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on Real Estate | Canada
2014
Perspective on Real Estate 2010
ACKNOWLEDGEMENTS
We would like to acknowledge the assistance we received from the following parties in
completing this report:
Benefits Canada, Bloomberg, CB Richard Ellis, CIBC World Markets, Canadian Institutional
Investment Network, Canada Mortgage and Housing Corporation, Centre for the Study of
Commercial Activity (CSCA), Colliers International, Conference Board of Canada, Cushman &
Wakefield LePage, Cushman & Wakefield LePage Valuation and Advisory Services, Economap
Inc., Frank Russell Canada (RCPI), Global Insight, Globe & Mail, InSite-Altus Research,
International Council of Shopping Centres (ICSC), Investment Property Databank Ltd. (IPD), J.J.
Barnicke, Kubas Consultants, MCAP Inc., National Association of Real Estate Investment Trusts
(NAREIT), National Council of Real Estate Investment Fiduciaries (NCREIF), National Post, RBC
Capital Markets, RBC Financial Group, RealNet Canada, RealTrack, Standard & Poor’s, Statistics
Canada, Scotia Capital, TD Economics, Vizbits.
We would also like to thank the many individuals who are employed by these parties as well as
the real estate owners and managers who helped us with insights and guidance along the way.
On the cover: 121 King Street West, Toronto, ON
(owner: Prime Canadian Property Fund)
Copyright © 2014 by Bentall Kennedy (Canada) LP
All rights reserved
The information and statistics contained in this report were obtained from sources deemed reliable.
However, Bentall Kennedy Group does not guarantee the accuracy or completeness of the information
presented, nor does it assume any responsibility or liability for any errors or omissions. All opinions
expressed and data provided herein are subject to change without notice. This report cannot be reproduced
in part or in full in any format without the prior written consent of Bentall Kennedy Group.
2| Bentall Kennedy (Canada) LP
Contents
Chapter 1 Executive Overview 5
Chapter 2 Economic Outlook 9
Chapter 3 Real Estate & Capital Markets
Investment Summary 21
Debt Markets 29
Public Equity Market 32
Chapter 4 Space Market Trends
Office 36
Retail 40
Industrial 44
Multi-residential 48
Chapter 5 Regional Overviews
Vancouver 54
Calgary 56
Edmonton 58
Toronto 60
Ottawa 66
Montreal 68
Bentall Kennedy Group 71
Bentall Kennedy (Canada) LP |3
Perspective on Real Estate 2014 - Canada Bentall V, Vancouver BC (owner: Prime Canadian Property Fund together with other Bentall Kennedy clients)
Executive Overview 1
At a Turning Point?
As we progress through the fifth year of recovery from the Great “With rising values
Financial Crisis of 2008, we appear to finally be able to “expect the
expected” rather than the unexpected, albeit still needing to live with and cap rates for
diminished expectations. After three years leading the pack, Canada
has now experienced two years of modest growth. The U.S. continued
“best-in-class” properties
its chaotic political environment but moved toward the front of the at record lows, investors
pack by maintaining its moderate growth. Meanwhile, weaker domestic
fundamentals in conjunction with lackluster trade demand is thwarting should be concerned
the ability for emerging markets to sustain the type of robust growth about the future path
that powered the global economy during the last decade. As we wrote
last year, investors must expect these sluggish economic conditions to of interest rates.”
persist as the global economy continues to slowly work off the excesses
and imbalances it accumulated over the past decade.
Through all the twists and turns of the past year, real estate continued
to deliver strong returns to investors. In an environment of low interest
rates, the stable, growing cash flows of operating properties continue
to attract a broad range of investors. Despite beginning the year with
cap rates near all time lows, operating properties delivered double
digit total return in both the United States and Canada. In keeping
with the economic story, income growth accounted for the majority of
appreciation in the U.S. while cap rate compression, especially among
the very highest quality properties, accounted for the majority of capital
appreciation in Canada.
With rising values and cap rates for “best-in-class” properties at
record lows, investors should be concerned about the future path of
interest rates. As the U.S. Federal Reserve Bank begins tapering its
extraordinary program of quantitative easing, the first small step in
withdrawing the excess liquidity that leading central banks have pushed
into the market to support the global recovery over the past five years,
two opposite risks develop. On the one hand, there is a risk that the
withdrawal of liquidity is too slow, resulting in excess stimulation of the
economy, potential asset price bubbles and eventually, sharply rising
inflation. On the other hand, there is a risk that the economy is too
weak to absorb the withdrawal of stimulus, resulting in slower economic
growth as inflation declines even further below the comfort zone of 2%,
potentially even resulting in deflation. Real estate investors must be
alert for both risks.
Kennedy (Canada) LP |5
Perspective on Real Estate 2014 - Canada
In the first case, the near term should bring stronger income growth must come to the fore in investment
real estate demand growth, particularly among strategy. Location and property quality become
properties with a high exposure to the U.S. economy much more important in this phase of the cycle. As
and continued low interest rates, followed later by discussed in detail in the capital markets and property
rising inflation. All of these are apparently positive sections, 2013 highlighted a clear differentiation
for real estate investors, but carry with them the between “best-in-class” and more commodity-type
substantial risk that the acceleration of supply properties, as increased supply and reduced demand
growth already experienced in 2013 continues as has begun to shift bargaining power from landlords
values rise faster than the cost of construction. Rising to tenants in some markets. This was quite evident
prices without excessive new supply poses a short in the retail sector, where the limited number of
term pricing risk for investors but does not put at fortress malls continued to be strongly in demand by
jeopardy future income streams. Excessive supply is retailers while centres without strong anchors and/
the real risk that investors must monitor, as it does or not offering a differentiated shopping experience,
jeopardize future income streams. The development showed signs of strain. As the invasion of American
discipline that Canada experienced in all property and other foreign retailers continues in Canada,
types except residential condominiums over the past this distinction between “good and bad” is likely to
20 years produced an unprecedented string of years accelerate since these retailers are used to competing
of positive income growth, in stark contrast to the in markets with too much retail space and a long term
repeating pattern of supply excess and wide cycles pattern of “winning and losing” shopping centres.
of income growth in the United States. While we
remain optimistic that Canada will continue to resist
excess development, the country is currently in the “ With the shift from capital
midst of a very active commercial development cycle, market tailwinds to headwinds
particularly in downtown office properties. As such,
investors must be more alert to this risk than at any and the recent moderation of the
time in the last 20 years.
Canadian economy, property
In the second case, where the economy is too weak level performance and income
to absorb the withdrawal of stimulus, the near term
brings initially higher interest rates followed by a growth must come to the fore in
decline in demand, perhaps to the level of another investment strategy.”
recession, and likely then followed by a period of
further prolonged low interest rates. In this scenario,
near term supply risk is augmented by demand risk. In the office market, the differentiation appeared as
Investors must be prepared for lower values initially, a continued shift in demand toward properties with
as rising interest rates eliminate the remaining spread strong sustainability features, especially public transit
to current cap rates and then as weaker demand and energy efficiency. While downtown occupancies
growth impacts income. The real risk in this scenario remained above suburban in most Canadian markets,
is deflation and its pernicious impact on all areas of the gap has recently narrowed, with accessible
demand. Fortunately, younger demographics and suburban properties performing better than more
solid population growth mean both the United States generic office properties in several markets. Flexibility
and Canada have less deflation risk than the rest of of space utilization and cost is an increasingly
the developed world. important criterion for office users and some are
finding that comparatively more affordable suburban
With the shift from capital market tailwinds to buildings can provide better flexibility than older
headwinds and the recent moderation of Canadian urban towers.
economic growth, property level performance and
6| Bentall Kennedy (Canada) LP
Executive Overview 1
Among industrial properties, modern distribution the respective levels seen in the U.S. at the height of
facilities able to meet the demands of global its housing bubble in 2006, suggesting that demand
logisticians remain strongly in demand. Older in Canada may now be at or near a peak. This is
properties without the ceiling height, floor loading, particularly true since the direction of interest rates is
and dock ratios demanded by these tenants are forced more likely to move higher than lower going forward.
to compete for local tenants on price. If housing demand materially softens and condo
prices and average rents begin to fall in response
The housing sector remains a source of strength for to excess supply, it could prompt condo investors
the Canadian economy but is also an area which to dump product, thereby further amplifying the
requires the closest attention. High rise condominium imbalances in this sector.
development continues at extraordinary levels,
especially in Canada’s largest city – Toronto – As the Canadian economy and thus real estate
although historically low mortgage rates and healthy demand growth shifts from leader to middle of the
population growth have kept unsold inventories pack, investors need to be especially vigilant and
low for now. Lenders have ensured that each focused on the defensibility of the income streams in
individual project continues to meet strong pre- their investments and the ability and sophistication
sales requirements and stable prices have kept of their managers. As we wrote last year, we are now
both investor and occupier demand high. But it in the part of the cycle where alpha generation must
is important to remember that these conditions replace beta as the primary driver of solid returns in
are not inconsistent with a speculative bubble. real estate. The heterogeneity of real estate has long
Homeownership rates in Canada have surged to made it an asset class where well executed strategies
70% and household debt to income ratios are at a can produce solid returns through most parts of the
record high of over 160%. These figures are above economic and capital market cycle. •
Bayview Village, Toronto, ON
(owner: bcIMC)Perspective on Real Estate 2014 - Canada Bayview at Coal Harbour, Vancouver, BC (owner: bcIMC)
Economic Outlook 2
Global Economy: A Light
at the End of the Tunnel
Viewed from the rear view mirror, the path of the global economy “Forward looking
has certainly been grim. Weighed down by significant fiscal austerity,
economic growth has come up short of its potential in most advanced indicators suggest that
economies with the Euro area still mired in recession. Unemployment
has also been persistently high across much of the advanced world
global growth while still
as the considerable excesses accumulated over the previous decade sluggish, is regaining
continue to get worked off. Even emerging markets – previously the
powerhouses that once delivered much of the heavy lifting for the momentum.”
global economy – have experienced a substantial deceleration in the
pace of their expansions.
Fortunately the view ahead appears to be considerably brighter and
for the first time in a long time, there are signs of a light at the end of
the tunnel. In fact, a number of recent data
reports and forward looking indicators suggest
that global economic growth – while still Fig. 2.1
sluggish compared to historical averages – is Annual Real GDP Growth
finally regaining momentum (see Fig. 2.1).
10
Much of the positive news springs from the
beleaguered advanced countries themselves. 8
6
The United States, for example, has recently
Y/Y % Change
4
seen decent progress in job growth and
housing demand while a number of U.S. 2
purchasing managers’ surveys have shown 0
unexpectedly strong increases in business
-2
sentiment. On the other side of the Atlantic, Euro Area
Emerging Market and
business and consumer confidence indices in -4
Developing Economies
the Eurozone moved to their highest levels in -6
Major Advanced Economies (G7)
more than two years in late 2013, indicating 2000 2002 2004 2006 2008 2010 2012 2014F 2016F 2018F
a potential rise in consumer spending. In
Source: IMF; October 2013 Forecast
addition, the Eurozone’s ZEW index – a key
indicator of investor confidence – rose in late
Bentall Kennedy (Canada) LP |9Perspective on Real Estate 2014 - Canada
2013 to its highest level in more than four years, going. In fact, the ECB’s governor pledged that policy
indicating that the end of recession may be close rates will remain at “present or lower levels for an
at hand. Even the dysfunctional Japanese economy extended period of time.” A similar refrain has been
has displayed some vigor. Led by Prime Minister heard from other major central banks across the
Shinzo Abe’s ambitious monetary and fiscal plan to world.
end deflation and jump-start growth, “Abenomics”
delivered average annualized growth in Japan of There is certainly plenty of room for monetary policy
nearly 4% during the first half of 2013. to remain extremely accommodative. With so much
excess slack lingering in advanced economies, rapidly
Such improvements have helped to offset the growing consumer prices are nowhere to be seen,
deceleration in economic activity occurring in several as inflation rates sit broadly below the targeted
emerging markets particularly China, where years 2% range of most central banks (see Fig. 2.2). This
of “double-digit” growth have long since ended. is especially true in the Eurozone where signs of
Although emerging market growth rates continue deflation (falling prices) have even appeared. It is
to handily outperform the advanced world, financial unlikely that inflation rates in advanced countries
imbalances and structural reforms are expected can comfortably return to or exceed targets until
to hold a number of these economies back from well after 2016, when much of the excessive slack
growing at their full potential over the near and accumulated over the past few years should finally be
medium term. absorbed.
Slower demand in emerging markets, along with Although consumer inflation remains subdued,
technological innovations that have helped to policy officials, particularly the U.S. Federal Reserve,
increase supply, is a principal reason why commodity are growing increasingly concerned about their
prices are not delivering the same type of explosive, prolonged experimentation with quantitative easing
shortage-induced growth evident in the last decade. (asset purchases funded by money printing) and its
This may be evidence that the “commodity super potential role in creating asset price distortions and
cycle” – a key global economic theme during the
last decade – has come to an end. For resource-
based economies such as Australia, Canada and Fig. 2.2
Brazil, slower commodity price growth has directly Annual Inflation
contributed to a slower economic expansion and
lower resource revenues. It has also taken some of 7
World
the shine off their commodity-driven currencies. Advanced Economies
6
To be sure, policy measures continue to be a major 5
Y/Y % Change
factor influencing the trajectory of global growth.
4
Political bickering and brinksmanship aside, fiscal
developments are thankfully becoming less of a 3
drag in most advanced economies as the size of
2
government spending cuts becomes smaller and
government revenues increase in-line with better 1
nominal GDP growth. Offsetting the impact of fiscal
0
tightening over the last few years is the persistence 06 07 08 09 10 11 12 13 14F 15F 16F 17F 18F
of extremely stimulative monetary policy and most
central bankers remain committed to keeping policy Source: IMF October 2013 Forecast
rates near their current levels to keep the recovery
10 | Bentall Kennedy (Canada) LPEconomic Outlook 2
excessive risk-taking by investors. Partly because of outcome that might be welcome by some of these
this, the Fed began its long journey towards winding countries because it improves their relative trade
down its QE program with a modest tapering of its positions.
asset purchases beginning in early 2014. (See U.S.
economy section). Other risks also remain present for the global
economy including the potential for exogenous
Tapering should be viewed as a concrete sign that the shocks caused by geopolitics and extreme weather.
U.S. economy is becoming more capable of standing In our increasingly interconnected, 24/7 world,
on its own two feet. But its effects could also pose such surprises, regardless of where they occur, will
some risk to the global economy since it has the continue to draw an immediate reaction from financial
potential to disrupt financial markets by drawing markets. This type of volatility is a theme that
global capital flows back to the U.S., weakening investors have certainly grown accustomed to over
foreign equity markets and asset values. On the other the last several years and one that is not about to
hand, it has the effect of weakening the currencies abate any time soon.
of some of America’s chief trading partners – an
Hillside Centre, Victoria, BC
(owner: Prime Canadian Property
Bentall Kennedy | 11
(Canada) LPFund)Perspective on Real Estate 2014 - Canada
United States
Turning the corner exceptional business investment growth in several
U.S. states, and reducing oil imports as well as the
After five long years, the U.S. economy looks like U.S. trade deficit. The U.S. now produces more
it has finally reached a turning point for the better. natural gas than Canada, the number one energy
Consumers and businesses have rebuilt their balance exporter to the U.S. It is expected to even produce
sheets, paid down debts and are spending again. The more oil than Russia and Saudi Arabia (the previous
housing market has worked off much of the excesses world leaders) by 2020 making the U.S. a step closer
that led it into a bubble with both the homeowner to energy self-sufficiency (see Fig. 2.5). With natural
and renter vacancy rate approaching long term gas prices much lower than in many other advanced
averages (see Fig 2.3). Governments are also seeing economies ($4 versus $12 in Europe), the U.S. now
good news. Although fiscal austerity remains the enjoys a cost advantage in terms of production and
most intense since the post-War period, the federal transportation that is unlikely to be challenged any
deficit is now the smallest in five years thanks not time soon.
only to cost-cutting, but also rising revenues (see Fig
2.4). Even many state and municipal administrations All told, these positive developments have forecasters
have seen increasing revenues. And while the national ramping up their expectations for the U.S. economy
unemployment rate (at just above 7%) remains higher with most anticipating growth to strengthen to just
than its long term historical average and there is still below 3% in 2014 - considerably faster than the
plenty of slack to keep a lid on wage growth, job 1.9% rate estimated for 2013. Barring an unforeseen
gains are broadening across sectors and regions of shock, expectations for 2015 are even better with
the U.S. with unemployment declining in a majority of growth likely to surpass 3% - near the U.S. economy’s
states over the past year. potential and going a long way to absorbing the
remaining slack left over from the Great Recession.
Meantime, the shale energy boom is driving
Fig. 2.3 Fig. 2.4
Homeowner & Renter Vacancy Rate* U.S. Federal Budget Balance
4.0 12 4.0
Homeowner (LHS)
Renter (RHS)
3.5 2.0
10
3.0 0.0
Homeowner (%)
8
2.5 -2.0
Renter (%)
% of GDP
2.0 6 -4.0
1.5 -6.0
4
1.0 -8.0
2
0.5 -10.0
0.0 0 -12.0
56 60 64 68 72 76 80 84 88 92 96 00 04 08 12 2000 2003 2006 2009 2012 2015 2018 2021
Source: Census Bureau, *Straight lines are long term averages Source: Congressional Budget Office
12 | Bentall Kennedy (Canada) LPEconomic Outlook 2
Fig. 2.5 Fed crafts an exit strategy
Oil Production - Millions Barrels a Day
Given the momentum evident in the U.S. economy
15 and growing concerns that excessive monetary
stimulus could potentially be causing a number
of financial market distortions (including possible
10
asset price bubbles) the Federal Reserve began
Oil Barrels
telegraphing its intention to scale back its massive QE
monetary experiment early in 2013. In reaction, U.S.
Treasuries yields rose appreciably over the first half of
5 the year only to partially fall back again in September,
U.S. as the Fed surprised markets by deciding not to
Saudi Arabia
Russia “taper” after all. That decision largely stemmed from
0
the potential economic risks associated with the
1990 2011 2015 2020 2025 looming government shutdown in October and to a
lesser extent, softness in some leading indicators at
Note: Figures included crude and liquids Source: International Energy Agency
the time. It must be pointed out, however, that the
Fed’s decision not to taper in September was less
Peace in Washington for now important than the rise in rates that ended up taking
place in anticipation of it. It is clear that the market is
As the elements of a sustained recovery were falling preparing for a sustained period of higher rates which
into place in 2013, political bickering in Washington is why the retrenchment in September did not fully
concerning funding disagreements remained a key unwind the initial increases. This is understandable
stumbling block for the U.S. economy. In fact, last since the market has not grappled with a sustained
October’s politically-motivated two week government period of rising rates in over 30 years.
shutdown directly shaved a few percentage points
off Q4 growth and just as importantly, slowed down For this reason, a major emerging theme for investors
the economy’s momentum by once again damaging over the next several years will be how the removal
confidence among business and consumers. of the Fed’s excess monetary stimulus plays out. With
the transition to new Fed Chair Janet Yellen complete
Fortunately, a degree of fiscal peace was brokered and risks of another government shutdown over for
in Washington in the waning days of 2013 as now, the Fed finally had a green light to announce
both Houses agreed to end debate on budget that it would scale back asset purchases, but only by
agreements. The deal reverses a portion of spending a modest $10 billion starting in January of this year.
cuts planned for the next two years, suggesting that Since the move was largely priced in by markets and
the federal government will be less of a drag on the Fed explicitly stated its intention to keep financial
economic growth going forward. It also thankfully conditions accommodative, long term interest rates
means that for the time being, partisan bickering will have, so far, only moved up modestly.
not derail the U.S. economy. In fact, even though
there is still uncertainty around the statutory debt The Fed similarly made it clear that any changes to
limit (which was not part of the budget deal and its current zero-interest rate policy (ZIRP) for short
which will need to be extended again in February), rates are not imminent. For example, the threshold to
politicians have assured the public that they will not guide the policy target rate requires a decline in the
use the debt ceiling as a bargaining tool. unemployment rate “well past” 6.5% and inflation to
run closer to 2%. With inflation still stuck at the low
Bentall Kennedy (Canada) LP | 13Perspective on Real Estate 2014 - Canada
end of the Fed’s comfort range (the core personal the yield curve will continue to be anchored by very
consumption expenditure (PCE) price index – the low short term rates in support of a still tentative
Fed’s favorite measure of inflation – has been running recovery and low expected overall inflation. As such,
at less than 1% throughout 2013) and unemployment overall monetary conditions should remain very
still hovering above 7%, it’s clear that the U.S. central accommodative over the next two years.
bank has little motivation to start hiking its policy
rate anytime soon. In fact, most forecasters do not This is good news especially for the U.S.’s fragile
anticipate any movement on the short end of the housing market. Although the basic fundamentals
yield curve until at least late 2015 or possibly into supporting the U.S. housing recovery remain
2016 based on the Fed’s forward guidance. intact (for example, the overhang of unsold homes
has almost been completely worked off, housing
construction is still running well below expected
Tapering should not derail economy household growth and house prices have stabilized),
the swift increase in mortgage rates last year reduced
In response to ongoing efforts by the Fed to unwind
refinancing demand and sharply eroded housing
its extraordinary monetary stimulus, forecasters
affordability (See Fig. 2.6). Fortunately, the current
expect long term interest rates to continue drifting
level of housing affordability is still very attractive
higher but only by about 100bps over the next two
relative to history owing in part to the sharp
years - see the Debt Market section in Chapter 3 for
correction in house prices since the bubble collapsed.
more details. This subdued pace is largely because
Consequently, there remains a wide buffer to absorb
moderately higher rates going forward.
Fig. 2.6 Of course, it remains anyone’s guess how unwinding
U.S. Housing Affordability Index* the Fed’s bold monetary experiment ultimately plays
out over the longer run given the lack of historical
250 precedent to draw upon. Rather than “moderate”
and “gradual” increases, the potential path for
200 interest rates could become far more volatile, moving
More affordable in fits and starts, particularly if there are any miss-
150 steps in Fed communication along the way. Needless
Index*
to say, if interest rates do move up too sharply,
100
especially in the near term, there is a high probability
that it would fully derail the burgeoning U.S. recovery,
Less affordable
50
mostly by damaging psychology and causing sharp
price declines in real estate, stocks and other financial
0
assets. On the other hand, there is a risk that the Fed
81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 could fall behind the curve as prolonged low rates
Source: NAR fuel asset price bubbles and raises the possibility
Note: *Value of 100 means that a family with the median income has exactly enough
income to qualify for a mortgage on a median-priced home. An index above 100 signifies of runaway longer term inflation. Either way, the
that family earning the median income has more than enough income to qualify for a
mortgage loan on a median-priced home, assuming a 20 percent down payment road back to ‘normal’ is likely to be anything but
predictable.
14 | Bentall Kennedy (Canada) LPEconomic Outlook 2
Canada
Slow but stable growth Although it was able to admirably rely on its domestic
sector to steer it out of the largest downturn the
Canada’s economy has cooled down significantly over world has seen since the Great Depression, Canada
the past two years. After increasing by just 1.7% in is simply not able to do this indefinitely. It ultimately
2012, Canadian real GDP was hard pressed to do any requires support from external demand for its
better in 2013. As a result, Canada has gone from economy to grow at its full potential. Fortunately, the
the top of the advanced world’s growth charts in the world and specifically the U.S., finally appears ready
years immediately following the Great Recession, to lend a hand.
to the middle of the pack. With the U.S. economy
picking up momentum, Canada is also lagging behind The source of Canada’s current economic weakness
its neighbour to the south for the first time in several remains the same. Exports have gone almost nowhere
years. in the past two years (see Fig. 2.7) and factory output
continues to be very weak, largely in response to
After a good run, it may be tempting to focus on just what was an overvalued currency and sluggish global
how sluggish the Canadian economy has become. But demand. But another developing factor has been the
it is important to put this situation into perspective. relative slowdown of sectors that were previously at
Canada has a fundamentally small open economy. the heart of Canada’s outperformance. For example,
resource extraction, especially base and precious
metals mining, has cooled off markedly given the
Fig. 2.7 deceleration in emerging market demand for these
Canadian Real Domestic Demand & Exports commodities. This has directly softened net national
income growth.
15
Canada’s important energy sector is also confronting
10 major structural challenges. In the wake of its shale
energy revolution, the U.S. no longer requires as
Y/Y % Change
5 much natural gas imports from Canada as it once
did. Although Canada continues to be a key exporter
0
of oil to the U.S., the discount on Canadian oil from
-5 international prices has widened considerably in the
past two years owing to the growing mid-continent
-10
Exports glut of oil caused by insufficient southbound pipeline
Domestic Demand capacity. While energy production has picked up as of
-15
91 93 95 97 99 01 03 05 07 09 11 13E 15F
late 2013, discounts on Canadian oil remain, posing
some long term challenges for oil producers and
complicating the task of government and corporate
Source: Statistics Canada, Forecast TD Economics
budgeters in provinces (mainly Alberta) that depend
heavily on oil revenue. This cyclical but also partly
Bentall Kennedy (Canada) LP | 15Perspective on Real Estate 2014 - Canada
structural moderation in commodity performance second half of 2013 and were trending at above-
is a major reason why the economic gulf between normal levels again. Strength was especially apparent
Canada’s resource-dependent western provinces and in Canada’s two most expensive markets – Toronto
the rest of the country has eased, with the disparity and Vancouver – where house price growth has
likely to remain narrower than during the previous re-accelerated.
decade.
New residential construction also continues to
grow above household formation rates, with more
Housing to the rescue….again than 50,000 condo units now under construction
in Toronto – an all-time high for the city (see Fig.
Amidst the on-going weakness on the external side
2.8). With moderating job gains in other sectors,
of its economy, Canada has had to keep relying on
the booming residential market has helped to make
domestic demand to support growth. But with federal
construction a major driver of the labour market, not
and provincial governments tightening their purse
just in Toronto but across the rest of the country too.
strings (most are on track to balance their books next
year) the burden continues to fall on other parts of There are certainly solid fundamental reasons behind
the domestic economy. Consumers are still stepping the resilience of Canada’s housing market including
up where needed. While core retail sales have cooled strong immigration, foreign investors looking for a
over the past two years, household spending on big- safe haven to park their capital and a growing echo
ticket items such as cars remains strong, driven by boomer population. But a rush to secure financing
extremely attractive financing rates. amidst rising mortgage rates last summer was likely
the main catalyst behind the resurgence of housing
Home buying did cool off appreciably in late 2012
activity. As rates moderately rise over the forecast
owing to stricter mortgage rules imposed by the
horizon, consumer spending and housing activity will
federal government, but it has since reignited. Home
simply have limited capacity to carry on growing at
sales increased by double digit levels during the
outsized rates.
To help pay down their record high debt levels,
Fig. 2.8 households have already begun to reign in
Toronto CMA Apartment Starts discretionary spending. And with income growth
barely keeping pace with home prices, stressed
60,000 housing affordability levels in Canada’s major cities
are likely to deteriorate further as mortgage rates
50,000 nudge higher and CMHC (the country’s major insurer
5 Year Average of high ratio mortgages) limits its insurance in-force.
40,000
This will likely weigh on home sales, home prices
Units
10 Year Average
30,000
and homebuilding particularly among condos in
Long Term Average
Toronto. But the extent of the adjustment in Canada’s
20,000 overall housing market remains uncertain. An optimal
outcome would be for income growth to increase
10,000 faster than home prices owing to stronger job and
wage growth outside of the construction sector. This
0 would allow housing valuations and overall activity
73 76 79 81 84 87 90 93 96 98 01 04 07 10 13
to normalize before interest rates do. For now, this
Source: CMHC “soft landing” for Canada’s housing market remains a
forecast rather than a fact.
16 | Bentall Kennedy (Canada) LPEconomic Outlook 2
Shifting growth drivers Barring another shock, the burgeoning recovery in
the U.S. will also go a long way to improving the
With little capacity left from consumers and outlook for Canadian business investment. Outside
government, economic drivers in Canada need to of robust spending on non-residential development,
shift towards exports and business investment to much of Corporate Canada has fallen into a slump
sustain future growth. These sectors have traditionally with capital investment and private sector hiring
been the main engines of the Canadian economy, decelerating significantly in 2013. While this is partly
but have been held back in recent years by both an due to weaker corporate profit growth, especially
overvalued Canadian dollar and the depth of the U.S. in Canada’s resource patch, it’s also simply due to
recession. Fortunately, sustained improvements in the a lack of confidence. Unlike consumers, Canadian
U.S. economy should result in greater demand for businesses have excellent balance sheets and sit
Canadian exports going forward. on stockpiles of cash. Yet outside of the real estate
sector, businesses have been cautious to deploy
A weaker currency should also help. The loonie has capital given the instability they have seen in the
moved into a lower, but more fairly valued range of rest of the world. The anticipated turnaround of the
90 – 95 U.S. cents, and will likely remain there over global economy and especially the U.S. should help
the next 24 months owing partly to softer commodity to unleash this pent-up corporate demand in Canada,
prices (see Fig. 2.9). This will make Canadian exports particularly among the numerous U.S. branch offices
more attractively priced in the U.S. and should largely clustered in the Greater Toronto area.
especially improve the fortunes of the beleaguered
manufacturing heartland in Ontario and Quebec. But
any sustained improvement in Canada’s trade picture BoC removes its tightening bias
also requires enhancements to Canadian productivity
When the Canadian economy quickly recovered
as well as export diversification into emerging
from the Great Recession more than three years
markets that are growing faster than the U.S. Much
ago, the Bank of Canada was one of only a handful
more progress is required on both of these fronts.
of central banks to initiate rake hikes to remove
excess monetary stimulus. Despite its inactivity
Fig. 2.9 since September 2010, the Bank’s tightening bias
Bank of Canada Commodity Price Index & C$ remained in place and was a major factor pushing
Canada’s currency into overvalued territory over the
past few years.
Commodity Price Index (1972 = 100)
1000 Commodity Price Index (LHS) 1.2
900
CAD (RHS) But weakening growth has opened up pockets of
1.1
slack in Canada’s economy and reduced business
800
1.0
pricing power. Along with significant price
U.S. Cents
700 competition in the retail sector, Canada’s inflation
600 0.9 rate has consequently slipped below the Bank of
500
Canada’s 2% target range in 2013, sticking closer
0.8 to 1% for well over a year. This “disinflation” finally
400
forced the Bank to remove its tightening bias
0.7
300 last October. With economic growth in Canada
200 0.6 expected to improve this year but still come up
00 02 04 06 08 10 12 14F short of its potential, the Bank is unlikely to return
to a tightening bias until at least 2015 as economic
Source: Bank of Canada; C$ Forecast: TD Economics momentum eventually picks up on the back of the
U.S. recovery.
Bentall Kennedy (Canada) LP | 17Perspective on Real Estate 2014 - Canada
Fig. 2.10
Unemployment Rates By Country
10
Canada
United Kingdom
9
United States
8
Percent (%)
7
6
5
4
3
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: IMF; Shaded Area is Recession
This change in the Bank of Canada’s tune, especially than other countries given its comparatively healthy
at a time when the Federal Reserve is beginning to institutions and limited structural impediments.
remove excess stimulus in its economy, has pulled For example: Canada’s fiscal situation remains far
previously strong international capital flows out of more manageable than other developed countries,
Canada. This is another force putting downward especially the U.S.; the eventual normalization
pressure on the loonie. In fact, with inflation running of monetary policy in Canada carries fewer
low and potentially slipping below 1% in the complications than other countries because the
upcoming year, there is now even a case to be made Bank of Canada never engaged in an expansion
for a rate cut. However, the Bank is unlikely to go of its balance sheet through QE; at 6.9% in late
there just yet, partly in fear of stoking the housing 2013, Canada’s unemployment rate is much closer
market again. to its pre-recession levels and full employment
potential than other developed countries (see Fig.
2.10); and Canada’s demographic situation remains
Bottom line
comparatively healthy with a younger and faster
No doubt, the next several years will be a tricky growing urban population than most other developed
period for Canada as it migrates from domestic led countries. All told, these factors suggest that Canada
growth and unwinding imbalances in its household should remain a bastion of stability among global
sector, to leveraging off the better growth prospects economies over the long term even if its cyclical
in the rest of the world. But making the long term outperformance in real GDP growth may have come
transition to “normal” should be easier for Canada to an end. •
18 | Bentall Kennedy (Canada) LPPerspective on Real Estate 2014 - Canada
White Oaks Mall, London, ON
(owner: Prime Canadian Property Fund)Perspective on Real Estate 2014 - Canada
Building
Sun
20 | Life
BentallName,
Building, City, State
Montréal,
Kennedy (Canada) LP Ownership
QCReal Estate & Capital Markets 3
Investment Summary
The Canadian IPD property index posted a robust total return of 12.7% in the
twelve months ending Q3 2013. Although the performance of this benchmark
“Compressing cap
index for direct property investment in Canada has eased over the past rates have been a
year, it remains above its ten year average of 11.5%. As of Q3 2013, direct
property has broadly outperformed other Canadian asset classes including dominant driver of
bonds, Canadian equities and REITs. And unlike their relative economies, real estate returns,
direct property investments in Canada have also narrowly outperformed their
U.S. counterpart as the U.S. NCREIF Property Index (NPI) returned 11% in but its positive
the twelve months to Q3 2013. To put this into context, Canadian IPD index
returns have been higher than the U.S. NPI in eight of the past twelve years.
impact is fading.”
Capital appreciation continues to drive IPD returns
Capital appreciation remained a key driver of direct property investments in
Canada but its impact is narrowing. For example, the twelve month change
in capital values for standing properties in the IPD index was +6.8% as of Q3
2013, down from +8.4% a year earlier. Meanwhile, income yields continued to
compress and were 5.5% as of Q3 2013, down from 5.9% the year before.
A decomposition of the IPD’s return indicates that
the valuation effect (ie., the value gain arising from Fig. 3.1
compressing cap rates) accounted for a majority Decomposition of IPD Canada Returns
of the capital appreciation over the twelve months
ending Q3 2013, with an increase of 5.3%. This 25
was 40 bps higher than during the same period in 20
2012. The other component of capital appreciation,
15
net operating income (NOI) growth, increased by
Percent (%)
1.5% in the twelve months to September 2013, 10
a substantially slower pace than the 3.5% annual 5
increase over the same period in 2012. Slower NOI
0
growth was therefore entirely responsible for the
softer pace of capital appreciation in Canadian IPD -5
Valuation Effect
index (see Fig. 3.1).1 -10 NOI Growth (y/y)
Income Yield
-15 Total Return
1 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Although the U.S. NPI saw weaker capital growth than the Canadian IPD
index, it outperformed in terms of NOI growth (+4.1% in the twelve months Note: Twelve Months To Third Quarter Of Every Year
Source: IPD Canada, Bentall Kennedy
to September 2013). This outperformance is more consistent with the recent
pattern of economic growth in the two countries last year.
Bentall Kennedy (Canada) LP | 21Perspective on Real Estate 2014 - Canada
Although the positive valuation effect from see better income yields than other property types
compressing cap rates remained a dominant driver of (6.4%), total performance lagged at 10.3% largely
capital growth in the Canadian IPD, it is important to because of comparatively weaker capital appreciation
keep in mind that the index is subject to appraisal lag. owing to tepid NOI growth.
For example, less than half of the IPD portfolio was
re-valued as of Q3 2013. However, as we explain in Meanwhile, household-driven property types such as
subsequent sections, cap rates for institutional quality retail and residential, posted the highest total returns
real estate appeared to have stabilized by mid-2013 in the IPD index as of Q3 2013, at 14.3 % and 13.9%
in response to higher long term interest rates. As respectively. The retail sector was buoyed mainly by
such, Q4 2013 returns (which have not been released robust valuation increases while net operating income
as of publication time) are likely to be more telling. (NOI) growth was a major driver of residential returns.
In terms of performance by property type, those
Transaction volumes remain elevated
sectors driven predominantly by the business cycle –
office and industrial – were laggards in the Canadian The Canadian real estate investment market remained
IPD index last year (see Fig. 3.2). Office returns eased strong in 2013 with year to date transactions reaching
to 11.9% in the twelve months to September 2013, $20.2 billion as of the third quarter. This is only $2
4.8 percentage points lower than for the same period billion behind the same period in 2012 with full year
a year earlier. Weaker capital growth was largely 2013 numbers on track to be the third best on record
responsible for this with both valuation effects and (see Fig. 3.3 below). It should be noted, however, that
NOI growth weakening compared to the same period volumes fell 26.6% quarter-over-quarter in Q3 2013.
in 2012. Although industrial returns continued to
Fig. 3.2 Fig. 3.3
Decomposition of Returns by Property Type - 2013 Q3 Investment Activity By Asset Type
25 35
Hotel Industrial
20 Land Office
30
Multi-Res Year End Forecast
15 Retail
25
10
Percent (%)
Billions ($)
20
5
15
0
10
-5
Valuation Effect
NOI Growth (y/y % ch.) 5
-10
Income Yield
Total Return
-15 0
Retail Residential Office Industrial 2007 2008 2009 2010 2011 2012 2013
YTD
*Twelve Months To Third Quarter Of Every Year Source: IPD Canada; Bentall Kennedy Source: CBRE; RealNet and Realtrack
22 | Bentall Kennedy (Canada) LPReal Estate & Capital Markets 3
fact, pension funds/advisors, private equity (whose
Fig. 3.4 capital is often directly from pension funds and other
Canadian Real Estate Purchaser Profile institutional investors) and private Canadian buyers
(some of which can include pension funds) accounted
100 for just over 70% of transaction activity as of year
90
to date Q3 2013. This level of combined activity is
80
more in-line with the level of involvement this group
70
had prior to the financial crisis. For reasons we will
Foreign Investor
outline later, we think pension funds and other private
Perecent (%)
60 Institutional
REIT/REOC institutional investors will continue to dominate
50 Pension Fund/
Advisors Canadian investment activity in the near term.
40
Private Equity*
Private Canadian
30
Investor*
Foreign investors also saw an increasing, albeit still
20 minor, presence in the Canadian market in 2013. As
10 we noted in last year’s Perspective, foreigners have
0 acknowledged the attractive qualities that make
2007 2008 2009 2010 2011 2012 2013
Q3/YTD Canada a good place to invest. But because property
Source: CBRE, RealNet Inc. values have continued to grow in Canada compared
* Note: May include pension funds and other institutions
to declining values in some of their home countries,
a number of foreigners have simply become net
sellers of Canadian real estate. As momentum in
This marks a significant deceleration in the pace of the global economy picks up and the value of their
activity going into the second half of the year and domestic portfolios stabilize, however, we think
broadly coincided with the almost 100bps increase in foreign demand may become incrementally more
long term interest rates during the period. pronounced going forward.
Another noticeable turning point by mid-year was in
underlying purchaser activity. Specifically, acquisitions Cap rates bifurcate
by REIT/REOCs slowed dramatically in the second
half of 2013, with the sector only accounting for 7.5% Canadian cap rates generally remained stable in
of the volume in Q3 2013. This compares to more 2013, albeit last year’s interest rate increases ushered
than 30% of deals done annually over the previous in a modest bifurcation in underlying pricing trends.
two years (see Fig. 3.4). As discussed in more detail in Cap rates for top-tier, institutional-quality core
the Public Equity section, the pullback in investment properties continued to trade at record lows with
activity by the REITs was largely triggered by falling the bid remaining deep. On the other hand, a more
share prices as interest rates rose last year. While it’s cautionary view of pricing for properties in non-
hard to count them out given their appetite over the primary markets and/or those deemed to be of lower
last decade, we believe there are compelling reasons or less favourable quality appears to have emerged,
why the Canadian REIT sector could take a back-seat largely driven by the REIT sector pullback. Based on
role in transactions this year. investor trend surveys, cap rates for these properties
increased by 10-25 bps, on average, between Q1 and
While REITs recoiled, pension funds as well as other Q3 2013.
private investors came back to the fore in 2013. In
Bentall Kennedy (Canada) LP | 23Perspective on Real Estate 2014 - Canada
Fig. 3.5 Fig. 3.6
Downtown vs. Suburban A Office Cap Rates Spread (Bps)
11 Downtown 120
Historical Average
Suburbs
10 100
9
80
Percent (%)
8
60
7
40
6
5 20
4 0
02 03 04 05 06 07 08 09 10 11 12 13 02 03 04 05 06 07 08 09 10 11 12 13
Source: CBRE, Bentall Kennedy Source: CBRE, Bentall Kennedy
The diverging pricing trend is especially noticeable in relative to its competitors and allowed REITs to even
the office sector where cap rates for suburban office become active bidders of larger institutional-quality
properties have generally remained elevated because properties, which they rarely transacted in historically.
of expectations of future earnings weakness while However, last year’s higher interest rates reduced
cap rates for downtown properties have compressed this advantage. As a result, the REIT bid faded across
significantly over the past three years due to robust all asset classes and types, but most notably in the
expectations of earnings growth. As Fig. 3.5 and 3.6 mid-market where REITs have traditionally dominated
illustrate, this has resulted in the widest spread on transaction activity.
record for this sector although the spread is unlikely
to widen further in the near term given the recent In contrast, demand for large core-type properties,
stabilization of downtown property cap rates. product which is often coveted by institutional
investors such as pension funds, remained strong as
While the “pricing divergence story” broadly reflects capital flows from this group continued unabated.
investor expectations of property performance, it There are fundamental reasons why we think
also reflects how underlying capital flows have been institutional investors such as pension funds have
impacted by last year’s increase in interest rates. the lowest cost of capital again and consequently,
For example, lenders have become more cautious why capital from this group is likely to dominate
underwriting secondary/tertiary markets with transactions in the near term.
financing for non-primary markets and/or non-core
properties becoming more costly and less available in
Pension funds increasing allocations to
some instances (see Debt Market section).
real estate
An even more noticeable impact was evident on the
The value of all assets under management for
equity side. As we detail in the Public Equity section,
Canadian pension funds has grown significantly
artificially low interest rates were a huge source of
since the Great Recession in 2009. A combination of
support for listed REITs over the last few years. It
recovering market values and increased net savings
provided the sector with a very low cost of capital
24 | Bentall Kennedy (Canada) LPReal Estate & Capital Markets 3
have seen the market value of Canadian pension plan
assets (including RRSP’s) rise to just over $2.5 trillion Fig. 3.7
in 2012, roughly a 9% increase from the year before. Canadian Pension Fund Investments in Real Estate
Canadian pension fund net investment directly in 100,000 9
Net Real Estate Investments - LHS
domestic real estate has moved in a similar growth 90,000 % of Total Fund Net Assets - RHS 8
trajectory over the past three years. As Fig. 3.7
80,000
shows, net real estate investment has increased from 7
70,000
$61 billion in 2008 to over $90 billion by the end of
Millions ($)
6
Percent (%)
2012, an annualized growth rate of almost 10% per 60,000
5
year. This $90 billion in invested equity (which reflects 50,000
4
both increasing allocations and rising property 40,000
values) represents a weighted average allocation to 30,000
3
real estate of 6.5% for all Canadian pension funds 2
20,000
including those funds without any real estate (see
10,000 1
Table 3.1). If only those pension funds with real estate
are included, then the weighted average allocation 0
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
0
increases to 8.2%.
Source: Canadian Institutional Investment Network,
Various Financial Statements, Bentall Kennedy
Not surprisingly, the ten largest pension plans
in Canada accounted for a majority (80%) of this
invested equity. Many of these large pension funds markets in the mid-1990s, were able to accumulate
were “early adopters” of real estate investment portfolios of some of the most iconic properties in
and through the dislocation of commercial property Canada. These large pension funds now have the
Table. 3.1
Canadian Pension Fund Investments in Real Estate
FUND CANADIAN % CANADIAN
ASSETS RE EQUITY REAL ESTATE
FUND SIZE (Net Assets) ($MM) ($MM)
BREAKDOWN OF CANADIAN PENSION FUND INVESTMENT
Funds with Real Estate
Top 10 Funds with Real Estate 854,365 72,514 8.5
Other Funds > $1B 224,061 16,146 7.2
$100MM to $1B 25,641 1,958 7.6
$0 to $100MM 1,715 116 6.8
Funds with Real Estate 1,105,781 90,734 8.2
Funds without Real Estate 289,398 - 0
All Funds 1,395,179 90,734 6.5
Source: Canadian Pension F und Directory, Bentall Kennedy
Bentall Kennedy (Canada) LP | 25Perspective on Real Estate 2014 - Canada
Table 3.2
Canada’s Ten Largest Pension Funds - As of December 2012
RE Allocation
PENSION FUND SIZE $(MM) RE %1 $(MM)
CDP 176,200 10.20 17,972
CPP Investment Board 161,600 10.60 17,130
Ontario Teachers' Pension Plan Board 127,263 16.78 21,355
bcIMC** 99,600 14.70 14,641
Public Sector Pension Investment Board** 76,100 12.40 9,436
AIMCO* 69,700 10.00 6,970
Ontario Municipal Employees Retirement System (OMERS) 60,767 13.20 8,021
Healthcare of Ontario Pension Plan 47,400 11.00 5,214
Ontario Pension Board 18,991 14.60 2,773
Canada Post Corp. 16,744 7.30 1,222
Top 10 Total 854,365 12.26 104,735
*As Of March 31, 2012 **As Of March 31, 2013 Source: Canadian Institutional Investment Network, Various Financial Statements
1
Allocation includes BOTH domestic & foreign holdings
highest average allocations to domestic real estate correlations with traditional financial assets, providing
at 8.5% as of 2012. However, many large pension greater diversification benefits across all asset classes,
funds have positions in foreign real estate too. When thereby helping large institutions achieve a more
domestic and international real estate positions are “market neutral” portfolio.
rolled up, Canada’s ten largest pension funds had
a weighted allocation to real estate of 12.3% at the It is generally these structural factors (longer
end of 2012 (see Table 3.2) – more than double the investment horizons, limited need for liquidity, low
exposure to this asset class only 8 years prior and risk tolerance and low return hurdles) which explain
more than triple the dollar value of invested equity. why pension funds typically have a cost of capital
advantage among real estate investors in Canada.
Where do these large pension funds go from here? As noted in the Public Equity section, competing
Most are already close to their targeted levels Canadian REITs were only able to achieve a lower cost
but many have considered further increasing their of capital recently, thanks to the artificially-induced,
allocations to direct real estate, to as much as 20%. historically low interest rates that arose following the
Cyclical developments like historically low interest Great Recession. In other words, the REITs edge over
rates and heightened volatility in equity markets pension funds in the investment market during the
are certainly driving part of this shift into private/ last few years was more of a cyclical development
alternative assets like direct real estate as pension whose time may be coming to an end as interest
funds seek to “de-risk” their portfolios. But this is rates grind higher.
not necessarily the main factor. A bigger reason is
more structural in nature. Non-listed asset classes
such as private real estate, infrastructure and other
Size dictates different approaches
alternatives are a natural fit for pension funds because Armed with a low cost of capital and growing direct
of their long investment horizons and limited need real estate targets, we expect that large pension
for liquidity. Non-listed asset classes also have lower
26 | Bentall Kennedy (Canada) LPReal Estate & Capital Markets 3
funds will continue to be important players in the led acquisitions in foreign lands were done in the last
Canadian real estate investment market going three years.
forward. However, since these funds already control
some of the best real estate in the country, their Smaller pension funds and other institutions,
strategies may be less about acquisitions and more particularly those with little to no direct real estate,
about investing in what they own to ensure that it have similar reasons to their larger counterparts
stays “best in class” as we have seen over the last for increasing allocations to the asset class. Subject
decade. Along these lines and given robust existing to their level of sophistication or relative scale,
pricing, investment may also increasingly include deployment of their capital could be in the form of
build to core programs which allow these funds to either direct investment or pooled funds.
add to their stable of “best in class” assets while
generating some alpha too. Whether property Since it would be their first foray into real estate for
markets require this new supply is a different question many of these smaller funds, we believe most are
and one that will be addressed in Chapter 4. likely to invest domestically rather than abroad. On
this basis, should all small to mid-sized Canadian
Alternatively, large pension funds have also pension funds as well as endowments take their real
increasingly looked at “near-real estate” assets estate allocations up to levels similar to the domestic
in Canada (self-storage, trailer-parks, farmland or allocations of the top 10 pension funds in Canada,
timber) and/or improving regional diversification the total amount of potential capital available for
by seeking real estate outside of Canada’s borders, investment in real estate is estimated to be as much
often at more opportunistic yields. With regard to the as $30 billion. This backstop of potential pension fund
latter, CBRE notes that over $53 billion in Canadian- capital in Canada is substantial.
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