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2019 Investment Returns: March turbulence
CAPRICIOUS QUARTER
2020 Challenges Tinge 2019 Investment Returns
By Barbara Carss
The Canadian commercial real estate industry’s outlook and expectations offer a “before” and “after” picture of COVID-19’s sudden descent into the market during the early months of 2020. The following juxtaposes the perspectives from late January and early April – Editor.
THE INDUSTRIAL-RETAIL seesaw continued to epitomize investment performance last year for the 47 institutional real estate portfolios participating in the MSCI/REALPAC Canada Property Index. Results from the index producer peg the 2019 total return on 2,723 directly held standing assets scattered across eight major markets at 6.65%, but that overarching number cloaks significant variances between property sectors, and from market to market.
“It’s a rate that, in general, was maybe a bit lower than people were expecting,” James Harkness, Executive Director with MSCI, told a late January gathering in Toronto.
The slip from a 7.3% total return in the previous year is attributed to a decline in capital growth — at 2% versus 2.6% in 2018 — and to the lowest yet recorded income return, which nudged down 10 more basis points to rest at 4.6%. However, Harkness pointed to another unprecedented metric.
“We’ve had 10 years of capital growth being positive and that’s a cycle we have not seen before,” he said.
The 2019 total return marginally surpasses the four-year average of 6.5%, while trailing a 10-year average of 9.2%. Drilling down to the component sectors, industrial properties soared above the allasset average, delivering an average total return of 16.4%. Retail properties slumped in the opposite direction, eking out an average total return of 1.8%, but losing 2.4% of capital value since 2018.
“You can’t sugar-coat this,” Harkness acknowledged — referring to the potpourri of assets, from super-regional malls to neighbourhood food-anchored convenience centres, falling into the retail category.
Regionally, retail was healthiest in Vancouver, Toronto and Ottawa, albeit consistently the weakest performer, trailing generally strong returns for office, residential and industrial in the three cities. Total retail returns dipped below 1% in Calgary and Montreal, while sliding into negative territory in Edmonton, Winnipeg and Halifax.
“For anyone who is long on retail, it’s a tough number,” observed Michael Brooks, Chief Executive Officer of REALPAC, who steered the discussion as a panel of industry insiders was tasked with providing on-thespot reaction to the results.
INDUSTRIAL RUNWAY On the upside, Teresa Neto, Chief Financial Officer of Granite REIT, predicted continuing industrial gains as e-commerce flourishes, new types of demand arise and new customers — also known as immigrants — steadily arrive. In the United States, e-commerce boasts a share of retail sales that’s about double its current stake in the Canadian market, and analysts there expect it to expand further.
Already, the strongest industrial returns were found in Canada’s most populous regions: 22.8% in Toronto; 21.4% in Montreal; 15% in Vancouver; and 14.8%
CAPRICIOUS QUARTER
in Ottawa. Neto noted that rent typically accounts for 5% of logistics costs, translating into opportunities for industrial landlords positioned to provide distribution space in close proximity to urban customers.
“A 2% reduction in your transportation costs gives you [room for] a 20% increase in rent,” she advised. “So there’s a lot of runway.”
“There are a lot of areas on the industrial side, like cold storage, for example, where we’re expecting growth,” concurred Jon Ramscar, Executive Vice President and Managing Director with CBRE Limited. That’s in support of a predicted boom in food and pharmaceutical e-commerce.
With that, comes another possible option for tapping into unused density that could help reposition struggling community shopping centres — an exercise Ramscar called particularly challenging in smaller markets. “You have to get creative,” he said.
“More neighbourhoods [mall operators] are thinking about adding a residential tower on the corner of a retail site. What’s to say that doesn’t get converted into last-mile delivery,” mused Christina Iacoucci, Managing Director with BentallGreenOak. “It’s often difficult to find sites big enough for these delivery facilities.”
Panellists likewise identified land supply as a key and increasingly scarce ingredient for continued growth. “There is desire for a lot of development. Lack of land is a challenge in Toronto,” Neto reported.
Oxford Properties is currently building Canada’s first multi-level industrial building in Burnaby, British Columbia, and it’s expected to be a spreading trend. “We’re probably going to start seeing that in Toronto,” she said.
For now, index participants’ tight industrial vacancy rates — 0.9% in Toronto; 1.7% in Montreal and 2.8% in Vancouver — are seen as one of the contributors to this year’s low income return. While enthusing, “on the industrial side, rents have just exploded”, Iacoucci noted that turnover has been more of a trickle.
“When you’re in a market that is so low, how are you capturing those rents that are double-digit? Being able to produce that into an income return takes some time,” she submitted.
REGIONAL VARIANCE Between the widely divergent industrial and retail bookends, residential and office properties stayed more on course with 2018 performance. Both surpassed the all-asset average for 2019, as residential properties delivered an average total return of 11.4%, with the office average total return at 7.1%.
Residential returns were particularly strong in the eastern half of Canada. Notably, a total return of nearly 40% in Halifax was largely responsible for the city’s unprecedented ranking as Canada’s best performing market in 2019 — bumping Toronto and Vancouver into second and third. That’s attributed to a significant deal for a 14-building portfolio last year, reverberating in a market that recorded a 1% negative total return in 2018.
“In a secondary market, one trade can swing the market so much,” Ramscar reiterated.
Even with Halifax retail properties delivering a negative total return of nearly 16%, the chart-topping all-asset average total return shook out to 13.3%. Elsewhere, Toronto registered a 10.1% average total return, followed by Vancouver at 8.4%. Montreal also surpassed the national average, with a total return of 7%.
Looking to the prairies, Calgary, Edmonton and Winnipeg continued to struggle. While Winnipeg was alone in recording a negative total return, all three cities experienced declining capital value. Calgary saw negative total returns for both office and residential properties, and also reported the highest office vacancy rate among Canadian markets.
Industrial properties were the strongest performers for index participants in Calgary and Edmonton, but — with total returns of 2.7% and 3% respectively — well off the average national pace. Office was Winnipeg’s strongest sector, delivering an average total return of 1.6%.
“There is clearly not momentum in these markets,” Harkness said.
FUND PERFORMANCE Meanwhile, the MSCI/REALPAC Property Fund Index shows roughly comparable results on a smaller base. Approximately 1,000 assets — collectively equating to $37-billion of capital value versus the $184-billion collective value of the directly held assets in the Canada Property Index — contributed to an all-property 8.3% total return for 2019.
Industrial was the top performer for the nine participating funds, delivering an average total return of 16.6%. Retail properties in the funds fared slightly better than those that are directly held, recording an average total return of 2.3%. Toronto was the top performing market with an average total return of 13%. Calgary bottomed out the list with a negative total return of 0.6%. zz
SIGNIFICANT TURBULENCE HITS Q1
The first quarter ended very differently than it began across Canadian real estate markets, as a long-conjectured brake on momentum arrived in an unexpected form. Analysts foresee cap rates will hold steady in the coming months because few trades are expected.
Rather, CBRE’s quarterly cap rates and investment report — the first for the new decade — is more an exercise in weighing and digesting the “significant turbulence” that has engulfed the business landscape.
“It has become clear that the short-term economic impact of COVID-19 will be unprecedented and real estate asset values will not escape the carnage,” surmises Paul Morassutti, CBRE’s Vice Chair, Valuation and Advisory services. “However, at this point, there is little actual evidence of material cap rate expansion. NOI (net operating income) erosion as a result of widespread rent concessions will likely have greater impact.”
The national average cap rate hovered just below 6% at the end of March with a 493 basis point spread above the 10-year bond yield. Similar to several recent previous quarters, rates were tightest in the multifamily sector, at an average of 3.79% nationally for Class A high-rise product, and in select industrial markets, including Vancouver, Toronto, Ottawa and Montreal.
CBRE analysts project the office, industrial and multifamily sectors are better positioned to recover solidly once business activity resumes, while retail and hotels will take longer to catch up. Although the circumstances of the 2008 financial downturn were very different, Morassutti sees some likely parallels for commercial real estate.
“That crisis saw deal flow essentially halt and resume once the smoke had cleared,” he recounts. “We fully expect that this will be the case in Canada as well-capitalized owners have little inclination to sell into a market at a discount if they believe conditions will be markedly different 12 months from now.”
“In a world which came to a jarring stop for everyday life and conventional commerce, the principles of commercial real estate haven’t changed but implications have,” observes Carmin Di Fiore, Executive Vice President, Debt and Structured Finance, with CBRE. “Systemic pragmatism about the flow of rental payments through the real estate daisy chain is now the singular focus for tenants, landlords, lenders, regulators and governments.”
Accordingly, it’s expected office landlords will be primarily focused on issues around rent deferrals and mechanisms for payment support well into Q2. Meanwhile, social distancing imperatives have accentuated somewhat diametrical trajectories for industrial and retail assets. The potential for strong e-commerce gains should bolster industrial fundamentals, while bricks-and-mortar retail reels from radically curbed consumer demand and retail tenants’ mounting business constraints.
“The critical role of industrial assets in omni-channel and global supply chains is only forecast to increase and will ensure the sector remains well supported by strong fundamentals, especially on a relative basis,” CBRE analysts hypothesize. “Mandatory closures [in the retail sector] have had severe impacts on business revenues across the industry. Given current market conditions, it’s expected that this slowdown will have significant impacts on near-term operating proformas moving forward. That said, the magnitude of NOI deterioration is yet to be seen.”
Multifamily landlords are deemed to have more of a cushion.
“Due to the record strength in fundamentals pre-shutdown, its overall inherent resilience and its counter-cyclical relationship to economic downturns, the multifamily sector is well-positioned relative to other sectors and investment products,” maintains David Montressor, Executive Vice President with CBRE’s national apartment group.
Nevertheless, Morassutti suggests all real estate players will be navigating much rougher terrain than the signs indicated three months ago.
“Buckle up,” he advises.
CBRE’s quarterly Canada Cap Rate and Investment Insights can be found at www.cbre.ca/en/ research-and-reports
