COVID-19 fallout

Some drag in buoyant 2018 investment returns

Record high prices, record low yields in leading property sectors and markets
Friday, February 8, 2019
By Barbara Carss

A surging industrial sector helped to counterbalance slipping retail values and push up 2018 investment returns on Canadian commercial real estate. Annual results of the MSCI/REALPAC Canada Property Index, released February 1, reveal a national total return of 7.4 per cent across 2,424 directly held standing assets. That’s an improvement over 2017 when the national total return was 6.7 per cent, and also exceeds the five-year average of 7 per cent.

Contributing components of the broad all-property average — which breaks down to 4.7 per cent income return and 2.6 per cent capital growth — include the highest capital growth rate since 2015, continued cap rate compression, particularly strong markets in Toronto and Vancouver and greater divergence between leading and trailing property sectors. Meanwhile, Calgary and Edmonton showed some upward momentum, largely credited to multifamily and industrial performance.

“National returns may be up because Alberta is less bad than it used to be,” Simon Fairchild, executive director with the Index producer, MSCI, told a Toronto gathering.

Conversely, retail’s 38.5 per cent share of the Index’s capital value gives it the weight to pull returns down. “We may be seeing in Canada things that we’ve seen playing out in the U.S. (retail sector) for a couple of years now,” he speculated.

A panel of industry insiders enlisted to provide on-the-spot feedback concurred with Fairchild that the 2018 numbers follow logically from 2017 trends and reinforce what they’re seeing in their own portfolios. That’s also true for Canada’s comparatively better results than the 7.2 per cent total return in the United States or 6 per cent total return in the United Kingdom in 2018.

“I’m not surprised by any of the numbers. Canada is our best business, globally, this year,” reported Michael Turner, president of Oxford Properties and OMERS’ executive vice president and global head of real estate. He’s in a good position to judge given that 58 per cent of Oxford’s approximately $58 billion worth of assets under management are outside Canada.

With the exception of retail’s decline, most of the changes in direction were positive in 2018. Looking back to the Index genesis in 1985, Fairchild called the 2.6 per cent capital growth rate “pretty good in historic terms” and noted that it represents an unprecedented ninth consecutive year of rising values. Last year also saw a 1.3 per cent increase in net income.

“We are actually in the longest run of uninterrupted capital growth we’ve seen in the history of the Index,” he said. “We are seeing actual real improvement in rents.”

“I am glad to see income growth is the lion’s share of the growth given the underlying fundamentals of the property market,” reflected Emily Hanna, a partner, investments, with Crown Realty Partners.

As of year-end 2018, the Index comprises 45 portfolios collectively valued at more than CAD $160 billion. Retail and office properties account for nearly three-quarters of the capital value, with industrial and residential carrying lesser weights of 12 and 11 per cent respectively. Hotel and other properties make up the remaining 3 per cent.

Toronto is home base for 41 per cent of the capital value, while Calgary and Vancouver each host roughly a 12.5 per cent share. Among the five other markets highlighted in the 2018 results, Montreal represents about 9 per cent, Ottawa and Edmonton have portions in the 5 per cent range, and Winnipeg and Halifax are indistinctly lumped into the approximately 14 per cent stake of capital value in the “rest of Canada”.

Gap widens between industrial and retail

“Industrial and residential tend to be strong wherever you look,” Fairchild observed. Office also surpassed the national average, as the three property sectors delivered stronger returns than in 2017.

Industrial tops the chart with a total return of 13.8 per cent, followed by multifamily at 11.5 per cent and office at 7.8 per cent. Similarly, three markets — Toronto at 11.1 per cent, Vancouver at 10.6 per cent, and Ottawa at 7.7 per cent — outperformed the national average and their own 2017 returns.

“You have to go back to 2013 to see Toronto under-perform the national rate of return,” Fairchild added. (Calgary and Edmonton were the top markets that year, recording 12.9 and 12.8 per cent total returns, while regional malls delivered a total return of 14.2 per cent.)

Varied regional results underpin retail’s average total return of 4.4 per cent — a slide from 5.3 per cent in 2017. After recording a national capital growth rate of 0.8 per cent in 2017, retail properties enjoyed gains ranging from 5.3 per cent to 0.8 per cent in Vancouver, Toronto, Ottawa and Montreal, while losing value in Calgary, Edmonton, Winnipeg and Halifax. Sector-wide, a 4.3 per cent income return exceeded multifamily’s 3.9 per cent yield.

“It’s maybe a bit of a surprise that the gap between industrial and retail is opening up as wide as it is,” Fairchild said. “The mid-size regional malls have tended to under-perform of late. The main challenge for 2018 is the continued weakening in the super-regional malls.”

The divide between industrial and retail performance is most obvious in the strongest market, Toronto, where industrial boasted a 14.6 per cent capital growth rate versus retail’s 2.7 per cent gain, and in the weakest, Halifax, where industrial squeaked out 0.7 per cent capital growth, while retail lost 9.9 per cent in value. Wide splits were also recorded in Montreal (8.4 per cent) and Vancouver (7.2 per cent).

Calgary office still losing value

In contrast, office remains Calgary’s most troubled sector. Office properties in the city dropped 6.7 per cent in value — a much steeper decline than retail’s 1.9 per cent negative capital growth. On the flipside, the industrial and residential sectors saw gains of 2.4 per cent and 1.9 per cent respectively.

“Values are still falling, but investors aren’t losing all of their money,” Fairchild said.

“We are still seeing an impairment of values in Calgary,” agreed Steven Marino, senior vice president, portfolio management, with GWL Realty Advisors. “We have been taking write-downs in Calgary for the last four years. There are some aggressive leasing deals being done in Calgary, which is affecting value every day.”

Elsewhere, Toronto and Vancouver, again, post healthy gains in office value — 7.3 and 7 per cent, respectively — while Ottawa was the only other market boasting capital growth in the office sector. Multifamily was the only sector to enjoy capital growth in every major market where Index participants hold assets. It also posted the lowest yield in a year when income return nudged down across all property sectors.

From a regional perspective, Fairchild noted that Montreal has joined Toronto and Vancouver in the lowest-yield zone. Together, Montreal and Toronto also captured more than two-thirds of net investment last year equating to nearly $2 billion in Montreal and $2.8 billion in Toronto. “Toronto is the main destination for net new money from the institutions,” he said.

Looking to 2019

While citing “record low yields and record high prices” as defining features of the market, Fairchild makes no dire prognoses. “I can make an argument, I think, that the market is actually pretty healthy right now,” he submitted.

Nevertheless, that double whammy is causing some wariness. “We are long into the cycle,” Turner advised. “I think the biggest risk is cap rates. They have to normalize or expand at some point.”

Economically damaging fallout from political manoeuvring — via either “Trump”, as Marino hypothesized, or “populism across the board”, as Hanna conjectured — is seen as another plausible risk for 2019. Yet, REITs’ relative standout status in tanking capital markets last year offers some reassurance

“It’s almost a vote of confidence in real estate,” suggested Michael Brooks, REALPAC’s chief executive officer.

Panellists also expect to see continued new development in a market where there is not much left to buy. “In the property market, fiduciaries like us have such a pent up demand for product,” Hanna noted.

“Real estate is fully priced,” Turner said. “The best return we see for unit of risk is development.”

“We are seeing a lot more of our peers move into the development space,” Marino concurred.

Looking ahead, Marino predicted a total return of 7.3 per cent for 2019, while Hanna went just one notch lower in her projection of 7.2 per cent. Turner was the outlier on the low end as he pegged the 2019 total return at 5.7 per cent, albeit with a qualifier. “By the way, Oxford will beat that number,” he quipped.

Honours for most accurately projecting the 2018 total return go to Paul Au of Blackwood Partners. He emerged the winner from 140 submissions to the annual contest made at the release of 2017 investment results last winter.

Barbara Carss is editor-in-chief of Canadian Property Management.

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