Presenters and panellists at the REALpac/IPD Canada Real Estate Investment Forum in Toronto. Photo courtesy of REALpac.

An upside to declining investment returns

Real estate remains a stable performer among asset classes
Tuesday, February 10, 2015
By Barbara Carss

Real estate industry insiders now weighing declining investment returns against prevailing trends for other asset classes generally conclude that their market is in reasonable shape. Recently released results for the 42 portfolios participating in the REALpac/IPD Canada Quarterly Property Index — representing more than 375 million square feet in 2,351 properties — pegged the total return for directly held standing investments in 2014 at 7.3 per cent, down from the 10.7 per cent index-wide performance of 2013.

Analysts note that’s in keeping with Canada’s waning real estate cycle following four years of double-digit returns and sustained outperformance of most other markets around the globe. On the flipside, however, current prospects for national bond yields are hardly buoyant.

“In Canada, real estate is still probably the least-worse asset,” mused Stephen Taylor, vice president, real estate, with Healthcare of Ontario Pension Plan (HOOPP), as part of an immediate-reaction panel discussion in conjunction with last week’s release of the 2014 index results.

“I think what the market is telling us right now is there are not a lot of places to go that are stable,” concurred fellow panellist, Heather Kirk, managing director, equity research, with BMO Capital Markets.

Even before a largely unforeseen drop in oil prices sidetracked the Alberta and Canadian economies in the second half of 2014, forecasters had expected a continued ebbing of the spectacular returns earlier in the decade, which peaked at 15.4 per cent nationally in 2011. Also true to earlier predictions, income return, at 5.2 per cent, accounted for the bulk of total returns in 2014, with capital growth trailing at 1.9 per cent.

“7.3 per cent clearly represents a market slowdown, but it’s still a rate of return that would have been pretty good in many markets in 2013,” Simon Fairchild, executive director with the index producer, MSCI Inc., told the gathering of real estate professionals in downtown Toronto. “Yes, we’re at a historically low yield for real estate — 5.2 per cent — but, yes again, the same is true for interest rates.”

Both equities and bonds outperformed direct real estate in 2014, but REITs were the clear class of the field. As of January 31, 2015, the FTSE Canadian Capped REIT Index reports average annual one-year returns of 20.7 per cent.

“Listed real estate outperformed the wider stock market,” Fairchild reported — a trend that Kirk expects will continue.

“I think the REIT market is always looking for what is further out. Number one, it’s a stock market, so it always overacts,” she said.

For unlisted properties, as Fairchild observed, a total return of 7.3 per cent in 2014 is a better result than was recorded in Switzerland, Japan, Germany or France in 2013. However, Canada and the U.K. were previously somewhat on par with total returns at 10.7 per cent and 10.5 per cent in 2013, while Canada’s 2014 performance lags well behind the U.K.’s projected 17.9 per cent total return. Looking back two years, the scenario was reversed as the Canadian index delivered a total return of 14.1 per cent in 2012 versus a 2.7 per cent total return in the U.K.

“It’s revealing that the Canadian market may be on a different path (with) different trends than what we are seeing elsewhere. The Canadian market seems to be on the wane and converging in on global norms,” Fairchild said. “It’s probably fair to say that Canada will under-perform a lot of markets around the world, but that might not be a bad thing for some of the big pension funds that have diversified.”

Drilling deeper into the numbers, Fairchild pointed to sectoral and regional trends. After a multi-year run as the top performer, office properties delivered the lowest returns — 6.4 per cent nationally — while industrial ranked first with total returns of 9.2 per cent. Retail returns, nationally, were at 7.7 per cent with multi-residential at 7.4 per cent.

For panellist Alain Dumaine, senior vice president, global portfolio management and strategic planning, with Ivanhoé Cambridge, an earlier peak for industrial and lingering status for retail were among the few muted surprises of the day.

“I expected it (industrial’s top return) would be in 2015,” he said. “I would have thought that retail would be lower this year, not the second highest performer.”

Regionally, Winnipeg emerged the frontrunner among 10 individual metro markets and the broadly labelled “rest of Canada,” delivering total returns of 10.2 per cent. Four other cities — Regina, Vancouver, Calgary and Toronto — surpassed the national average of 7.3 per cent, while Ottawa/Gatineau and Montreal trailed with returns of 4.4 per cent and 4.1 per cent.

“As someone from Vancouver and someone who has a big industrial portfolio in Winnipeg, I was certainly happy to see that,” observed Remco Daal, president and chief operating officer with Bentall Kennedy.

Nearly half — or 49.5 per cent — of the reported $5.5 billion net investment in 2014 occurred in Toronto. Even so, Calgary topped the list for development expenditure at $576 million, ahead of Toronto’s $466 million. Together, the two cities accounted for more than half of the development expenditure in Canada last year. (In contrast, although the top-performing urban centres, Winnipeg and Regina represent relatively small markets within the index.)

Both the numbers and panellists’ anecdotes highlight Calgary’s slipping status. Total returns of 8.8 per cent in 2014 are well off 2013’s 12.9 per cent performance. “On the margins, already we are seeing people’s expansions plans put off or, on renewal, they’re taking less space,” Taylor acknowledged.

REITs tell much the same story. “A lot of the worst performers so far are the ones that are exposed to western Canada,” Kirk added.

That said, owners and investors are primarily bracing for a soft leasing market rather than longer-term repercussions. Few anticipate a flood of dispositions.

“I don’t think there will be any deals,” Dumaine said. “We’re going to stay through the cycle.”

“People have been more than paid for their risk in Calgary over the last 15 years,” Daal affirmed.

That could be the theme in general, as Fairchild remarked on the index’s 10-year return rate of 11.4 per cent.

“I think that says, by itself, it has just been a phenomenal decade,” he asserted. “Further, it’s remarkable for a mature economy and what’s more remarkable is that, right slap-dab in the middle of that, we had the global financial crisis.”

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

Presenters and panellists at the REALpac/IPD Canada Real Estate Investment Forum in Toronto. Photo courtesy of REALpac.

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