Industrial-retail seesaw in play for investors

Income return nudges down during 10th consecutive year of capital growth
Tuesday, February 4, 2020
By Barbara Carss

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. Newly released 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 per cent, 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 gathering in Toronto late last week.

The slip from a 7.3 per cent total return in the previous year is attributed to a decline in capital growth — at 2 per cent versus 2.6 per cent in 2018 — and to the lowest yet recorded income return, which nudged down 10 more basis points to rest at 4.6 per cent. 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 per cent, while trailing a 10-year average of 9.2 per cent. Drilling down to the component sectors, industrial properties soared above the all-asset average, delivering an average total return of 16.4 per cent. Retail properties slumped in the opposite direction, eking out an average total return of 1.8 per cent, but losing 2.4 per cent 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 returns dipped below 1 per cent 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-the-spot reaction to the results.

Runway for industrial growth

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 per cent in Toronto; 21.4 per cent in Montreal; 15 per cent in Vancouver; and 14.8 per cent in Ottawa. Neto noted that rent typically accounts for 5 per cent of logistics costs, translating into opportunities for industrial landlords positioned to provide distribution space in close proximity to urban customers.

“A two per cent reduction in your transportation costs gives you (room for) a 20 per cent 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 per cent in Toronto; 1.7 per cent in Montreal and 2.8 per cent 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.

Halifax on unprecedented pinnacle

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 per cent, with the office average total return at 7.1 per cent.

Residential returns were particularly strong in the eastern half of Canada. Notably, a total return of nearly 40 per cent 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 per cent 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 per cent, the chart-topping all-asset average total return shook out to 13.3 per cent. Elsewhere, Toronto registered a 10.1 per cent average total return, followed by Vancouver at 8.4 per cent. Montreal also surpassed the national average, with a total return of 7 per cent.

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 per cent and 3 per cent respectively — well off the average national pace. Office was Winnipeg’s strongest sector, delivering an average total return of 1.6 per cent.

“There is clearly not momentum in these markets,” Harkness said.

Comparable 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 per cent total return for 2019.

Industrial was the top performer for the nine participating funds, delivering an average total return of 16.6 per cent. Retail properties in the funds fared slightly better than those that are directly held, recording an average total return of 2.3 per cent. Toronto was the top performing market with an average total return of 13 per cent. Calgary bottomed out the list with a negative total return of 0.6 per cent.

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

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