Setting the global stage

The credit crunch that began to materialize in 2007 became a global financial crisis in the second half of 2008 and the fallout will continue to be felt throughout 2009. What started out as bad subprime loans to US homeowners spread throughout the global financial system through the securitization and commoditization of risk affecting all credit related securities and triggering a global economic recession. The mighty have since fallen in the commercial real estate lending arena– Lehman Brothers, AIG, Merrill Lynch, Bear Stearns, Citibank, Fortis, HBOS, Royal Bank of Scotland and Hypo to name a few – leaving in their wake a significant reduction in available debt capital in the marketplace for real estate and all other asset classes. Governments have been responding with co-ordinated interest rate cuts, injections of liquidity and bailouts / nationalization of major financial institutions after the Libor-OIS swap spread hit an all-time high at the end of September signaling that lending in the market had essentially ground to a halt.

Tremendous equity market volatility has led to a flight to quality with the yield on US Treasuries reaching historic lows as risk averse investors look for a safe haven in the midst of deteriorating financial conditions.

The crisis works its way through the four quadrants

Commercial real estate capital markets have not escaped the upheaval in global finance, with both public and private equity and debt affected.

For publicly-traded equity (REITs and listed companies) and debt (CMBS), market reaction has been swift around the globe. Major REIT indices around the globe have tumbled in lockstep and were down roughly 52% in 2008, after peaking in 2007. Canada has not been spared, as Canadian REIT stocks traded down for the year. Given the current value of REIT units it is difficult if not impossible for REITs to make an accretive acquisition.

Annual Global REIT Total Returns (US Dollar)

Publicly-traded debt via the CMBS market has all but disappeared, with global issuance down nearly 90 percent over the levels achieved in each of the prior two years. In Canada, where CMBS outstanding of $19 billion accounts for just over 1% of the global total, we have seen CMBS issuance fall from the range of $2 to $4 billion per annum that prevailed earlier in the decade to nil this year, with no new issuance in Canada in 2008. Canadians have good company in this area, however, as there was no new CMBS issuance in 2008 in Italy, France and Australia, either.

With REITs sidelined and the CMBS market frozen worldwide, private equity and debt remain the main source of available capital today, but some major classes of private investors face hurdles of their own. Pension funds, for example, have been a significant source of investment capital over the years and as such many of these funds have significant allocations to real estate. In 2008, pension funds saw the value of their entire portfolio decline significantly and could be facing an unfunded liability situation as a result. With the denominator effect in play many pension funds have become over-allocated in real estate and may be looking to adjust their portfolio holdings accordingly, or will remain on the sidelines for the near term.

In the investment sales market, the timing of the market correction has been varied around the globe. The UK led the rapid re-pricing in the market after a steep run up in values became unsustainable, accentuated by the economic downturn. This was followed by the US, with emerging markets in Europe and Asia now adjusting as well. In the US, cap rates have increased roughly 75 basis points, equating to a 10-15% decline in asset value. In London this increase is more like 150 basis points with a 25% decline in value. Nonetheless, investment sales volume has now dropped everywhere. The market peaked in 2007 and throughout 2008 a correction took place across the globe with transaction volumes off over 60% worldwide, according to data from both DTZ and Real Capital Analytics. Expect much of the same for 2009.

Buyer-seller disconnect

As a result of the ongoing market correction, a growing disconnect now exists between buyers and sellers in the marketplace. Those buyers with available capital are expecting “fire sale” pricing given the market perception that the “sky is falling”. Buyers are of the mindset – why buy today when it may be cheaper tomorrow - and are thus prepared to hold out for the best deal possible. Owners, on the other hand, are still holding on to the dream of record high asset values and having to face the dire realization that their portfolios are not worth as much in the market as they perceive them to be. Many of these owners do not need to sell their assets today, for the sole reason that most properties are cash flow positive, and are thus happy to sit tight until values recover.

Other owners, however, may be forced to sell in order to raise equity to satisfy debt obligations or, in the case of government bailouts or receiverships, may be forced to liquidate entire portfolios. Pressured sellers are on the rise as debt laden investment entities look to shore up their balance sheets. Sale/leaseback agreements may increase in popularity as a means for corporations, distressed or not, to turn real estate holdings into necessary capital.

How does Canada fit into the picture?

While Canada has not been immune to what’s happening around the globe, the nation entered into this correction on a much more solid footing that many other markets around the globe. Canada’s banking system remains more solid and the exposure to subprime far more muted. Canada’s banks exhibit far more conservative lending practices on both the residential and commercial side, lessons learned from the last major downturn of the early 1990’s.

In contrast to market downturns experienced in the past, today we see much more conservative supply delivery, significant pre-leasing requirements and relatively low vacancy rates in most markets across the country. Adding stability to the market is the fact that ownership of Canadian commercial real estate is consolidated in the hands of the country’s largest institutional investors, particularly for office and retail property.

With the exception of Calgary, and some would argue Toronto, there is very little overheating in the supply of new construction across the country. Calgary has added roughly 5.8 million square feet of new office supply, a mix of build to suit and spec, over the past two years and is set to add an additional 4.5 million square feet in 2009 and 3.1 million square feet between 2010 and 2011, the majority of this delivery in the Downtown market. Under construction supply is running at about 60% pre-leased; however, the Calgary market has seen some softening of demand and increasing of vacancy rates due to the general economic climate and retraction in energy prices that had been supporting the buoyancy of the oil and gas and related services sector. Toronto is on track to add 3.2 million square feet to the downtown Class A market in 2009, with an additional 1.1 million square feet scheduled for 2010-2011. New supply is running at roughly 63% pre-leased. Toronto has also experienced some softening of demand and an increase in market availability, particularly for sublease, going into 2009. Given the injection of supply, it will be the tenant appetite for the backfill space in both Calgary and Toronto which will determine the health of these markets over the near term, both from a leasing as well as an investment perspective, as income stream is a determining factor in asset valuation.

Investment activity in all markets was down for the most part in 2008. In Toronto, the country’s largest market, office investment decreased 32%, industrial investment was down 46% while retail investment decreased 24%. ICI land sales were off only 16% however it is expected that land sales will suffer further declines as the cost of buying and holding land for the longer term is outweighed by the need for liquidity and capital today. Weaker industrial prospects will continue over the near term as manufacturing activity, particularly that tied to exports and the auto sector, continues to be challenged by the economic climate.

The largest office transactions in the Toronto market included the 50% interest in Brookfield Place (TD Canada Trust Tower) for $424 million; the sale of North York City Centre for $161 million; and the sale of 1 Toronto Street/92 King Street for $122 million. The largest industrial sales included 8020-8030 Esquesing Line for $59 million; 325 Humber College Boulevard for $56 million; and 6580 & 6590 Millcreek Drive for $40 million.

In the booming Calgary market, office investment volume decreased 15% and retail decreased 16%. In sharp contrast, industrial activity increased 147% over 2007 while ICI land sales increased 80%. However, as much of the activity in the Calgary market is predicated on the strength of the energy sector it is expected that weaker oil prices will slow investment in the oil sands and moderate real estate investment activity in this market over the near term. Investment activity in Edmonton will also be affected by the decline in energy prices.

The largest transactions in the Calgary office market included IBM Corporate Park for $181.5 million; Energy Plaza for $176 million; and 205 Quarry Park Boulevard SE for $141 million. The largest industrial sales included the Versacold Portfolio of 8 Alberta properties for $111 million; Hopewell Business Park buildings C&D and Lincoln Park Place for $39.7 million; and Maynard Technology Centre for $36.4 million.

In Vancouver, office transactions declined 38% for the year with industrial down 7% and retail down 31%. Vancouver boasts low vacancy for both office and industrial which bodes well for continued market stability with the backdrop of limited new supply additions. The ramp-up to the 2010 Olympics has injected significant capital expenditure into the market.

The largest transactions in the Vancouver office market included Richmond Riverfront Business Park for $38 million, Yaletown Centre for $20.5 million; and 6500 River Road for $18.5 million. The largest industrial transactions include 31785 Marshall Road for $27 million; 3231-3271 No. 6 Road for $19.4 million; and 836 Cliveden Avenue for $19.2 million.

Ottawa’s market stability continues to be buoyed by the public administration sector. Office transactions declined 21% for the year with industrial down 62%. The largest office market transactions included 171 Slater Street for $35 million; 1001 Farrar Road for $35 million; and 270 Albert Street for $34.8 million.

Perception in the marketplace is that cap rates have increased 75 to 100 basis points since 2007. Once transaction volume resumes we will have a much better sense of the extent to which the market has adjusted due to the economic climate.

Looking ahead

In general, markets in Canada did not experience the steep run up in values that were experienced in markets such as London and New York, nor were investors dependent on maximizing the proceeds of short term financing to fund a boom in the property market. While there will be some deterioration in underlying market fundamentals, it is anticipated that Canada will not experience the same degree of market correction seen in other parts of the globe. The energy driven markets of Calgary and Edmonton may be the exceptions.

In 2009, Canadian investors will suffer the same capital availability challenges felt in other markets around the globe. However, the dust will likely settle and the year may present a great opportunity to acquire property for well-capitalized private buyers, pension funds that are not over allocated to real estate already as well as select public entities. Buy-side competition will be more limited as ‘cash will be king’.