We have decided to focus on major trends in this presentation, rather than merely providing a commentary on the many excellent statistics we produce. All of which you can find in our recently released 2014 Canadian Market Outlook.
Last year we highlighted four trends we thought would characterize 2013. They were:
- A continuation of the broadly based commercial development cycle.
- Active trading. Not at the $30.0 billion levels of 2012, but in the range of $26.0 billion.
- The imminent prospect of a U.S. rebound, which would start to stimulate job creating sectors of our economy.
- And a continuation of the growth in the number and activity of the REITs.
We were looking rather good until May 21, 2013 and the subsequent market reaction to the Fed tapering announcement.
So, our theme this year is simple. Build your view of the commercial real estate markets from the research up and not, as we are seeing so often, from the headlines down. Solid research and titillating sound bites are rarely compatible. What do we anticipate this year?
We definitely see an increasing divergence in the performance of leasing markets across both geography and asset classes. The rising tide that lifted all boats is ebbing, especially where we have lots of supply coming down the pipe. We will focus our attention this morning on those sectors where we see the greatest volatility. So if you own industrial and multi res, my apologies, our lack of a deep dive is a compliment not an indictment.
In the investment space, it is clear that the tolerance for risk continues to decline and consequently the spread of yields has significantly widened between the best and the rest. In this context, it is noteworthy that the REALpac sentiment survey continues to trend down. Investment activity should come close to 2013. If it is off it will probably be slightly to the downside, always subject to any merger and acquisition activity. And mergers and acquisition does remain a real possibility depending on the potential arbitrage opportunities in the REIT valuations.
On the buy side, REITs are slowly putting their foot back on the gas. But they are now a combination of both sellers and buyers. In this space, the ability to grow Adjusted Funds from Operations (AFFO) and a compelling core strategy remain key metrics for investors. Lastly, the success of Loblaws and Canadian Tire in launching their REITs, and the consequent benefits to the parent corp, demonstrates that companies can surface significant imbedded value from their real estate but only if but they have scale and high enough asset and covenant quality.
Let’s do our deeper dive into these trends, starting with those leasing markets. We see another year of progress for industrial, with the logistics expansion providing steady demand and the continuing recovery of the U.S., combined with a softening Canadian dollar, helping stimulate industrial activity across most markets. The fact that supply has remained highly disciplined has greatly helped the sector.
One very noticeable trend in the industrial space is the buying of large development land parcels by institutions, either alone or in conjunction with experienced local partners. Look for these institutions to become increasingly dominant players in the industrial development sector over the next decade.
Supply restraint is definitely not a label you could apply to the office sector, particularly the downtowns of most Canadian cities. From a percentage addition perspective three markets stand out, Toronto, Calgary and Vancouver. Since we have limited time, let’s focus on Toronto. We do take issue with some of the more dramatic headlines on the effect of the new builds. They invariably invoke the ghosts of the early 90’s and tend to apply high level macro averages to an analysis that could and probably should be almost asset specific.
If you think you have seen this movie before, you have, in 2009. Specifically for Calgary and Toronto. The consensus call, including us, was for double digit vacancies and a dySFunctional market. Despite the most disruptive of economic times, the pig did pass through the python with a minimum of discomfort. So what is either the same or different in this next three to four year delivery cycle?
Let’s revert to a recognized journalistic approach to any story:
- Where are these office buildings being built?
- What type of buildings are they building?
- When will the buildings be delivered?
- Who is building the office space?
- Why are the buildings being built and who are the new tenants?
The first three of questions are easy to answer. As you can see, the buildings are almost exclusively confined to the core and downtown south. They are large projects, with the top five averaging 860,000 SF, with floor plates of approximately 25,000 SF and a minimum leed designation of gold. All of these buildings will be delivered by 2017.
Now let’s get to the meat – who is building them and what are they thinking. Concentrating on the 4.3 million SF under construction in the core and south of union station, three things are immediately obvious.
- All of the capital is either fully institutional or completely aligned with the instincts of institutional capital.
- All of the developers already own assets in the same area in which they are developing and some will lose tenants from their existing inventory to fill these new towers.
- And lastly, the developers are all smart and experienced – there are definitely no rookies in this lineup.
So, we are just left with the pivotal question of why. Basically the answer can be divided into two components. First, institutions can build brand new office buildings and add them to their portfolios at better pro forma returns than they can buy the equivalent product in the market – assuming it is even available. In addition, the development risk, for risk there always is, can be accommodated within extremely large, high quality, diversified portfolios which generally continue to outperform.
Rationale number two. The buildings are being built because tenants, who are after all the customers in this scenario, want the new space. What is driving these tenants, well:
- Most of them need to address new workplace standards. Which means that they either relocate or restack and renovate. Since the hard costs are similar in either scenario and the dislocation of restacking often daunting – moving is often the only logical answer.
- Also as a part of this new, emerging four generational workplace, buildings have to be able to physically handle greatly increased employee densities.
- Lastly, geographically dispersed tenants want to consolidate multiple locations into one and drive the attendant efficiencies.
At a mid $30.00 psf rental rate for a new build, does the math work? Well, if you face a mid to high $20.00 psf renewal rate, and you take 15.0% to 20.0% less square footage, which is about the intensification norm, then the math does indeed work. If you throw in the realty tax break some head office tenants qualify for, then the financials become even more compelling.
Clearly the numbers can work for both the owner and the tenant – there is only one real problem. Who backfills the almost 4.0 million SF which is being emptied to fill up the new projects and what is the spillover effect for the rest of the market.
In 2009, despite worldwide chaos, the financial sector found itself basically intact and over the next 24 months expanded its space requirements to reactivate deferred expansion plans and accommodate g
rowth from market share gains. That combination of factors is not present this time around but the reality is that, as an industry, we have great difficulty accurately predicting future space demand.
At a recent real estate event, Jon Love pointed out that analysts took inordinate pride in forecasting new supply – an accomplishment somewhat diminished in his eyes by the fact that the very large hole in the ground, followed by a steadily growing tower, made the task of new supply recognition a less than stellar accomplishment.
The intellectual gap has clearly been that we have invariably applied historical demand averages to these supply numbers in order to predict market movements. These demand averages are clearly very useful as comparators but remarkably unhelpful as predictors.
So we have developed a brand new demand tool. Using bank of Canada data on hiring intentions, we have tested the results against previous leasing cycles. You can see a high correlation against a rolling four quarter absorption number. So we now have a tool that is predictive, and which we can add to our other economic indicators. We have baked this additional analysis into our demand forecast for 2014 and the encouraging part of the data is that we are seeing hiring intentions turning up for the first time since the second quarter of 2012.
Another important factor is where do vacancy rates sit coming into this supply crunch. As can be seen from this graphic, the good news is that we are entering this period with relatively tight vacancies in the downtown core.
So, when the dust settles, what do we think will happen?
- The new builds, on average, will fill up more slowly than in the last cycle but not drastically so.
- The return space will contain enough large blocks that they will be competitive with new builds in the context of providing sufficient contiguous floors for larger tenants.
- Much of the return space and/or buildings will be refurbished to accommodate greater densities for the four generational tenant workplaces.
- Most importantly, the rental levels for this return space, which will include sublets, will fall and create a significant “spot market”. The rent reductions will primarily be offered through free rent and tenant allowances, preserving face rates wherever possible, until the return space has cleared. As mentioned, this rent reduction will make the older space far more price competitive with the next wave of new builds, thereby somewhat constricting the next cycle of development.
So how about the question of contagion? Let’s first look at geography. The areas surrounding the core, to the west in particular, are very tight from a vacancy and new supply perspective. The key issue is, will tenants migrate from existing stock in other office concentrations to take advantage of rent “bargains” in this geographically concentrated spot market?
Let’s look at a specific portfolio as a comparator. Allied REIT has about 3.5 million SF in Toronto, primarily to the west of the core. From an economic perspective these buildings enjoy roughly a $14.00 psf T&O cost advantage over conventional core towers, and during the past six years have achieved a 97.0% occupancy level, with a high/low variation of only 230 basis points (bps).
So the question is, will tenants be tempted to abandon buildings they like, in locations that have a rationale for them, with double digit operating cost and tax advantages, in order to gain a one cycle rent arbitrage. They have not before and we seriously doubt they will do so in the future.
Some concluding thoughts on this subject. Is there a looming problem? Yes. How will the problem manifest itself? We would suggest the following:
- Annual appraisal values on some, but definitely not all, downtown office assets will fall but the effects will be mitigated by the fact that the Net Operating Income (NOI) decline will be baked into an argus model that amortizes, rather than capitalizes, drops in income.
- Any value declines will be folded into very large portfolios that contain a high proportion of diversified, high-quality and over-performing assets, many of which have recorded significant value gains in recent years.
- By the nature of the landlords involved, the pricing of the return space will be dictated by rational expediency not by irrational panic and will recalibrate quickly as soon as availability begins to fall.
- Many of the same principals we have discussed in relation to Toronto also apply to Calgary and Vancouver. Calgary has the highest percentage of space coming on stream in the country, but if there was ever a market that is used to absorbing new supply, and producing stellar gdp growth, Calgary is the poster child.
- Lastly, for tenants prepared to accommodate the physical constraints of an older building, they may gain significant financial benefits – it will all be in the timing. So adjustment, yes. Armageddon, no.
Moving onto multi- housing. Like industrial, this sector has a highly physically constrained supply. The older stock, which dominates the inventory, continues to provide a useful, low cost bridge to eventual home ownership, especially for many new immigrant communities. By contrast, the younger, technology and financial workers, are gravitating to the few, new, purpose-built rental buildings and the large stock of rental condos, primarily in urban cores across Canada.
Multi-housing remains a low volatility play, characterized by highly skilled property platforms that understand how to manage capital expenditures and utilities. The biggest impediment to even more capital entering the sector remains scarcity of supply rather than lack of demand. So my apologies to industrial and multi-housing participants – at this juncture of the cycle, to quote Mr. Flaherty, you are also boring. But in the world of risk mitigation, which is clearly the predominant mood, boring is definitively a virtue.
As for retail. Well the macro factors are mixed:
- The Canadian consumers high debt levels are flattening and the effects continue to be mitigated by continuing low interest rates. But there seems little room to the upside in consumer spending.
- A recently depreciated dollar will definitely negatively impact the margins of a number of retailers.
- As the rest of the G20 is in various stages of recovery, and offering much improved opportunities, Canada is no longer a “slam dunk” market for new tenants. Our day in the spotlight appears to be temporarily over and we are left with the antics of Rob Ford and Justin Beiber to make us highly noteworthy.
The other factor, which is an ever present in any discussion of retail, is a technology guru sounding the death knell for conventional bricks-and-mortar retail real estate.
It is obvious that e-commerce and multi-channel retailing continue to gain traction, especially in certain product categories. The penetration levels for Canada and the U.S. are 5.0% and 9.0%, respectively, with annual growth in the low teens.
The Barnes & Noble, Chapters and Best Buy categories of retailers continue to be negatively impacted by the “showrooming” phenomenon, where products are viewed in store and ordered online. The Best Buy response of a price matching guarantee has helped slow the decline but definitely at the expense of profit and long-term viability.
Invariably, the debate around formats is framed around an either or choice. The future reality is likely to be closer to a recent blog tag of neither friend nor enemy but of “frenemies”. This term synopsises the omni channel reality that was captured perfectly in warren’s description of ret
The most successful of retailers in the new technology realities will be the ones who effectively mine the synergies of “bricks and clicks” to drive higher volume across their channels. The consumer who is predisposed to go online before visiting a store, and is well informed about product and product lines, can be expected to spend up to 50.0% more or higher than the bricks or clicks consumer, who only shops one channel.
The battleground is the consumer and most pointedly the younger consumer. In a recent survey conducted in the U.S., millennials, the most digital generation of all, said that they would still opt for discount retailers over amazon, especially when they become parents. After all, what parent wants to sit inside and listen to their children alone when you can take them to the mall and share the experience with others. Shopping is definitely a social phenomenom that dates back to the earliest points in civilization and likely isn’t going anywhere any time soon.
So how do we see this retail landscape progressing?
- The fact that retail tenants are constantly evolving their brands and space needs is the ever present reality of retail. This evolution was in full force last year when you consider some of the mega mergers and acquisition deals.
- In no other asset class are the fortunes of landlords and tenants more highly synchronized and dependent upon each other for success.
- E-commerce is also evolving. An essential feature of this evolution will be a combination of logistics space and space in traditional bricks-and-mortar real estate.
- The last reason why retail real estate will remain highly resilient was first articulated by our good friend Mr. Ed Sonshine who said many, many years ago that, in its essence, good retail is a low coverage development site with excellent carrying income.
- So will multi-channel retailing kill conventional retail formats? Clearly not, but it will irrevocably change both the economics and functions of the retail landscape.
- And, although mixed-use development better reflects some of the evolving face of retail, it is largely a downtown phenomenom at present. The urbanization and densification of the suburbs is the next frontier. As with many aspects of city building, transit will be the key to this evolution. As this slide shows, it is a challenge that has yet to be fully embraced by the various levels of government.
Lastly, let’s look at the interrelated areas of debt / trading volumes / the outlook for REITs and the widely held view that increasing interest rates inevitably means increasing cap rates and subsequent declining values.
As we mentioned earlier, moderate increases in bond rates, stable to declining spreads and a good mix of lenders has meant that debt is attractive and relatively plentiful. What has been encouraging for many public borrowers recently, has been the receptiveness of the market for, large, unsecured debenture offerings. The same liquidity trend is true for the buyer line up. All purchaser groups are active. However, the biggest variable is the outlook for the REIT sector and the proposition that REITs will be inexorably hobbled by rising rates.
The overriding factor that influences both liquidity and value, particularly at this stage of the cycle, is that all real estate is not created equal. At the top end of the quality curve there are clearly not enough assets to match the capital available to buy. Additionally, higher quality properties, in prime locations, have the ability to generate higher than average NOI growth. A case in point is the escalation in prime retail rents around the world and the yields prime retail is attracting from investors. So a highly competitive market for assets, especially those referenced as super prime, combined with prospects for strong NOI growth, can mitigate or even fully offset interest rate increases.
Lastly one also has to take into account where real estate return spreads are relative to the long term bonds. Clearly, we have come through a very attractive period for spreads. Today they have settled at, or very close to, historic norms.
So, if you want a definite answer to the interest rate/value conundrum, and don’t we all, then based on some excellent analysis in Canada and the U.S., we would conclude that, on average, for every 100 bps of long term rate increases you would see an average cap rate increase of approximately 50 bps. This widening of cap rates would be lower, or mitigated entirely, if the property has any combination of scarcity, and high income growth potential and the converse is equally true for weaker assets, in weaker locations.
Let’s finish with the buyer group most affected by the May 21st fed tapering announcement. This caused the total return, capped REIT index, to fall 10.6% over the full year. Was this an overshoot or a long anticipated correction? Certainly it is difficult to argue with CIBC’s Alex Avery when he points out that a 15-year run, with an average compound return of 13.0%, means that the REIT sector has extracted every advantage possible from the long decline in interest rates. Eat your heart out Warren Buffet.
So what is next? Well, for a start a new focus on operations and value-add opportunities, including both development and redevelopment. This transition will entail less reliance on lower interest rates or improving rent levels, and a commitment to more flexible capital structures and lower pay out rates. This transition to more of a U.S. model for our REITs is already a part of our investment landscape. The public markets have recognized those companies who have the ability to grow net income, or AFFO, and they have the advantage of lower yields. Which makes them fully able to compete for most assets, most of the time. In other words, many of our familiar REIT names will be active again in 2014.
However, as mentioned earlier, they will now be active as sellers as well as buyers. The days of pure asset aggregation are behind us and this renewed focus on operations means that assets that do not fit the core strategy will be gone. The REITs that will struggle will be those where it is difficult to articulate a coherent rationale for the owned assets and where income growth relies solely upon fortuitous fundamentals rather than intrinsic asset quality.
If there are any similar overshoots in the reaction of the capital markets to future interest rate prospects, look for the well capitalized pension funds to exercise their muscle, either in direct merger and acquisitions, or even teaming up with a capital partner to make a bid. But the discount to NAV would have to widen in order to stimulate activity.
So how to wrap up this entire discussion up into one concluding thought. It would be to be careful of simplistic conclusions drawn from complex trends. Proof positive being the seemingly never ending discussion of the imminent Canadian housing decline, which ironically, has far more merit today than it did four years ago, when the remarkably uninformed debate began.
It is also worth remembering the 2008 prognostications of Mr. Jeff Rubin who, on the back of a fearless $225 a barrel oil price prediction, painted a picture of an apocalyptic world, where suburbs were returned to farmland, air travel a rare extravagence and resort hotels shuttered and redundant. The point being, not that the price of oil does not exercise a massive influence on economic acitivity, but that reactions and interactions are not short term, simplistic nor one dimensional. When assessing some of the self proclaimed great prognosticators, we would do well to recall the words of a famous Canadian, John Kenneth Galbraith, who said, “The only true function of any economic forecasting is to make astrology loo
To see slides from John O’Bryan’s speech, click on the .pdf attachment.