Real estate investment faces challenges

While Canada’s residential real estate market posted its largest year-over-year gain in two years this July, its commercial real estate sector still faces “trying times” and significant obstacles that could send some owners into creditor protection, according to a PricewaterhouseCoopers (PwC) report.

The report blames tight industry lending conditions; poor investor appetite for commercial mortgage-backed securities; higher expectations for capitalization rates; and continued financial weakness among tenants for the sluggish pace.

Frank Magliocco, partner and leader of PwC’s Real Estate practice in Canada, says, “Owners need to immediately implement monthly or quarterly cash flow reviews to understand exactly what their short-, medium- and long-term capital needs are and, perhaps even more importantly, identify what options are available to overcome inevitable refinancing hurdles.”

He also suggests that certain owners of commercial real estate consider divesting non-core or underperforming properties as a means to generate cash or capitalize on growth. “On the other hand, well-capitalized investors may want to see if value can be extracted from the downturn via opportunistic acquisitions.”

Mark Hannah, senior vice-president of Avison Young, a Vancouver-based independently owned commercial real estate services company, agrees the availability of attractive debt on the terms we are accustomed to is very challenging to find today. “There are far fewer lenders than 12 months ago.”

“This might be the perfect time to sell for investors whose debt is maturing,” he says.

Hannah doesn’t, however, see this market as being in a downturn; he rather calls it a much-needed adjustment. “Cap rates were compressed to such a level, they just didn’t make sense.”

He says the private buyer is still very active in all markets across Canada. “Pension funds took a step back because they needed to catch their breath; publicly traded REITs had to take a step back as they ran out of capital and their stock prices went down. But the private purchaser is starting to come back and will be a major player in next 12 to 18 months.”

John Nicola, founding partner and financial planner at Nicola Wealth Management, doesn’t agree the market for commercial real estate is in such dire straits across Canada. “Not all markets are the same. Vancouver is still relatively strong; even though Alberta may be relatively weak.”

He scoffs at concerns the new rents may be lower this year (and even next year) than what they were in 2007. “It misses the point that you’re not renewing leases that were done a year ago. You’re renewing leases done say five and 10 years ago. So the income on the assets is still rising.

“Between now and the end of the year — for the first time in two years — the market will make enough sense for us to buy a real hard asset. We can’t buy at the cap rates implied by the RIETS in the open marketplace yet, but we’re getting closer,” he says.

As long as investors aren’t highly leveraged, Nicola argues, refinancing rates and mortgage rates haven’t gone up. “Mortgage rates, if anything, may have slightly gone down. Potentially for the first time, we’re beginning to see some good valuation in the marketplace.”

And since markets are all about opportunity, Nicola says for those who believe two or three years from now oil or natural gas prices would come back, Alberta would actually provide better value than Vancouver.

Leslie Lundquist, co-lead manager of Bissett Income Fund, agrees for those bullish on natural gas and oil, real estate investment trusts concentrated in the West, such as Boardwalk REIT, might be a good investment.

“The Cominar REIT too has a distribution yield of a little more than 9% today and that’s pretty attractive considering where bond yields are at. The only potential problem is its very heavily weighted in Quebec,” she adds.

Lundquist does, however, agree that at present there seems to be a mismatch in the marketplace where the overall participants can’t come to a real agreement on what the correct cap rate is at this point. As a result, the commercial real estate sector is seeing very little M&A and acquisition and disposition activity in the publicly traded REITS.

“The comments we hear out of most REITS are they have properties they would like to sell but buyers aren’t willing to buy at prices sellers believe reasonable,” she says. “Conversely, some REITS that are sitting on a cash pile, and would like to invest it in properties, are reporting the same thing from the other side — they’re interested in buying properties but the sellers aren’t interested in selling.”

She adds, however, that the value of the real estate held within REITS is appreciating in value. “They’re up quite nicely. As capital becomes more available, more and more cash will chase properties, making them more valuable. Overall indications suggest property values are higher and cap rates lower than two quarters ago.”

While he’s all for REITS, Nicola considers open-ended mutual funds bad vehicles for real estate because redemptions can force a manager to sell relatively illiquid assets.

“Mutual funds are open-ended structures, and in theory you’re supposed to redeem assets on demand. But real estate is not a liquid asset, can’t easily be sold or even easily be valued in a changing marketplace, and should be never designed to be a mutual fund with a redemption requirement on demand,” he says.

When mutual funds come out with net asset value, Nicola says it’s always a bit of a guess. “Secondly, if a lot of people were trying to redeem at the same time, the only way they can do that is sell off the asset, which in the case of real estate can take months, sometimes years, and they may actually be exacerbating the problem by forcing the sale at distressed prices.”

He recommends closed-end mutual fund structures. “We have them already and they are called REITs. We still feel they represent good value and cash flow.”

Lundquist agrees REITS are an excellent structure for real estate exposure as they allow liquidity in the market. “There are roughly 25 REITS in the Canadian market, and of those maybe 10 to 12 have reasonable quality characteristics.”

Depending on what you’re investing for, she says, “If you’re hoping to pick up bargain basement assets when capital was very tight — it’s too late for that. We’ve already seen most of the higher quality REITS in Canada come off their bottoms because they’ve had access to capital. So the very best bargains are behind us.”

However, if you’re investing in order to get a distribution and stream, Lundquist says you can still get fairly health yields out of the REIT market, because the worst is behind us.

(08/17/09)