Canada a rising star
The Canadian market is integrating into the global real estate market, as more institutional investors include foreign real estate in their investment portfolio.
Prior to the North American real estate recession of the mid-1990s, the Canadian real estate market had a long history of foreign capital involvement, particularly by British and German investors. As Canada recovered from the recession, domestic institutions seized the opportunity to buy top-quality property and dominated the market. Over the past six years, however, the investor profile has been changing. Foreign investors once again increased the flow of funds to Canada, as they witnessed Canada’s stable economy and healthy real estate market.
Foreign investors’ share of the Canadian property market increased from 1% in 1997 to more than 17% in 2003. Though the official estimate for 2004 is not available yet, it is likely that foreign buyers would represent more than 40% of the total investment in 2004.
The amount of global capital seeking real estate continues to increase in Canada. It has resulted in continuing upward pressure on asset pricing, and downward pressure on cap rates over the past two years. In such a capital-flush environment, most of the large domestic players were on the sidelines or are net sellers, while foreign buyers and leveraged private buyers drove capital flows in 2004. In comparison to the overall global transaction growth of 20% estimated by LaSalle Investment Management, transaction volumes were up between 37% and 100% in major Canadian markets for the year.
Although the US is Canada’s largest trading partner, surprisingly European investors instead of US investors have been the main source of foreign direct real estate investments in Canada. German and Israeli investors have dominated the Canadian real estate market over the past few years. Poor prospects in their home countries’ real estate market have prompted investors to think beyond national borders. Germany is a great example. Low yields have driven German open-ended real estate funds to navigate to cross-border investments . Additionally, structural or legislative changes in some European countries have facilitated investments outside of domestic borders.
All of these factors combined to entice more interest from European investors than US investors in the Canadian market. European investors have displayed a wide variety of interest among all property types in eastern Canada, particularly the Toronto-Montreal-Ottawa triangle. British investors have also been active in Canada. Prudential UK recently purchased Holland Cross, a two-tower office complex with retail components. This was a notable example of British capital investing in institutional grade product in Canada.
In addition to the US real estate market, foreign capital has discovered Canada as another attractive destination for portfolio diversification within North America. The amount of foreign capital seeking investments in Canada is growing rapidly.
Competitive and steady income, and portfolio diversification benefits provided by Canadian real estate assets are the main reasons why foreign investors find Canada a good fit for their asset allocation. Over time, Canadian real estate yields have traditionally offered a slight premium over the US, especially over the past two to three years. Since 1986, Canadian private real estate has produced an average annual income return of 8.2%, while the US private real estate has a slightly lower average annual income return of 8%. Over the past two years, Canadian private real estate has provided an average annual income yield of 8.3%, more than 40 basis points higher than in the US.
According to the Jones Lang LaSalle Global Real Estate Transparency Index 2004, the Canadian real estate market is as transparent as that in the US. Tax regulations, zoning and building codes, and other legal factors in real estate transactions are applied with relative consistency between domestic and foreign investors in Canada. Such an environment has given comfort to foreign investors. Among all the market transparency issues for cross-border investors, taxation is one of the major concerns. The tax treatment for each foreign entity that invests in Canada varies according to specific investor profiles and the structure of deals. Specialised tax and legal professionals are readily available in Canada to help minimise negative tax consequences.
Globally, many investors, particularly institutional investors, are willing to pay high prices in exchange for stable income streams. Inevitably, the convergence to global norms in Canadian real estate pricing has caused swift cap-rate compression during the past two years, but real estate asset pricing is still very attractive to cross-border investors. This is simply because Canadian markets are economically and structurally sound.
Canada has better fundamentals than in the US. As the rising Canadian dollar slowed the rate of growth in the export sector, the economy grew 2.8% in 2004, much slower than the 4.4% growth in the US. Both Canadian office and industrial markets, however, are tighter than those in the US. In step with rising stock market and steady job growth, the Canadian office markets are recovering at a much faster pace than in the US.
Office vacancy rates continue to decline in the downtown Class A markets of Montreal, Toronto and Vancouver. Office construction is generally constrained, and building costs are rising faster than inflation due to competition from single-family homes, condominiums and large infrastructure projects. Ottawa and Calgary are the best performing markets in the country.
Industrial markets, with a national vacancy rate of approximately 5%, are much stronger than the US with an 11% vacancy rate. Toronto is one of the healthiest industrial markets in the North America. With rents below C$5/ft2, Toronto continues to be one of the most affordable industrial hubs among major North American markets.
In addition, Canada has significant supply constraints relative to US due to stronger planning and regulatory authorities, the institutional character of the large development companies, and unwillingness of lenders to extend construction financing until there is a high percentage of lease commitments or pre-sales in place. For instance, 65% of pre-sales is required to finance a condominium project in Canada, while usually 50% pre-sales is required in the US.
The outlook for the Canadian real estate market is encouraging, as faster growth in net operating income is expected over the next three years than in the US.
Office fundamentals will continue to improve in 2005. As the economy experiences steady growth and firms expand their space needs, strong office market recovery will bring the market to equilibrium in near term. Even if interest rates rise, office prices will continue to rise since both domestic and foreign capital seeking office properties are deep and broad.
Industrial markets will remain strong in Canada. Increasing import volumes from Asia will further strengthen the growth in distribution/logistics activities, boosting the demand for industrial space. A supply cycle is under way to respond to such a demand trend. This will also keep rent increases in line with the increase in land and construction costs. Additionally, the increasing land, energy and construction material costs for industrial space will continue to lift up replacement costs, suggesting higher rental rates.
Retail sales are expected to be strong on the heels of housing sales and job growth. Tenant expansions will continue in 2005, supporting strong occupancy levels. Thus, demand for retail properties is high. Since the majority of investment grade shopping centres are owned by Canadian retail REITs and they are unlikely to sell, Class B community shopping centres are being offered to the market to meet investor demand.
Among all major property types, apartments may see a continued plateau in earnings driven by low occupancy rates. Housing purchases are siphoning off apartment demand, which will lead to higher vacancy rates in most markets, with a few exceptions such as British Columbia.
The recent passage of codified limited liability legislation in Ontario was a milestone in the Canadian public real estate market. Such regulatory changes are likely to invite more institutional investors who are attracted by the yields available in Canada vis-à-vis other asset classes to invest in the REIT market, which will indirectly bring more capital and competition to the direct real estate market.
Undoubtedly, investors of all types increasingly consider Canadian real estate as an important part of a well-balanced portfolio. The trend is unlikely to change over the near-term, and it may become even more amplified in 2005 as institutional and individual investors both seek stable yield and portfolio diversification in real estate. British investment played a huge role in the development of Canada, including prestigious investors like Grosvenor and Slough, as they seek competitive returns and less risk than their home countries. European investors may find the current situation to be an inviting new era to invest in Canada.
Catherine Marshall is director of research and strategy, and Wai Kuen Elysia Tse is an associate at LaSalle Investment Management