When Ottawa experienced the largest commercial real estate deal in its history last fall, one of the insiders noted in a media interview the strategy of many investors right now is to “own very core assets in core markets.”
This is a trend that’s bound to continue in 2018 if the first couple of weeks of the new year are any indication.
Last week, Blackstone Property Partners purchased Canada’s Pure Industrial Real Estate Trust (PIRET) for US$3.8 billion. Over the past decade, PIRET (AAR-UN-T) reports a total return of 345 per cent from its portfolio of 168 properties across Canada.
Meanwhile, the Canadian Pension Plan Investment Board continues to build its portfolio of student housing properties, through its joint venture, Scion Student Communities. The CPPIB announced another US$1.1-billion deal. In the two years of its operation, Scion has invested a total of US$4 billion in student housing.
And that deal for Ottawa last fall? The $480-million purchase of Constitution Square, a class-AA office complex downtown. The value of the deal was more than double that of the previous record-holder.
In fact, the past two years have been record-breakers for Canadian CRE investment in general. There is a lot of money floating around, looking for a place to land, but why?
Oodles of cash thanks to central banks
In response to the 2008 recession, central banks in the U.S. and the U.K. engaged in quantitative easing to spur economic activity when it became evident slashing interest rates wouldn’t suffice.
They bought up trillions of dollars in bonds and other government financial instruments from banks with “digital money” that didn’t previously exist in the hope this would encourage said banks to make more loans. In other words, to drive an economic recovery built on credit.
The big risk is this can fuel hyper-inflation, like has been seen in the past with financial crises in Zimbabwe and Germany’s Weimar Republic following the First World War. Or at least some inflationary pressure, reminiscent of the 15 to 20 years after 1974 which is understood to have resulted from monetary policy primarily related to financing the American war in Vietnam.
This hasn’t occurred, thanks largely to a fractional reserve banking system in which banks loan and reloan their deposits on hand. (See this great article on the subject from Investopedia.)
But while inflation didn’t shoot up, CRE asset valuations in many markets have. So where did all that cash go? Between North America and the U.K., we are talking trillions of dollars.
Indications are it did more to boost bond and stock markets than it did economies. Much of it appears to have ended up with big institutional investors like banks, insurance companies and pension funds. If the volume of activity in Canada in recent years is any indication, CRE as an investment class is obviously a major beneficiary.
Big deals, despite low cap rates
Another indicator big investors have become twitchy about the buckets of money they have sitting idle is the fact capitalization rates in CRE remain low by historic standards.
Not so long ago, CRE investing at cap rates under five per cent was not attractive, but in the current reality, making something is better than making nothing. Institutional investors such as insurance companies and pension funds need cash flow to meet their obligations to claimants and pensioners.
That makes this a market of long-term plays that rely on large and stable assets to offset a low cap rate. It’s the realm of big investors looking at big assets. The founder of our company has lived through the transition from a time when virtually all real estate was owned locally and markets were driven to a large extent by the attitudes of these local investors.
There has been a dramatic change in the nature of real estate investing and investors. Little guys aren’t equipped to play in this sandbox because they are not prepared to take less than five per cent, while the big guys likely aren’t interested in assets that are anything but Tier 1. It may be that Tier 2 and minus assets will remain the purview of the little guys.
But, you ask, why wouldn’t these big investors just put their money in the stock market?
That is a valid point. Markets have been strong as well the past two years, and stocks are much more liquid than real estate. That old joke about a boater’s life often does apply to real estate – the happiest two days are the day you bought it and the day you sold it.
Long-term effects on real estate
The level of activity in both the stock market and the CRE market suggests money has been flooding into both – investors have been diversifying, and perhaps using what they deem to be stable investments in CRE to hedge the risks of playing in stocks.
Because there is still a risk, long-term. Some economists warn that when central banks start to sell the assets they have accumulated through the economic stimulus juggle of the past decade, interest rates will soar and choke off an economic recovery. In that scenario, a CRE portfolio, even with a low cap rate, may balance any resulting volatility in the stock market.
Only time will tell how all this plays out. But one clear trend does appear to have emerged – a significant concentration of ownership of CRE assets among a smaller group of large entities. Smaller players may find themselves frozen out of top-tier investment opportunities in the years to come.
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