No winner has been declared in the REALPAC/MSCI challenge to peg the 2020 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 average total return — settling at negative 4.1 per cent — when the annual contest was conducted last winter.
A ten-year run of capital growth abruptly reversed in the ensuing months, resulting in a 7.8 per cent loss of 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 per cent.
“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 month. “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 per cent total return. Multifamily also remained on the plus side of the scale, recording a 5.7 per cent total return. In counterbalance, office and retail, which together account for more than 68 per cent of index value, pulled the average down with total returns of negative 1.5 per cent and negative 15.1 per cent, 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 per cent — down about 4 per cent from 2019. Meanwhile, investors in the United Kingdom experienced less slippage, recording an average total return of negative 0.8 per cent. 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.”
Industrial and Ottawa emerge as property and regional leaders
Looking at the capital growth and income return splits for all property types, retail took the biggest hit, with a 17.8 per cent loss of capital value and an income return of 3.2 per cent. It suffered a 30 per cent drop in net operating income relative to 2019, compared to a 13 per cent decline across all properties.
While both industrial and multifamily properties recorded capital growth — at 7.8 per cent and 2.2 per cent respectively — only industrial saw year-over-year income growth, at 1.2 per cent. Office properties, equating to 37 per cent of the index value, lost 5.9 per cent of capital value with an income yield of 4.7 per cent. The sector experienced a 2 per cent decrease in net operating income for a better year-over-year outcome than multifamily assets, which sustained a 2.7 per cent 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 per cent total return largely attributable to 4.3 per cent income yield. Toronto — last year’s top-performing market — held on to second place with a total return of negative 0.8 per cent, while Calgary bottomed out the field at negative 12.7 per cent.
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.”
Yet, in serving as the discussion moderator, REALPAC chief executive officer Michael Brooks cited a per capita U.S. death rate that’s more than 2.5 times greater than Canada’s to weigh that pandemic-induced uncertainty against other outcomes. “Maybe we’ve clamped down harder and that’s hurt our markets more, but more people are alive,” he said.
Ghost town tableaus haunt urban office
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 per cent range in Q3 to negative 1.7 per cent in Q4, while suburban office experienced a gentler slide from about 4 per cent to negative 0.9 per cent 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 self-isolate 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 awaits post-pandemic uptick
Diverging performance of neighbourhood and regional shopping malls was even more pronounced, with a 13.5 per cent difference in their total returns at Q4 — at negative 3 versus negative 16.5 per cent — and a further drop to negative 18 per cent for super-regional 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.
“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-square-foot 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 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 per cent differential between the best and worst-performing 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 post-COVID,” 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 capital growth projected for 2021
Although last year’s annual contest proved to be a washout, panellists and online attendees were invited to predict the timing of the recovery and to 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 per cent capital growth over the coming months. Panellists agreed that much will depend on curbing COVID-19’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 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.”
Barbara Carss is editor-in-chief of Canadian Property Management.