With equity market volatility persisting and bond yields at depressingly (and historically) low levels, Canadian pension funds have been seeking sources of stable return. One of the asset categories they have been turning to is direct real estate. On average, Canadian pension plans have allocated almost 8% to real estate assets, though this masks differences in allocation due to size and type of plan.
Research by Greenwich Associates for 2011 found the following:
- while Canadian DB plans have allocated 8% to real estate assets, DC members have only allocated 2% of their assets to real estate, likely due to it not being offered by many carriers for DC pension plans;
- public pension plans have allocated 11.4% to real estate, while endowments have allocated less than 2%;
- Canadian-controlled corporations have allocations of 4.3%, more than double that allocated by Canadian corporate subsidiaries of U.S. parents (less than 2%); and
- larger plans (those with assets greater than $1 billion) have allocated, on average, 8.5%, while plans with assets less than $250 million have allocated 1.5%.
For those who have taken the plunge and invested in Canadian real estate, the rewards have been attractive. Real estate has delivered an annualized 7.1% return for the four years ending March 31, 2012, compared to Canadian equities, which has provided a paltry 1.1% annualized over the same time period (real estate returns are the IPD/ICREIM Index; Canadian equity returns are the S&P/TSX Composite Index). With interest rates at lows, what does the future look like for Canadian real estate?
In 2008 and 2009, there was very little lending for real estate projects and sales, causing many investors who wished to transact (buy or sell) to have to wait for a period of time. More recently, liquidity has returned to the market, augmented by real estate investment trusts (REITs) having raised substantial amounts of equity. Capitalization rates and interest rates remain stable with transaction volumes constrained by lack of supply and good quality product. (Note: A capitalization rate can be defined as net operating income divided by the market value. It helps determine the current market value of a real estate property on the basis of net operating income.)
Quality commercial real estate in Canada is held mainly by pension funds, REITs and large domestic corporate investors—i.e., stable, long-term investors. Canadian investors are generally conservative and have employed relatively low amounts of leverage (between 10% to 50%), thereby avoiding many of the pitfalls of their U.S. cousins. While the Canadian real estate market remains strong, prices are quite high for core assets, which, given the strong demand over the past few years, is not surprising.
Investors are focusing on major centres, overweighting regions with job growth. The western region is performing well, driven by resource development. The Vancouver office and industrial markets have low vacancies, while Edmonton and Calgary fundamentals look solid, with tightening vacancy rates and upward pressure on rental rates.
This contrasts with the eastern region. With a large manufacturing base, Eastern Canada is experiencing higher levels of unemployment. Surprisingly, the impact on real estate markets and values has been minimal. The Toronto office market remains healthy and active, especially in the central business district. The recent sale of the Scotia Plaza is evidence of this. However, the industrial market has not made a full recovery and some vacancy exists. That being said, there is little new supply coming to market that is supportive of this sector. The greater Montreal office market remains healthy, and industrial vacancy is expected to decline. Finally, the Ottawa market remains steady.
Given the performance of the Canadian real estate market and the prices being asked for core properties, it is not surprising that Canadian investors are seeking other markets and/or approaches. It might surprise you to know that Canadians are already significant owners of U.S. real estate properties.
The U.S. market is attractive to Canadian investors for a number of reasons. There is little in the way of multi-unit residential properties available in Canada, but these are a strong feature of the U.S. real estate market, especially in the major centres of Boston, New York, Washington and Los Angeles. There are many distressed opportunities—debt and equity—available, as some investors over-extended themselves. These properties are not impaired and offer some interesting returns, though are somewhat more risky than the traditional core assets sought by many investors. Retail properties are also more abundant than in Canada. And of course, there is the relatively strong Canadian dollar. There are tax implications associated with investing in U.S. real estate, so it is important to do your homework. Several managers of leading U.S. funds are setting up appropriate fund structures to manage this exposure.
While real estate has been featured in many investors’ portfolios to date, there is evidence that interest remains. Greenwich Associates estimates that approximately 30% of the plan sponsors they interviewed in 2011 expect to initiate and/or increase allocations to real estate. It is important for investors to be mindful of where we are in the current investment cycle for Canadian real estate, as price does matter.