Robust Returns Ahead for Canadian REITs

The Canadian real estate investment trust (REIT) sector is generating significant buzz, with industry experts projecting a period of strong outperformance against global peers in the coming year. This optimistic forecast emerged from the 15th annual RealREIT conference, a pivotal gathering of real estate and investment professionals held recently at the Metro Toronto Convention Centre in downtown Toronto. The consensus among panelists and attendees alike points to a unique confluence of factors positioning Canadian REITs for robust growth, driven by resilient domestic market fundamentals and strategic advantages in key property types.

During a high-profile roundtable discussion, John Murphy, a seasoned real estate securities analyst at Cohen & Steers, captivated a large audience with his assessment. Murphy highlighted that Canadian retail REIT portfolios, in particular, appear notably more promising than comparable investment vehicles in nearly every other major country, including the United States and Australia. He explained that many other nations are currently grappling with the same retail real estate challenges that Canada proactively addressed years ago, exemplified by the significant market shifts brought about by the departures of major retailers like Sears, Zellers, and Target. This earlier adjustment has, paradoxically, left the Canadian retail landscape in a more robust and adaptive state.

Beyond retail, Murphy also underscored the positive outlook for REITs focused on rental housing in Canada. With the enthusiasm for home buying continuing to moderate across the nation, he anticipates “a lot of tailwinds going forward” for the rental sector. This sentiment was strongly supported by Kate MacDonald, portfolio manager of global real estate at Signature Global Asset Management. MacDonald further elaborated that both the apartment and industrial sectors are currently benefiting from “some of the strongest real estate fundamentals” seen in the market, pointing to sustained demand and favorable market conditions.

Strong Fundamentals Bolster Confidence in Canadian Market

The underlying confidence in Canada’s real estate market is well-founded, according to Tom Dicker, vice-president and portfolio manager of Dynamic Funds, who also participated in the roundtable. Dicker pointed to several key pillars of stability: “We have a developed (relatively stable) market, good banks, population growth . . .” These fundamental strengths create a fertile ground for REIT performance, offering investors a degree of predictability and resilience not always found in other global markets.

Divergent Forecasts for REIT Returns: Optimism Meets Caution

While the overall sentiment at the conference was largely positive, specific projections for Canadian REIT returns over the next year varied among experts. Two of the four panelists at the morning roundtable predicted returns in the range of five to eight percent. However, John Murphy presented a more bullish outlook, forecasting returns as high as ten percent. His optimism was partly fueled by the “lower for longer” interest rate environment, a significant factor influencing the cost of capital for REITs. Murphy noted, “Twelve months ago, I would have expected the multi-year tailwind of interest expense savings to be reversing. Now that is not going to happen,” implying continued financial benefits for REITs from prolonged low rates.

Derek Warren, portfolio manager of real estate equities for Lincluden Investment Management, echoed the five to eight percent growth projection but added a note of caution, anticipating “a bit of a rollercoaster in-between.” Warren also suggested an impending “bit of a shift” in investment focus, moving away from potentially overvalued industrial and residential sectors towards more diversified opportunities within the real estate market. This strategic repositioning reflects an adaptive approach to maximize returns in evolving conditions.

Kate MacDonald aligned with the mid to high single-digit return forecast for Canadian REITs over 2020. She highlighted Tricon Capital Group’s acquisition of Starlight U.S. Multi-Family Core Fund in June as a transaction worth monitoring. This strategic move provided Tricon with a robust multi-family platform, comprising 7,300 units across 23 properties, underscoring the ongoing appetite for significant portfolio expansions in the residential space.

In contrast to the prevailing optimism, Tom Dicker offered a more conservative perspective, suggesting that a two percent yield on REITs next year might be a more realistic expectation. Dicker cautioned, “The probability that we are in a recession today is not zero (but) they are priced like it is zero.” He pointed out that “certain areas are overvalued in this era of scarce growth and recession risk,” concluding with a prudent piece of advice for investors: “My best investment idea is: be careful.” This highlights the importance of discerning investment strategies even amidst a generally positive market outlook.

The Rising Influence of ESG in Real Estate Investment

A significant portion of the roundtable discussion was dedicated to the burgeoning impact of Environmental, Social, and Governance (ESG) factors on investment decisions. These three pillars measure the ethical and sustainability performance of a company or business, representing increasingly vital metrics for investors. While governance, encompassing aspects like staffing and executive compensation, is relatively straightforward to assess, Dicker noted that environmental and social factors remain “more nebulous” and, consequently, challenging to quantify accurately. He highlighted a particular concern: “There is certainly not a lot of auditing to ensure . . . disclosure of the good and bad of the environmental impact . . .” of development projects, suggesting a lack of standardized and transparent reporting mechanisms.

Despite these challenges, Dicker emphasized that ESG is rapidly gaining traction and is poised to become a critical rating factor. He pondered the future impact, questioning, “Are we going to see the ‘sustainalytics’ (a country’s risk rating to long-term prosperity) . . . have the type of effect that, say, a bond rating does on publicly traded equities where you get a downgrade in your ESG score and your stock falls a whole bunch the next morning?” This underscores the potential for ESG ratings to directly influence market valuations and investor confidence.

John Murphy elaborated on how Cohen & Steers integrates ESG into its investment framework, utilizing a third-party consultant to develop an internal ESG scorecard. Their evaluation process is twofold: assessing companies based on their sector-specific environmental and social impacts, and also evaluating their proactive efforts to enhance ESG performance, regardless of their property type. This comprehensive approach ensures a nuanced understanding of a company’s sustainability profile.

Murphy provided an illustrative example of how ESG ratings can vary, even for a single company. A self-storage business, for instance, typically scores high on the “E” (environmental) aspect of ESG. He explained, “Their buildings don’t use a lot of energy and there isn’t a lot of car traffic,” indicating a minimal ecological footprint. However, the same business might score “very poorly on the ‘G’” (governance) because “the workforce tends to be high school grads with lower wages than, say, a net lease company that is staffed by 10 finance grads.” This example vividly demonstrates the complexity and multi-faceted nature of ESG evaluation.

Kate MacDonald further commented on the nascent stage of ESG integration within the Canadian REIT landscape. She noted that only five Canadian REITs currently possess a formalized sustainability score or rating. “It (ESG) is really in its nascent stage. We don’t have a formalized process but increasingly it is becoming a part of our framework.” This indicates a growing awareness and commitment within the Canadian market. MacDonald also highlighted that Global Property Research recently launched three ESG-related indices, signaling a crucial development. She stated, “We will be watching very closely how much capital these ESG-oriented indices attract,” suggesting that the flow of investment into these indices will be a key indicator of ESG’s influence.

Navigating Risks and Optimizing Development Strategies

In a subsequent seminar focused on REIT risks, Mario Saric, managing director of real estate and REITs at Scotiabank, reinforced the positive outlook for specific sectors. Saric identified apartments and industrial properties as those that “still have room to grow” over the next twelve months, continuing their strong performance trajectory. This assessment further solidifies the view that these sectors offer compelling investment opportunities.

Jodi Shpigel, senior vice-president of development at First Capital Realty, offered practical advice on mitigating risks in supply-constrained markets. She emphasized the critical importance of developing in prime locations: “high-gross neighbourhoods accessible to public transit routes.” Such strategic positioning ensures both high demand and long-term value appreciation, crucial elements in managing development risk.

A general consensus among most panelists was that development deals yielding less than a five-percent return were typically “a no-go.” However, Shpigel provided an important nuance, explaining that acceptable returns are highly dependent on the specific location within Canada. For instance, a five percent return might be considered good in Toronto, where capitalization rates (cap rates) are traditionally low due to strong market demand. Conversely, investors might target higher yields in Montreal, where cap rates are generally higher. “Out west it is the opposite,” she added, illustrating the diverse market dynamics across Canadian provinces and the necessity of tailoring investment expectations to local conditions.

Hugh Clark, executive vice-president of development at Allied Properties REIT, contributed to the discussion by highlighting how the size of a development project directly impacts Allied’s willingness to undertake risk. The company tends to focus less on mega-projects and more on smaller-scale initiatives. Clark explained the rationale: “And if it does go bad, earning a five-per-cent return on a $100-million project is much more understandable – and you can recover from it – versus a $1.5-billion project.” This pragmatic approach underscores a fundamental principle of risk management in real estate development: prioritizing manageable exposure and ensuring pathways for recovery.

The 15th annual RealREIT conference, a vital platform for industry dialogue and insights, was meticulously organized by the Real Property Association of Canada and Informa Markets. Their efforts were significantly supported by the principal sponsor, RBC Capital Markets Real Estate Group, whose collaboration was instrumental in bringing together leading minds in the Canadian real estate investment landscape.