Private capital out there is enormous,” said Ross Moore, director of research with CBRE. “We obviously focus on the REITs and we focus on the institutional players, the insurance companies, the pension funds, but the private capital in this country is huge.
“They generally have very deep pockets and they have great access to financing – the banks are pretty well open for business. As soon as there is any void, those private investors are in. To me, it is remarkable.”
Blair McCreadie, head of Canadian Real Estate with Standard Life, similarly said he does not see investment capital drying up any time soon, in part because big-money players like pension funds have so few alternatives to real estate.
“Pension plans are in a very tough position,” he said. “Bonds are very worrisome for pension plans; they are afraid of equities. It continues to be ‘Where else am I going to put my money’ and real estate is kicking out double-digit returns . . . 11.9% over 10 years (for the REALpac/IPD Canada index).
“Our fund is over nine per cent over 30 years. It is a fantastic story and there is still a lot of capital chasing it.”
Even if the unlikely scenario capital appreciation is flat in 2014, McCreadie said properties will still churn out income in the five per cent range based on the 2013 average index income return of 5.5%.
CPPIB’s Ding said he expects “a very long period of a low return environment.” That is a positive for Canadian real estate, as is the 10% fall in the Canadian dollar, which means “Canada on a relative basis all of a sudden looks cheaper.”
McCreadie, whose company is attempting to attract international investor through its Canadian real estate investment fund, noted the country is still a tough sell.
“They are afraid of Canada from a real estate perspective because they think we are massively overpriced,” he said.
Even among domestic investors, Canadian real estate is a tougher sell after the four-year bounceback, McCreadie said. “Most Canadian investors that we are talking to are asking us how they can get to Europe.”
CPPIB looking abroad
Ding characterized his plan as “net sellers” in Canada.
“Not because we don’t like Canada, we really like it. But as some of the panelists have noted, the ability to acquire class-A retail, office, what have you product, is very tough. There are also half a dozen bidders at the table,” he said.
“The market has always been very strong in Canada whereas in other markets, even the U.S. and U.K., you saw that correction during the financial crisis so you are buying off of a much lower base.”
“So I think on a risk-adjusted basis we just see better value outside of Canada,” Ding said.
He noted that CPPIB remains a buyer of high-quality properties in Canada when they become available but the overall trend is to “cull” its portfolio here. He also said the plan sold $1 billion worth of retail assets over the past year.
CPPIB does not invest in public real estate markets by purchasing stakes in REITs, for example, but the investment director does like the trusts.
“On a relative basis, REITs look like better value compared to private assets. . . . We are focused on the private side of the business but if I had my way in terms of choosing whether public and private and could choose either/or and had to invest in real estate, I think REITs, personally, are better value at this point.”
Asked to predict what 2014 has in store, the CPPIB executive said, “there is more downside risk. On the fundamental side, I think office is still sort of going sideways, a lot of headwinds in terms of new product. I think I read somewhere that Toronto, Vancouver, Calgary and Ottawa are four of the five most active office construction markets in North America. That doesn’t seem right to me.”
Moore said CBRE has seen “a noticeable deceleration in office leasing” which is showing up most in downtowns which is puzzling given all the talk about urbanization as a prevailing trend. He chalks it up to key sectors such as banking and legal pulling back “a bit” and a general trend of tenants using less space.
Moore also worries about retail.
“We hear about how absolutely bullet-proof the big dominant regional malls are and they are,” he said. “But under that, you have retail sales that have been decelerating quite noticeably the last two or three years” as sales shift to online sources. That negative trend will likely be felt in retail not located in dominant, destination retail locations.