By Erik Sherman
Real estate might be the longest-term and dependable type of alternative investment. Buy the property, let the rents come in, watch the value grow over time, rebalance the portfolio periodically. People need places to live, companies need premises to do business.
But things have been changing in a big way. “A lot of people in position to make decisions seem to be buying time until there’s more clarity,” says Scott Figler, national research director for JLL Canada, a division of the commercial real estate (CRE) giant. “In the time I’ve been in this business, which is the last 12 years, this is probably the most interesting time. I’ve worked in different countries, and this is the most interesting cycle. Everything you learned goes out the window.”
That’s important to Canadian pension fund investing, which hold large amounts of real estate. At the end of 2022, British Columbia Investment Management had CAD$36.1 billion net real estate assets under management globally with 46.1%, or $16.6 billion in Canada. (Numbers for 2023 are not yet available.)
The Canada Pension Plan Investment Board had real estate as 9%, or $49 billion, of its asset mix in real estate, delivering 10.2% net return, while in geographical composition 16% of overall investments were in Canada.
AIMco saw a -3.4% total fund return in 2022, but real estate offered a positive 4.6% return.
Ontario Teachers’ Pension Plan had 12% of total assets, or $28.1 billion, in global real estate with an 8.3% return on the local assets.
A More Conservative Market
Thinking of Canadian markets as roughly the same as those in the United States is a basic and fundamental mistake.
“Broadly speaking, the fundamentals we follow in lockstep with what happens in the U.S. as relates to monetary policy,” says Rob Renaud, president of ENCOR Advisors, successor to the tenant representation part of what was Devencore. But monetary policy is tied in with, but not identical to, the CRE industry. Banks are regulated differently than in the U.S. “We don’t have as much risk-taking. It’s a more conservative lending marketplace. That saved us in the commercial mortgage meltdown in 2009.”
It also makes for almost unrecognizable dynamics. In the U.S., having 30-year mortgages, at least for residential properties, is common. In Canada, the amortization period for a property is 25 years, but refinancing happens every five years. “That allows the banks to mark to market for changes in interest rates,” says Figler. The Canadian financial market “is better insulated in times like these. There are more guardrails and protections.”
Look at U.S. commercial mortgages, especially in offices. “You take out a loan to buy an office building,” Figler says. But “it’s way easier in the U.S. to walk away from that building. It’s not tied to collateral in the same way.” Fewer lenders in Canada means fewer opportunities to find another source wiling to take a chance.
“If you walk away from assets, you’re going to get a reputation,” Figler adds. “Lenders can access the finances of whoever is the signing officer of the company or assets of the company as collateral. On the debt side, that’s been a big help. There’s not as much distress in the market. You’re not seeing what you see in the US with the Brookfields and Blackstones walking away from a building” as the New York Times and others have reported. Non-recourse loans largely stop at the southern border.
A Portfolio Shift
Pensions had already been rebalancing their real estate portfolios, “selling office and retail assets over the last five to seven years,” says Figler, because they were overweight on those two types. “Now the question is what does this rebalancing look like after such a turbulent year,” he asks. So far it looks like shifting more toward industrial and multifamily.
Still, Canada faces many problems that the U.S. does. Operating costs are rising. “Property taxes are going to be going up,” Renaud adds, noting there hasn’t been a reassessment in Ontario for two years. “Insurance has gone up.”
And then there is hybrid work as people want to work from home. “Where and when do workers want to work? How do they want to get to the office?” Renaud asks, saying that some cities like Toronto have relatively poor mass transit compared to other global metros.
The interest in staying home results in a reduction of amounts of office space companies need, a flight by commercial tenants to quality, inducements by landlords and investors to come and stay, and shorter terms for flexibility. One major investor Renaud has spoken to is propping up rents through high development allowances.
There are also the knock-on effects, with peaks and valleys throughout the week. “How does a retailer operating their sandwich shop survive?” Renaud says. “There’s a lot of that type that has to be worked out. [Owners like pension funds will] have to remained focus on strategically investing in their assets to improve them to attract workers back.”
Through crediting tightening, consumers are also “pulling back a bit,” which then affects the need for warehousing and raises the question of how much more property inventory will be needed. “We have one of the largest and most expensive industrial markets in North America,” says Renaud. “My prediction is a lot of these buildings that are being built in the next 18 months or so will be leased for slightly different terms,” and likely less money.
“There is certainly change happening, Renaud says. “As a general theme, there’s not as much growth in rents and a little more flexibility in how deals are being structured overall.” Leaving open the question of just how much return real estate assets will contribute at the end of 2024 compared to 2022.
