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UDI Panel Glows : Commercial Real Estate
Basking in Sunshine

By Darren Donnelly        September 25, 2002 

For those who lived through BC’s lost decade, the views expressed at yesterday’s Urban Development Institute seminar were strikingly upbeat. As moderator of the event, I enjoyed a front row seat as four industry experts entertained and informed the crowd with information gleaned from their personal involvement in dozens of recent transactions, backed up by research-heavy charts and graphs.

According to Kevin Meikle of Royal LePage Commercial, there is a new paradigm in the investment world in which real estate, generally, is very attractive. Richard Wozny of Royal LePage Advisors explained the factors behind Lower Mainland retail’s emergence as a hot market.  Colliers International's Ron Bagan spoke on what he referred to as the bond of Vancouver commercial real estate , industrial properties. Lastly, David Goodman of Macdonald Commercial and author of The Goodman Report rounded out the presentations with the reasons why he calls 2002 a magical time in the rental apartment market.

Investment increases despite rising vacancy

Following meetings last week as part of his firm’s National Investment Team, Kevin Meikle argued that the apparent "disconnect" in the marketplace of increased real estate investment activity and firm prices while vacancy rates (especially in Toronto office product) have risen sharply, is simply a reflection of "an evolution in the global investment stage, generally. Real estate has just changed its position in the marketplace.…If anything, it is connected to the marketplace much more so than we have ever had before because of changes which have occurred in the real estate market."

He points to new, conservative asset management and development strategies and believes that, nationally, real estate looks very strong as an investment vehicle. Since 1999, the spread between relatively stable cap rates -- around 8.5% for Toronto Class A office - and 10-year bond yields - now under 5% - has nearly doubled. During the same period, the TSE 300 Index has taken equity investors on a roller coaster ride from 7,000 to 11,000 and back down to 6,000. Real estate just looks good. The result has been increased activity across all sectors.

According to Meikle, obtaining financing for investment-grade product is easier than ever as "securitised" or "conduit" lenders have finally arrived in Canada in a significant way. He points to about ten players offering mortgage-backed security financing now, compared to just two a couple of years ago.

The market is attracting more foreign investors, REITs (Real Estate Investment Trusts) which are becoming more specialized in specific asset classes and private buyers getting involved in real estate in $25,000 or $50,000 investments through retail limited partnership syndicates being marketed by investment houses. Often they are buying from some of the larger pension funds and life companies which have had to sell real estate to maintain their asset allocation ratios in the face of plummeting equities.

In the national office investment market, Royal LePage believes that the market is bottoming out in terms of the negative absorption and that vacancy rates are stabilizing. Demand for quality downtown space exceeds supply and cap rates for prime properties are being pushed below 8%.

Meikle observed that "the big story is retail", where transaction volume has increased by up to 300% from 2000/2001. The pool of buyers is diverse. Israeli and German buyers have been very active in the East but have shied away from BC as this province continues to be more expensive than the rest of the country by as much as a full cap rate point. "So," he says, "it’s easier for us to take investors from Vancouver to the East than to bring Easterners here." Having said that, cap rates are now being pushed down to 9%, after a number of high quality Lower Mainland shopping centre sales were completed in 2001 and earlier this year at or above 10%.

In terms of clouds on the horizon, the economy is unpredictable, "Kyoto is a concern" and Royal LePage sees current REIT payout ratios as being unsustainable. The biggest concern, however, is that investment demand has shifted so dramatically to real estate that "prices are going to be pushed up to levels where maybe people start feeling uncomfortable."

Meikle stated "It is my belief that people that don’t play now are going to be left behind."

Retail: Strip Malls, Big Box and Street Front

Richard Wozny recalled that "in the late 1980’s shopping centre conventions were massive and extravagant affairs occupying the entire Toronto Convention Centre.…. By 1994, the convention could be held in a hotel room. Today once again things look great for most forms of retail real estate." His presentation focussed on the reasons retail real estate is attractive.

Wozny believes that difficult times in the 90’s "cleared out a lot of poor real estate and marginal retail tenants." The result is that the strong have survived and even what was once viewed as marginal street front retail is now healthy.

Among the many virtues of real estate hi-lighted by Wozny, he mentioned:

  • excellent risk/return ratios, outperforming stocks and other investment instruments by a wide margin over the last five years, and averaging an annual "and relatively reliable" return of about 8%.

  • it yields real cash income.

  • a real estate investment is relatively transparent and easy to understand. Meaningful due diligence can be carried out.

  • it involves a high degree of leverage, which is very good in the low interest rate times we are enjoying – although obviously risk will rise as interest rates do.

  • most new developments now have Wal-Mart or a major supermarket anchor, providing long-term stability.

  • REITs and other syndication vehicles are making real estate investment more liquid. Wozny noted that "The REITs are unlocking value in literally everything that is nailed down. For example, there is a new REIT in the US which invests in bank branches allowing the banks to become tenants, redeploy their capital and if necessary vacate. The new landlords have limited risk as most locations are suitable for another use, such as a coffee shop. It is reasonable to speculate that large retail firms with a lot of real estate will spin that real estate off in the form of a REIT."

Wozny made a number of other observations regarding Lower Mainland retail properties. He sees highways as increasingly attractive sites for retail as they offer good access over the long term in an increasingly congested city. He points to upside in street retail properties where an anchor might be attracted, citing East Hastings and Victoria Drive as examples where "rents are twice as high near London Drugs….as they are a few blocks away." He also notes that commercial street fronts are often immune from the impact of Wal-Mart and big boxes as they have a different food and service oriented role within the community. Regarding big box, generally, Wozny sees their expansion as nearing maturity.

Wozny closed by commenting that while retail "remains the most complex form of real estate, it has become easier to understand and a more stable asset if only because there are fewer players."

Syndicators, Stability Seekers and Owner-users eat up Industrial

In contrast to retail, Ron Bagan was able to point to the relative simplicity of industrial product from an investor’s point of view. He first looked at the important variables of vacancy, rents, cap rates and liquidity.

Over the last several years Lower Mainland industrial property has shown very little fluctuation in vacancy rates. Rents have been steady. The cap rate has "been plodding along at 8.75%". With the price of most properties below $5 million and owner-users making up about about one-quarter of the buyers, liquidity is typically very good. The significance of a large number of owner-occupiers is that - unlike retail, office and appartment properties - there is a market for untenanted buildings. In addition, owners need not maintain large capital reserves for tenant improvements and other major re-tenanting expenses.

Other factors favouring industrial investment include limited supply in the Lower Mainland, ease of construction phasing (as opposed to, say, a phased downtown office tower…) and a low entry level, making small syndications easy.

As a result, Bagan sees demand in high-quality areas like Richmond and Annacis Island now creating opportunities for owners to sell below 8% cap rates. It also means that "lenders have a huge appetite for it. They are able to make nice bite-sized loans under $5 million that are easy to move." He noted that 70% to 75% financing is not unusual.

Rental Apartment sales: A Magical Period

In the August, 2002 issue of The Goodman Report David Goodman reported on "A SURGING MARKET" and, apparently, it shows no signs of slowing.

Goodman reviewed the "gloomy" conditions existing in 1999. Investors had a poor view of BC under the NDP government, our high federal and provincial taxes were disincentives to sell, there existed intrusive provincial rent review legislation, investors were unfairly "spooked by leaky condos", and net out-migration and flat rents added to a bleak picture. The contrast with today’s conditions could not be greater.

He also pointed out contrasts with the post-Expo boom which lasted until 1992 showing that today’s market is much more fundamentally sound. "The late 80’s was a period of wild exuberance, tantamount to a feeding frenzy," according to Goodman. "Offshore investors were gobbling up properties." Average price per suite over that five-year period rose between 62% and 103%, depending on municipality. Not surprisingly, there was a lot of flipping. But with mortgage rates at 10% and cap rates of around 5% to 7%, investors were buying on the assumption that inflation was a given "and capital appreciation would win over negative cash flow", making a crash inevitable.

From a high of 353 apartment properties trading in 1989, the level of activity dropped to a range of 50 to 70 over the last seven years of the 90’s. During that decade average price per suite changed, depending on area by somewhere between minus 18% and plus 8%.

Today, Goodman points to a "positive convergence" which is extremely conducive to activity in this sector. He called it "a magical period where the sun, moon and stars have aligned" to create positive conditions for owners and investors alike. He pointed to a number of factors:

  • new provincial government has dropped personal taxes significantly

  • federal government has reduced capital gains inclusion by 50%

  • rents for new product over $2.00 per square foot are now common, encouraging new construction and renovation

  • low vacancy rates

  • historically low mortgage rates – "CMHC offering five-year money at 5% and 10-year money at 6%"

  • a great deal of institutional investment money available

As a result, there has been a dramatic increase in activity in the last 12 months. Goodman predicts total apartment transactions in the Lower Mainland will reach 160 this year, with a 100% increase in dollar volume from last year.

Goodman caught the attention of the 100 seminar attendees with a table showing the dramatic difference in the tax treatment for an individual selling a property in 1997 compared to 2002. The differences (see table) show the results of the top marginal tax rate reduction from 54% to 43% and the change in the capital gains rules. Looking ahead, Goodman sees increasing sales activity based on strong fundamentals and "low interest rates will enable new investors to benefit as they upgrade their buildings and correspondingly increase rents, which I consider undervalued." Also, he sees a continuing increase in supply of new rental units with rents, primarily in Vancouver with rents firmly in the $1.80 to $2.30 range.

Goodman concluded with a sentiment shared by the entire panel, "BC is again open for business."

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