Commercial real estate: What’s hot and what’s not

Investors looking for income and an inflation hedge may want to consider commercial real estate, but some segments are more attractive than others.

“When you are in a world where bonds don’t return anything, real estate has been an effective substitute and we think that’s why it offers great diversification in one’s portfolio,” said Andrew Moffs, senior vice-president and portfolio manager with Toronto-based Vision Capital Corp.

In 2021, Canadian government bonds were generating negative returns. Meanwhile, as of December, inflation was 4.8% in Canada, the highest since 1991.

“Real estate is a classic hedge against inflation,” said Jon Love, CEO of KingSett Capital.

From 1960 through 2017, REITs averaged a 6.4% compound annual growth rate, compared to a 5.5% real return from global stocks, Vision Capital reported, quoting a Dutch study.

“In the present economic landscape, REITs are generally well positioned to outpace rising interest rates with earnings growth,” Vision Capital said in a report to investors released Jan. 15.

“We think it’s a good time to invest in real estate,” agreed Brookfield REIT CEO Zach Vaughan. “Remember, you actually own the underlying asset. You own the underlying land and improvements too, and good quality land also appreciates above inflationary rates over time.”

But not all commercial real estate is an attractive investment.

“You have to look by different asset classes and then you have to look by different geographies,” said Love, who has a generally positive outlook on office space in the core of a large city.

With the ongoing Covid pandemic, some office tenants are considering how to adapt to hybrid work — whether that means reducing space or increasing space, said Love.

“Most companies are protecting their space footprint,” Love said. “Having the right environment to keep and maintain and motivate and build your culture, with people, is a much more compelling element to be focused on, versus just the … rent cost.”

Other considerations are the growth of the overall economy — which generates demand for white-collar jobs — and how much new supply exists to meet an increasing demand for office space, Love said.

Vision Capital, however, maintains a short position in the office sector in its Strategic Opportunity Fund LP, a private equity fund focused on real estate securities. It has long positions in residential, industrial and shopping centres. “We are negative on office,” Moffs said.

One factor is companies delaying — or indefinitely postponing — having their employees return from working from home, Vision Capital said in its Jan. 15 letter to shareholders of the Strategic Opportunity Fund LP.

But the trend toward reducing office space predates Covid. “Law firms don’t need law libraries anymore,” for example, Moffs said.

To use another example, some global accounting firms no longer provide office space for the exclusive use of those firms’ partners, Moffs observed. Instead, when partners come into the office, they use a shared workspace.

While office properties have trended toward fewer square feet per worker, this could be offset by a desire for larger common areas such as kitchens, Moffs said.

For several reasons, Vision Capital has an optimistic view on the industrial class. These include the rise of online shopping (meaning a greater demand for warehouses to store goods that ship to consumers) and a “re-shoring of manufacturing” that started during the pandemic, Moffs said.

For its part, Brookfield REIT invests in “infill logistics,” which includes small warehouse facilities on existing land “that generally serve as the last or one of the last transfer points for goods as they are distributed to the end users,” Vaughan said.

Vaughan contrasts the infill logistics category with a huge distribution facility that serves a region.

Vaughan suggests investors want to avoid investing in properties for which it would be difficult to find a replacement tenant — or convert to a different type of use — if the current tenant were to move out.

By contrast, even vacant office property in a major centre such as Toronto may be attractive because of the underlying value of the land.

Vaughan suggested avoiding a property with all of the following characteristics:

• outside of a major centre;
• aside from its existing commercial or industrial use, there is no other use for that property;
• there are not many other tenants available who would want that building in that location; and
• the property cannot easily be converted to a different use.

“You could have a stranded, or an orphan asset, which is never a good thing.”