Given my active practice in the field of real estate investment trusts (REITs) and other real estate investment vehicles, I have attended the annual RealREIT Conference in Toronto two of the past three years. RealREIT is presented annually by the same group that presents the annual Vancouver Real Estate Forum. Like the Vancouver Forum, RealREIT offers a program of industry experts speaking in panels on a variety of topics relevant to the investment and real estate communities which make up the Canadian REIT marketplace. My experiences from previous years have been that the panelists’ views have been generally fairly accurate in terms of where the market is going.
At the Conference in September, 2007, I was struck by how different the mood in Toronto was at the time than in Vancouver. The “liquidity crunch” had occurred in August, 2007, and panelists at the Conference spoke of possible recession in the United States affecting global prices for Canadian commodities and dramatically increasing capitalization rates. At that time, Vancouver was still riding the wave of rising housing prices and very active residential and commercial real estate markets, and the mood was strikingly different than in Toronto. Nonetheless, it turned out that the panelists provided a better prediction of things to come than one would have had simply looking at the Vancouver marketplace.
In the weeks prior to the 2008 Conference, Lehman Brothers collapsed, and it was uncertain whether the unprecedented levels of liquidity being injected into the economy by central banks globally would have the desired effects. This uncertainty permeated the panelists’ presentations at that year’s Conference.
This year, given recent positive news about the Canadian economy and, for the most part, news results which seem to indicate the end of the downward spiral in the United States (if not actual growth), I was interested in hearing what the owners, investors, executives, investment bankers, economists and other experts who make up the panels would predict in terms of the general and real estate economies. I learned that the Canadian REIT marketplace is generally very strong, supported by recovery in the Canadian economy to September, 2008 levels. At the same time, concern was expressed in every panel about the state of the US economy, the possibility of deflation and/or a double-dip recession, and of other global economic concerns.
As in previous years, the Conference’s first presentation was from Carolyn Blair, Managing Director of RBC Capital Markets Real Estate Group, who provided an overview of the Canadian REIT marketplace. She noted that from the bottom of the REIT marketplace in March, 2009, there has been a significant resurgence of the Canadian REITs. Two years spent bolstering balance sheets through deleveraging has brought the REITs back to their market levels of September, 2008 (albeit below their highs of mid-2007), with a total return in the TSX REIT Index of 55% in 2009 and of 18.5% in 2010 to date. Measured over the last 12 months, the TSX REIT Index has increased 37.5%, as compared to 12.7% for the TSX as a whole, 29% for the TSX income trust sector and 33% for US REITs.
Ms. Blair also commented on the Canadian economy generally, noting that it has “crawled back to neutral”, with GDP returning to September, 2008 levels and all of the jobs lost in Canada during the recession now being replaced. Bond rates are low, and “spreads” for corporate bonds have reduced significantly over the past 12 months, evidencing confidence among investors. From a global perspective, the revival of the Canadian economy is a success story. However, there continue to be significant risks to economic stability in Canada and globally, including the upcoming unwinding of central bank liquidity measures, sovereign debt risk among smaller European economies, mountainous debt levels both at government and individual levels, volatility in the equities markets, and the fragility of the US economy.
An “Investors’ Roundtable” followed, made up of institutional investment officers from Toronto and New York and two Toronto-based investment analysts. Unlike Ms. Blair’s upbeat assessment of the Canadian economy, the panel generally had a dampened view of the global economic environment, although they agreed that REITs provide an attractive investment alternative in all economies.
Myles Zyblock, Chief Institutional Strategist & Director, Capital Markets Research of RBC Capital Markets, noted that the global economic recovery is slowing, uneven and has uncovered lingering fragility. Japan is falling deeper into deflation, and there are persistent European sovereign debt issues. The US housing market has suffered its biggest collapse since the Depression and the collapse of the job market in the US has not been to this level in 80 years. Overheated real estate markets in China, Brazil and possibly Canada could be due for correction.
Bill Webb, Executive Vice President and Chief Investment Officer of Gluskin Sheff & Associates Inc. noted that the current recession has been a “balance sheet recession”, meaning that it resulted from corporate and individual over-leveraging. This kind of recession requires a massive credit deleveraging and has historically not worked out quickly. Recovery is faltering, and global economies may, at best, be only half way through the recovery cycle. Although corporate balance sheets are generally strong, having been bolstered by equity infusions, with governmental and personal debt loads at very high levels demand for products are limited, which will dampen growth. Mr. Webb predicted ongoing high volatility in the equity markets, with risks toward a deflationary cycle. Other panel members agreed that the global economies are working through a deflationary cycle, and that central banks will have to do whatever is necessary to avoid deflation, the result of which will be high levels of inflation in future years.
According to Scott Crowe, Senior Vice President & Global Strategist/Portfolio Manager Real Estate Securities of Cohen & Steers Capital Management in New York, we are in a period of normalization between developed world economies and those of emerging nations such as China, India and Brazil, in part due to the emergence of good government and education. He noted that one billion people will move into the middle class globally in the next decade, increasing incomes and demand. This will be positive for Canada, particularly Western Canada, due to demand for commodities. He predicted continued capitalization rate compression in Canada, and more global institutions seeking investment opportunities in Canada.
The panel agreed that the strength in the REIT marketplace, both in Canada and the US, should continue. Investors (including pension funds, institutions and an ever-aging populace) have suffered through two major stock market crises in the past decade and are seeking stability and yield, a trend which will persist for the next five to 10 years, and the equity market will remain volatile. This should continue to provide demand for REIT securities. The panel agreed that investors should focus on distribution levels and distribution growth on an ongoing basis.
In a subsequent panel on REIT performances around the world, there was discussion of the US real estate marketplace. The panel noted that although the US economy continues to struggle, the expected flood of distressed properties into the market has not come to fruition. Cap rates for retail properties continue to be in the range of 6%. This is the result, in part, of generally bullish attitudes among US investors and the fact that banks are still working through their portfolios of distressed properties (perhaps having little incentive to declare their loans “unperforming” all at once). The biggest factor, however, is the enormous amount of capital seeking investment in the real estate sector in the US, due to near zero interest rates, which make mortgage financing tremendously attractive and alternative investments such as bonds and other fixed income investments unattractive.
This panel also commented on the relatively limited size of the Canadian real estate marketplace and that large and well-capitalized Canadian REITs are starting to look to the US for properties. Riocan REIT, which has recently completed the acquisition of a significant US shopping centre, is one example. One opportunity which may arise in the United States is for Canadian investors to joint venture with existing, overleveraged US-based real estate operators looking for financial partners.
In a panel discussing the timing of bringing a REIT into the public market, Dennis Mitchell, Portfolio Manager at Sentry Investments noted that the performance of the US equity market is highly correlated with jobs. With the job outlook mixed in the US, there will continue to be volatility in the US equity markets. The panelists agreed that the US economy will continue to struggle toward recovery, and US interest rates will not increase any time soon. In fact, the biggest risk for REITs and other investors in commercial real estate is not increasing interest rates, but the continued viability of tenants.
Patricia Croft, Chief Economist of RBC Global Asset Management was the luncheon speaker, providing an Economic Outlook for 2011. Unfortunately, I was unable to attend. However, my friend and client Ed Mah, CFO of Ledingham McAllister provided me with his notes. Many thanks to Ed.
Ms. Croft advised that we are in an era of correcting collateral damage and predicted many years of fragile recovery. We have been through many years of massive misallocation of capital, which cannot be fixed with a quick recovery. Deflation is a bigger risk than inflation, although eventually we will be faced with much higher inflation. She predicted that after pausing in the short term, increases in interest rates in Canada will recommence in 2011 and continue into 2012.
Ms. Croft predicted that by 2020, China will be the world’s largest economy, surpassing the United States, and that we are on the cusp of a change in the “world currency” from the US dollar to the Chinese yuan, although she believes that the yuan is overvalued by 40%. She predicted that gold will reach $1,500 per ounce by 2011. The real estate market will cool off. The TSX will continue to be volatile for the next decade within its cyclical low (below 8,000) and recent highs (over 12,000). Lastly, Ms. Croft identified risks to the Canadian and global economies as being: policy mistakes by central banks; food price inflation; the risk of sovereign debt default; a rise in protectionism; political uncertainty; and how China will deal with growth and the value of its currency.
The afternoon speakers continued on with the same themes: investors seeking higher yield and stability will continue to invest in real estate and real estate equities, putting ongoing pressure on capitalization rates; the relative scarcity of affordable investment properties in Canada will lead Canadian REITs to the United States; the Canadian economy is strong and stable but subject to external risks; the US economy continues to face difficult challenges; mortgage and bond rates are low and are expected to continue to be.
These were the lessons I took from this year’s Conference. Based on my previous experience, these should be relatively accurate predictions of what we should expect over the next few years.
