Investors are expressing confidence in sustained industrial rent growth. More than 95 per cent of respondents to an online poll conducted in conjunction with the recent release of the Canada Annual Property Index 2021 results agree that annual gains of at least 5 per cent are needed to justify current cap rates, and there’s broad consensus that threshold is achievable.
Coming off a year when industrial assets in the index delivered a 31.6 per cent total return, including a 26.4 per cent increase in capital value, neither market analysts nor portfolio managers foresee new supply will catch up with rampant demand any time soon. Looking at a breakdown of even higher reported capital growth in the western and northern suburbs of the Greater Toronto Area, Eric Plesman, head of global real estate for the Healthcare of Ontario Pension Plan (HOOPP), cited evidence in his own portfolio.
“We have some assets in the Caledon area. We started last year with rents around $9 (per square foot) and all of sudden we saw leases being done at $14, $15, $16 by the end of the year,” he recounted. “That’s massive increases in a given year.”
“Those numbers that we put into the polling question about future rents weren’t just plucked out of the air: 2 per cent is the historic long-run average for rental growth for industrial in Canada; 2.5 per cent is the long-run growth in the U.S.,” advised Simon Fairchild, executive director with the index producer, MSCI. “So everybody is expecting the market is fundamentally different.”
On average, industrial assets in the index registered an 8.2 per cent increase in net operating income (NOI) in 2021, on top of a 1.2 per cent gain in the previous year. (In 2020, industrial assets were the only property sector in the index — which in 2021 encompassed 2,367 assets in 46 portfolios, collectively valued at $171.6 billion — to post an increase in NOI.) However, Fairchild underscored the much greater share of capital growth attributable to cap rate compression in markets like Toronto, Vancouver, Ottawa and Montreal.
“The exception is, of course, Alberta,” he noted. “What’s interesting there is actually the fundamental growth in NOIs is pretty comparable (to other Canadian markets), but it just hasn’t benefitted the strong investor demand pushing up values.”
Supply shortage driving cap rate suppression
Other industry insiders tasked with providing context for the 2021 index results tallied projected sources of industrial rent growth as both traditional warehouse users and the e-commerce sector jostle in increasingly tight markets everywhere. Jim Costello, MSCI’s chief economist and the director of its Real Capital Analytics subsidiary, reiterated that new development is still vastly lagging demand and warned that cap rates could continue to shrink, particularly until the market share for e-commerce levels out.
“Fundamentally it comes to the change in consumer behaviour and just how quickly the market can adapt to that. Prologis calculated that every dollar spent for consumption activity generates three times as much need for industrial space on the part of the people who ship these goods around. So the real unknown is how much longer does it (e-commerce) go up at an exponential weight?” he submitted. “Until we get to that point where it’s clear we’ve made enough of an adjustment, there is still going to be pressure in the space market.”
“Industrial has become a consumption-oriented class in addition to its traditional, trade movement of goods orientation,” agreed Paul Mouchakkaa, managing partner and Canadian head with BentallGreenOak. “You have sort of a combination of great tailwinds. First, an increasing demand on the e-commerce side, but also on the movement of goods side. The traditional industrial segment is still a growing part of the economy. Then you combine that with low availability rates across Canada and a very old inventory in Canada.”
In reference to the latter, many assets managers are concluding it’s a good time to cull their portfolios and reinvest the windfalls. Plesman suggested portfolios with new facilities under development could be well positioned to “take advantage of the pricing environment”, while Jaime McKenna, managing director and global head of real estate with Fengate Asset Management confirmed her company is doing exactly that.
“It’s one thing to value your industrial, but anybody who has transacted in industrial over the last 12 months probably got paid significantly more than they actually had on the books,” she observed.
After some dispositions to “clean up” its industrial portfolio, Fengate is typically opting to build new projects rather than trying to acquire facilities that can meet current market demands. Turning to envisioned prospects for 5 per cent annual rent growth, McKenna sees plenty of room to manoeuvre.
“You have to look at industrial rents from the perspective of affordability for the tenant. If you look at a residential rent, it can make up 30, 40 or 50 per cent of the renter’s income, whereas the industrial rent can be 5 to 10 per cent of the tenant’s income so it’s a much smaller factor,” she maintained. “We’re still bullish for industrial.”
Asset mix reflected in index performance
Industrial returns are identified as a factor in the Canada Property Index’s performance in 2021 — with an average total return of 7.9 per cent — relative to the Canada Property Fund Index, which delivered a net fund level return of 14.6 per cent and a direct real estate return of 11.4 per cent. The fund index represents nine non-listed open-end core real estate funds collectively holding 1,026 assets in 2021.
“One of the reasons these funds have been so strong is because they have a lot more industrial than you see in the main index. They carry about 10 per cent more industrial assets and that’s having a meaningful impact on the fund performance,” Fairchild reported.
“Historically, if you didn’t have big office and super-regional malls, you didn’t perform at the same level. Well, guess what?, the institutions own most of that,” Plesman mused. “The funds picked up a lot of the assets that they could aggregate, and they have been the favourite asset classes through COVID.”
He sees similar underpinnings in the gap with the U.S. Annual Property Index, which posted a 2021 total return of 18.2 per cent. “It’s asset mix, I think, that’s the biggest contributor to the difference between us and the U.S., where I expect there is a lot smaller retail component,” Plesman said.
Looking to the future, institutional investors are expected to adjust their portfolios accordingly. Plesman notes that institutions are already “proactively” selling some iconic office assets and predicts that trend will continue. Mouchakkaa foresees more focus on office properties’ asset-level strengths and weaknesses with less emphasis on picking winning markets.
“In a systematic world you were really betting on a given metro’s GDP wealth for the future. That has traditionally really been a big driver in office rents,” Mouchakkaa explained. “Going forward in this pandemic world, in the next three to five years, investing in the office space will be really micro and a stock digger’s type of strategy.”
Barbara Carss is editor-in-chief of Canadian Property Management.