2020 Investment Returns: Canada Annual

RARE RETURN

Canada Annual Property Index Records a Loss in Value for 2020

NO WINNER WAS declared this year in the annual REALPAC/MSCI challenge to peg the investment performance of directly held standing assets in the Canada Annual Property Index. That’s likely because no one foresaw a 1,000+ basis point slide in the 2020 average total return — settling at negative 4.1% — when the annual contest was conducted 12 months earlier.

A ten-year run of capital growth abruptly reversed, resulting in a 7.8% loss in value across the 2,356 assets that the 44 portfolios represented in the index collectively hold. Income return continued the record-setting downward trajectory witnessed in 2018 and 2019, dropping 70 more basis points to 3.9%.

“That’s not just down to the cap rate suppression we were seeing before; it’s really out of income suppression,” Simon Fairchild, Executive Director with the index producer, MSCI, advised during the online release of the 2020 results earlier this winter. “Performance in 2020 is more severe than we experienced in the financial crisis. You have to actually go back to the deepest years of the 1990s’ recession to see similar falls in value — in 1992, 1993.”

The overarching numbers hide a more uneven picture. Industrial once again emerged as the top-performing property type, delivering a 12.7% total return. Multifamily also remained on the plus side of the scale, recording a 5.7% total return.

In counterbalance, office and retail, which together account for more than 68% of index value, pulled the average down with total returns of negative 1.5 % and negative 15.1%, respectively.

Canada’s 2020 decline was steeper than in the United States where MSCI index results show investors realized a modest average total return of 1.8% down about 4% from 2019. Meanwhile, investors in the United Kingdom experienced less slippage, recording an average total return of negative 0.8%.

Industry insiders tasked with providing on-the-spot reaction to and context for the Canadian returns point to differences in market size, relative weight of property types within the index and responses to the COVID-19 pandemic as underlying reasons for national discrepancies.

“I suspect in the all-property index, Canada is being skewed a little bit by the office and retail component and that is impacting those capital returns,” hypothesized Peter Cuthbert, President and Head of Global Real Estate with Fiera Real Estate Investments. “Two bad quarters — quarter 2 and quarter 3, with quarter 2 being particularly bad — have made a difference.”

STRATIFIED RESULTS Looking at the capital growth and income return splits for all property types, retail took the biggest hit, with a 17.8% loss of capital value and an income return of 3.2%. It suffered a 30% drop in net operating income relative to 2019, compared to a 13% decline across all properties.

While both industrial and multifamily properties recorded capital growth — at 7.8% and 2.2% respectively — only industrial saw year-over-year income growth, at 1.2%.

Office properties, equating to 37% of the index value, lost 5.9% of capital value with an income yield of 4.7%. The sector experienced a 2% decrease in net operating income for a better year-over-

By Barbara Carss

RARE RETURN

year outcome than multifamily assets, which sustained a 2.7% loss.

Also indicative of office and retail weight in the index, seven of the eight major markets represented in the index registered a negative total return. Only Ottawa squeaked out a positive margin with a 0.1% total return largely attributable to 4.3% income yield.

Toronto — last year’s top-performing market — held on to second place with a total return of negative 0.8%, while Calgary bottomed out the field at negative 12.7%.

Colin Lynch, Head of Global Real Estate Investments for TD Asset Management, contrasted Canada’s relatively sparse canvas to the much denser overlay of markets and wider range of economic, social and government influences at play in the United States. There, the stringency of COVID-19 outbreaks and public health measures varied across a deeper pool of commercial real estate tenants and patrons.

“We’re in the middle of an exceptional situation where the response to that exceptional situation is clearly different country by country by country, and that’s having an impact, I think, on how folks are looking at property,” Lynch mused. “So much of this is relying on the nature of the government responses to the pandemic. That’s having a real impact — whether it is [commercial real estate] assets that are open versus closed, or whether it’s certainty in the market.”

OFFICE CHALLENGES Looking to the recovery period, panellists and MSCI analysts alike agree that some sectors of the economy and some property types face a more arduous climb back to pre-pandemic levels. Real estate owners, managers and investors are now grappling with some ongoing challenges that have intensified over the past year, and digesting others that they didn’t see coming.

In the latter category, total returns for downtown office in major markets fell from the 8 to 9% range in Q3 to negative

“Performance in 2020 is more severe than we experienced in the financial crisis. You have to actually go back to the deepest years of the 1990s’ recession to see similar falls in value — in 1992, 1993.”

“We may have underestimated retail as a leisure activity for a lot of people.”

1.7% in Q4, while suburban office experienced a gentler slide from about 4% to negative 0.9% in the same period. Fairchild links the quarter-to-quarter difference to the timing of evaluations and write-downs for rent abatement and deferrals appearing on the books, and the downtown-to-suburban contrast to the twists of pandemic fallout.

“One quarter doesn’t make a trend, of course,” he noted. “But it’s maybe not surprising. From what we know, the downtowns have been like ghost towns for the last year so that’s maybe starting to impact the values.”

If the year’s events have somewhat upended assumptions about stronger locations, they’ve also perhaps bolstered ESG (environmental, social, governance) policies, practices and monitoring. Deborah Ng, Head of Responsible Investment and Director, Total Fund Management, with the Ontario Teachers’ Pension Plan Board, maintains ESG has helped steer building owners/managers along unexpected bumpy terrain and will also serve landlords in a market where they’ll be seeking a competitive edge.

“If you want to attract and retain top-tier tenants in office and retail, you really need to have best-in-class sustainability,” she asserted. “Corporate Canada is increasingly setting targets and goals with relation to sustainability, and their property is a big reflection of that end and purpose. So there is definitely a role for real estate to help tenants achieve some of their goals.”

Warning that COVID-19 could be a relatively low hurdle ahead of looming climate change upheaval, she notes that the past year has also fleshed out the social dimension of asset management as almost all building users became more attuned to health, safety and exposure to risks that could affect their wider personal networks.

“There is always a focus on the E part of ESG, but I think COVID has really brought out the S aspect of it,” Ng said. “It’s been a challenging time for real estate on a number of fronts with increasing costs for labour as well as dealing with workers who need to selfisolate or need to take time off because they are unwell, and this is all happening at a time when the real estate market has been battered, people aren’t going to the office and retail is down.”

RETAIL DYNAMICS Diverging performance of neighbourhood and regional shopping malls was even more pronounced, with a 13.5% difference in their total returns at Q4 — at negative 3% versus negative 16.5% — and a further drop to negative 18% for superregional malls.

“Retail has been under pressure for a number of years since the peak in 2013 and we’ve seen a gradual decline since then, but it’s turned into a sharp decline in 2020 and it’s the largest malls that are being hit the hardest,” Fairchild summarized.

Panellists foresee some upturn from those depths when COVID-19 threats subside. With a few recent years of rising industrial values bringing the economics in line with big box retail, Cuthbert suggests the timing could be right for hybrid repositioning.

CANADIAN ASSET MANAGERS RANK WITH GLOBAL LARGEST

Brookfield Asset Management sits far atop the field in IPE Real Assets’ 2020 rankings of the world’s 150 largest real estate investment managers, registering nearly CAD $361 billion (€232 billion) in assets under management (AUM) as of June 30 last year. That’s a repeat of Brookfield’s standing in 2019, but with a gain of nearly CAD $85.3 billion (€55 billion) in AUM. It also outdistances The Blackstone Group’s second place tally by CAD $130 billion (€83.5 billion) in AUM.

Value growth is a general trend across the annual list from the European based institutional investment analyst and news service. Collectively, the top ten players recorded a CAD $203 billion (€130 billion) jump in AUM from the previous year. The top 100 managers of 2020 held CAD $577 billion (€370 billion more in real estate assets than the top 100 of 2019.

“The latest numbers continue the trend of recent years — a seemingly inexorable rise in AUM — fuelled by a combination of rising asset values and institutional allocations to the asset class,” the accompanying analysis states.

Five other Canadian asset managers are ranked in the top 50, while four more are placed farther down the group of 150. These include:

• Ivanhoé Cambridge, ranked 26th with CAD $72 billion in AUM; • BentallGreenOak, ranked 30th with CAD $68 billion in AUM; • Manulife Investment Management, ranked 40th with CAD $58.5 billion in AUM; • Oxford Properties Group, ranked 43rd with CAD $55 billion in AUM; • QuadReal Property Group, ranked 44th with CAD $54.6 billion in AUM: • Great-West LifeCo, ranked 72nd with CAD $28 billion in AUM: • BMO Real Estate Partners (an arm of BMO Global Asset Management), ranked 113th with CAD $11 billion in AUM; • Slate Asset Management, ranked 131st with CAD $6.2 billion in AUM; • Fiera Real Estate, ranked 134th with CAD $6 billion (€3.83 billion) in AUM.

The top 150 real estate investment managers are predominantly based in the North America, with 58% from the Americas. Europe is home to 29% of 2020’s largest asset managers, and the remaining 13% are headquartered in Asia-Pacific.

“Some of that big box retail is in exactly prime position to serve last-mile logistics, particularly the return channel. So who’s to say that your 15,000-squarefoot box can’t have 10,000 feet of warehouse and 5,000 feet of single-use retail in the front?” he asked. “I think retail and retail properties will bounce back in a different form.”

Gradual loosening of public health controls should also bring back consumers who initially may have few other options for discretionary spending.

“We may have underestimated retail as a leisure activity for a lot of people. A lot of people, that’s what they do with their spare time. They go to the shopping centre and hangout and interact socially, and a lot of those major centres are community centres as well,” Cuthbert observed.

After 2020’s 28% differential between the best and worstperforming assets, he predicts the spread will close tighter this year.

“It’s very possible that industrial cools off a bit. The pricing has gone through the roof,” he said. “I think we might be surprised to the downside on the top performer, industrial, and get a little bit of recovery in retail and office.”

“Retail will get a bit of reprieve postCOVID,” Lynch concurred. “A lot of us are locked up and cooped up and we would like to get out and experience things. So there’s going to be a bit of that when we’re all allowed to.”

Nevertheless, from the perspective of one Canada’s most prominent retail landlords — Ontario Teachers’ real estate arm, Cadillac Fairview — Ng sounded a note of caution. “I’m not as bullish on retail, just thinking of the number of bankruptcies that we’ve had, and those are our tenants,” she said.

MODEST EXPECTATIONS While last year’s annual contest proved to be a washout, panellists and online attendees were invited to predict the timing of the recovery and project capital growth for 2021 — an exercise that largely drew consensus around early 2022 for a return to pre-pandemic GDP, and 0.1 to 5% capital growth over the coming months. Panellists agreed that much will depend on curbing COVID19’s potency, but that there is more economic stimuli in play than has been seen in previous downturns.

“There are sectors — take travel, hospitality, leisure — where there is quite a bit of damage that will take some time

MULTIFAMILY ASSETS SURPASS INDEX AVERAGE

Multifamily assets were the second best performers last year for the 44 institutional real estate portfolios represented in the REALPAC/MSCI Canada Property Index.

“The headline return of 4.1 negative is masking a 28% spread from the best — industrial at 12.7%, which would be a good return in any kind of year — down to negative 15% for retail,” Simon Fairchild, Executive Director with index producer MSCI, observed during the online results presentation. “That spread between best and worst is twice as big as it was last year, and last year it was the largest that we’d seen.”

With a total return of 5.7%, multifamily performance slipped farther behind industrial than in 2019, but also pulled farther ahead of office properties, which slipped to a negative 1.5% total return. Multifamily assets delivered average capital growth of 2.2% and an average income return of 3.5%.

Investors saw a 2.7% decline in multifamily net operating income for the year — a gentler downward slope than the 30% plunge for retail assets. Meanwhile, sales values dipped from recent years, but stayed above the benchmark analysts typically use as an indicator of a strong market.

Historical data reveals that, on average, assets in the index sell at about a 5% premium over their market-adjusted evaluation — a trend Bryan Reid, MSCI’s Executive Director, Real Estate Research, attributes to a conservative valuation bias, buyers more actively seeking assets with unrealized potential and vendors more motivated to sell when they can reap a premium.

“There’s a certain amount of sample selection going on there, but you can also see that the premium will increase or decrease over time,” he advised. “In periods of market strength, we tend to see a higher premium than average, and during periods of weakness or uncertainty, that premium tends to decrease or perhaps even becomes negative.”

The latter is the case for retail properties, which recorded average transacted values nearing 10% lower than market valuations in 2020. In contrast, multifamily, industrial and office assets all surpassed the 5% premium. Although the year’s averages are drawn from about half the number of transactions that occurred in 2019, Fairchild reiterated that real estate continues to draw investment.

“The new money going into these portfolios has actually gone up, from about $3.7 billion [in 2019] to $3.9 billion. That’s maybe not what people would have expected,” he observed.

Multifamily drew more than $660 million of that net new capital investment. That’s about half of the nearly $1.3 billion directed to industrial development, but well ahead of the $220 million the retail sector captured.

In contemplating possible pandemic-fallout, commercial real estate insiders do foresee potential vulnerabilities of non-portable assets in a world where employees are increasingly untethered from their workplaces. Industry executives enlisted to provide on-the-spot insight into the 2020 returns reflected on possible implications for multifamily assets in major and secondary markets.

“The bigger underlying trends are very important,” reiterated Colin Lynch, Head of Global Real Estate Investments with TD Asset Management. “One: the Millennials are forming families — that’s happening later than before, but it is happening — and people are looking to bigger spaces to form those families. And two: especially in the USA, there is a cost dynamic that’s been going on for more than a decade where people are moving to cities such as Dallas, Houston, Atlanta, Raleigh and Durham. Why? Because those areas of the USA are cheaper.”

“The aggregate demand for real estate or shelter doesn’t really change. As long as we have people working, living and breathing, we need shelter to operate under. It’s just that the location of those functional elements of the economy may disperse to more affordable regions,” concurred Peter Cuthbert, President and Head of Global Real Estate with Fiera Real Estate Investments.

to come back. Then, clearly, a lot depends on things that are beyond the world of real estate: mutations; vaccination rollout; and the associated confidence of Canadian consumers around that,” Lynch reflected. “I do think that the dynamic of low interest rates and fiscal policy will provide a little bit of floor relative to other periods of distress. However, I can’t see a dramatic positive overall return for real estate in Canada.”

“We’ve got massive amounts of stimulus going into the major economies around the world and one would hope that will mean it will be a short downturn, but there are some very strong sectoral trends playing out within the real estate sector as well. We’ve got to think hard about the shape of the recovery,” Fairchild submitted. “Asset allocation is just such a critical part of the fund management process and now we see why.” zz

Getting Ahead of Property Repairs

Saving costs and time with proactive maintenance

When it comes to condo maintenance, planning ahead can pay off. Detecting and addressing minor issues on a building’s exterior or mechanical systems is a proven way of signifi cantly reducing the cost of future repairs and avoiding resident inconveniences. Not to mention, building envelope repairs can often contribute to energy savings, while ongoing preventive maintenance to the building envelope will extend its service life.

The following is a run-down of key building envelope inspection areas and simple preventive maintenance actions that can be undertaken now to prepare for the season ahead.

MECHANICAL SYSTEMS

• Replace air fi lters in the building’s primary make-up air units, as well as in suites with heat pumps or fans coils. Dirty fi lters can decrease air fl ow in the system and force fans to work harder, thereby decreasing the life and increasing operating costs. They can also reduce indoor air quality to increase the potential for mould growth. As such, plan to replace air fi lters about four times a year. • Operate all valves that are part of the domestic plumbing and hydronic HVAC systems at least two times a year. These valves can remain in the same position for years if not exercised as part of a maintenance program, and there is no worse time to discover a valve has seized than when a shutdown is required. • Complete a full seasonal maintenance on boilers and chillers/cooling towers, as recommended by their manufacturers. These are best completed during the change-over between heating and cooling seasons.

EXTERIOR WALLS

• Look for wetting patterns, efflorescence (salt deposits), and deterioration below the corners of metal window sill flashings. These are indicators of poor rain deflection at the ends of the sills. • Install drip deflectors at the ends of window sills to promote water flow over the sills and not on the walls. • At areas of deterioration, look for wetting patterns and details causing poor deflection of rainwater. Correct poor rain/snow melt deflection details. • Install metal drip flashings over brick window sills and at top of masonry walls without flashings since the brick will typically deteriorate much sooner without this protection.

FOUNDATION WALLS

• Raise the height of the grading around the foundation walls where they are settled to promote drainage away from the building. This will reduce the risk of leakage and deterioration of the foundation walls. • Check that roof downpipes and troughs are clear, connected, and directing water away from the building. • Test and check that sump pumps are working properly and are discharging water away from the building.

SEALANTS (CAULKING)

• Regularly replace failed sealants (caulking) where provided to control water penetration and air leakage.

Sealants should perform adequately for 10 to 15 years when proper materials and installation practices are employed.

WINDOWS AND DOORS

• Regularly replace worn and damaged weather-stripping at door and operable window perimeters. Maintaining tight air seals is necessary to control air leakage and drafts which in turn reduces heat loss and energy consumption. As well, tight seals also control rain water penetration. • Try to use other means of ventilation (e.g., kitchen and bathroom exhaust fans during cold weather) when an apartment does not have an automatic mechanical ventilation system. This is particularly important for apartments with hot water heating and radiators below windows to avoid the potential for burst pipes. If a tenant turns an in-suite thermostat on low and leaves a window open there is an increased risk for a costly pipe burst.

FLAT ROOFS

• Remove debris and vegetation at roof drains. Be sure to remove debris at the level of the waterproofi ng membrane as well for protected membrane systems. • Have a qualifi ed contractor and/or consultant to assess the condition of the roofi ng system every year or two. v

• If your roof has recently been replaced, ensure regular warranty inspections are performed to ensure the warranty is not voided.

SLOPED ROOFS AND ATTIC SPACES

• Arrange for an experienced contractor to access the attic space to seal pipe, exhaust duct, wiring and electrical box penetrations at the level of the drywall ceiling and air/vapour barrier. This practice will reduce air leakage from the building interior into the attic space thereby reducing heat loss and energy consumption. These measures will also signifi cantly reduce the risk of ice damming along the roof eaves. • Check the level of insulation. The Ontario

Building Code requires a minimum thermal resistance for attic insulation.

Although you are not required to upgrade to meet the current code, it may be a good time to consider adding to the

existing thickness of the insulation to reduce energy/fuel consumption from not only heating, but cooling. • Check that adequate venting at the soffi t and roof vents is provided and that the soffi t baffl es are not blocked by insulation. Proper venting will extend the life of asphalt shingles and reduce the risk of ice damming provided air sealing at the level of the ceiling is done fi rst. • Install downpipe extensions from upper to lower roofs to avoid accelerated shingle deterioration from increased water runoff and ice damage.

A little preventative maintenance goes a long way towards mitigating larger issues. And as with any building maintenance program, there is value in partnering with qualified contractors and consultants who can leverage their experience to assist with assessment and repair of the more complex issues.

Dave Moore is President of Pretium Engineering Inc. [www.pretiumengineering.com], a specialist building science, structural, and mechanical consulting engineering fi rm that provides high quality, evidence-driven services. Contact a local offi ce to see how “Working Together, Better” can work for you.