Real Estate Dorota Dyman & Associates blog: Canadian real estate’s next worry: commercial property
by Mike Farmer Dorota Dyman & AssociatesLooking east along King St. West from Peter St. in downtown Toronto
from an upper floor at 375 King St. West on Sept 9 2013. The Hyatt Regency
Toronto hotel is at left with bank towers located centre of photo. (Fred
Lum/The Globe and Mail)
First, it was Canada’s housing sector.
Now, it’s the country’s commercial
real estate market.
Pundits around the world are still
immersed in a vigorous debate about just how overheated the residential real
estate market here is, and whether it’s destined for a crash. Now some are also
training their sights on Canada’s commercial real
estate market – the wide array of office towers, shopping malls, and
factories that have become hot commodities in recent years.
The key players in this sector –
including Canadian pension funds, real
estate investment trusts and insurers – have been saying for at least a
year that the market, which has always been cyclical, appears to be near its
peak.
But questions are being raised about
whether they’ve done enough to prepare for a potential softening.
Richard Johnson, a Zurich-based managing
director of UBS Global Asset Management, held a meeting with pension funds in
Toronto last month and told them that UBS is concerned about their level of exposure
to Canadian real estate.
“With most Canadian institutional real
estate investment focused on domestic real estate, pension funds could be
seriously overexposed in the event of a downdraft in the market,” he says.
Canadian commercial real estate boasts a
10-year annualized total return of 11.9 per cent, according to Investment
Property Databank Ltd. That’s the highest of all countries covered by IPD,
except for South Africa.
It compares with a return of about 8 per
cent on equities and 5.6 per cent on bonds.
A number of factors have driven Canada’s
commercial real estate market to outperform expectations over the past five
years. Local landlords, such as pension funds and REITs, have had a lot of
capital to invest, leading to stiff competition for prized assets. And Canada’s
status as a safe haven in the wake of the financial crisis caused foreign
players to look for places to park their money here.
UBS expects the total return on Canadian
commercial real estate in the next three years or so will be in the
neighbourhood of 6 per cent. But William Hughes, head of UBS’s global asset
management real estate research and strategy group, says that the market’s
performance will be impacted more by perception than any fundamental changes.
And he says that if investors decide they’re ready to take on more risk to seek
higher yields, then some of those who were attracted to Canada by its
safe-haven status could look to invest their money elsewhere, hurting real
estate values here.
“Pricing is a concern,” says Leo de Bever, the CEO of the Alberta Investment Management Corp., or AIMCo. “Real estate has been the best-performing asset class since 2000. I’m not sure that will be the case going forward. That said, all asset classes are fully priced, or in the case of bonds, riskier than they have been since the 1950-1980 period.”
Most of the major pension funds have
been diversifying their portfolios, and increasingly looking for investment
opportunities abroad. A number of pension funds and other institutional players
are also shifting toward building new office towers and other commercial real
estate developments in Canada, rather than paying top prices for existing ones.
“The development cycle is working well
right now for sure, a lot of us are finding it easier to manufacture profits
than to buy them,” says Blake Hutcheson, CEO of Oxford Properties, the real
estate arm of the Ontario Municipal Employees Retirement System (OMERS).
But he adds that he believes supply and
demand are in check, and “I don’t think in any way Canada is overpriced. The
real estate fundamentals in Canada have remained as strong as any in the
world.”
There is some concern that too many new
office towers are being developed. More than 15 million square feet of new
office space is scheduled to be built across Canada in the next four years,
with the country in the midst of the most active downtown development cycle in
20 years, according to brokerage Cushman & Wakefield.
But Cushman CEO Scott Chandler noted
that the pension funds are developing much of the new supply – and the new
towers are likely to do well, at the expense of the older ones.
Similarly, market players note that in a
softening market the best assets will still hold their value, and many of those
– such as landmark shopping malls – are owned by the pension funds.
Amy Erixon, a managing director in
Avison Young’s investments business, said that pension funds in Canada tend to
have a large allocation to real estate as a means of diversifying, in part
because the stock market is so concentrated.
Lorenz Reibling, chairman of
Boston-based Taurus Investment Holdings, says that the real
estate investment firm has sold more than $150-million in Canadian real
estate lately, including shopping centres and office space.
“The best time to sell is when everyone
else wants to buy, so that’s what we have done,” he says.
Taurus still owns some shopping centres in
Canada, and Mr. Reibling says it’s looking for more Canadian assets to buy. But
they will be “riskier” assets – i.e., fixer-uppers – because the rest, he says,
are fully priced.
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