Solid Assets

The real estate investment market is hot and shows no signs of letting up. But with dwindling supply and greater competition for assets, the landscape — and market players — will continue to change

By Robert Colman

In early June, it was announced that a consortium comprised of Brookfield Properties Corp., the Canada Pension Plan Investment Board (CPP), and a third Canadian institutional investor were to purchase O&Y Properties Corp. and O&Y Real Estate Investment Trust (O&Y REIT) for approximately main billion.

O&Y Properties and O&Y REIT own prime office real estate across Canada. O&Y Properties’ two principal assets are the First Canadian Place office tower in downtown Toronto, and a 42% stake in the REIT, which owns 24 office properties across Canada. 

The deal was reached through a competitive bid process and, as it first stood, would have seen the consortium pay $13 per share for O&Y Properties. The limited voting units of O&Y REIT would have been redeemed for $15.50, an 8% premium over its trading price when the companies were put up for sale in February of this year.

Despite the premium, and the fact that O&Y Properties voted overwhelmingly in favour of the deal, the REIT shareholders rejected it. At press time, the Brookfield consortium had sweetened the deal for the REIT shareholders. Regardless of whether the new offer is accepted or not, the players in the transaction, and the fact that the initial offer fell through, is an interesting reflection of Canada’s dynamic real estate market — a market that creates both challenges and opportunities for investors and industry insiders.

Demand trumping supply

When asked what’s popular now with investors, Sandy McNair, president of Insite Real Estate Information Systems, was unequivocal. “The short answer is, everything’s popular,” he says.

InSite provides perspective to the commercial real estate industry in Canada through several initiatives, including interviewing the top 150 biggest investors in Canada every quarter to find out how they perceive the market — which asset types and markets are popular, and where they see valuations going over the next quarter. 

“Seven years ago, Toronto, Calgary and Vancouver were in favour and everything else was out of favour,” he explains. “Now, everything else is doing well — Montreal has calmed down, Ottawa is no longer perceived as just a government town, and there’s also more appetite for risk.

“It used to be that office space was the most popular asset to hold, with industrial in second place, apartments third, and retail as the fourth choice. That dynamic has changed somewhat, with office slipping a bit in popularity, and apartments becoming less popular because of low interest rates.”

Both McNair and Ken Jones, CMA, VP of JJ Barnicke Winnipeg’s investment group, characterize it as a simple supply and demand problem. “A large amount of capital is chasing very little product,” notes Jones. “Although Winnipeg is a secondary market in Canada, because so much is happening in the primary market, and returns are likely to get lower and lower, the secondary markets have become much more popular.”

McNair also notes that other market forces are working in favour of real estate. “Both the institutional and personal mindset right now is on solid assets,” he explains. “This is partly because expectations for stocks and bonds are steadily declining. The overall thrust is, if you want more than a 6% return on an investment, you’re not likely going to get it in this market.”

Many people around the world are considering investing in real estate for the same reason. Jones is seeing plenty of offshore money, from countries like Germany and Israel, coming into Canada. “They see places like Winnipeg as safe and stable places to invest,” he notes.

At the same time, institutional investors like Canada Pension Plan are looking for more space in which to invest. “CPP has a mandate to buy $8 billion in real estate in the next few years,” explains McNair. “They’re going to have to start spending that money around the planet. Anyone who doesn’t have real estate in their porfolio right now would probably be criticized.”

As CPP and others look overseas, we may see new players in Canada as well.

“REITs are having a tough time competing with offshore investors and pension plans,” says McNair. “Because the cost of capital is up, they can’t be quite as aggressive as they have been. What we may see is some partnerships among REITs. For instance, Australia has a pretty advanced REIT market, so we may see those trusts putting money into Canada and the U.S.”

The supply challenge and market strength may put O&Y REIT’s initial refusal of a deal into perspective, says McNair. “Investors might ask, if I sell, what am I going to buy? Where am I going to put that money?”

And no one really sees the market changing anytime soon. “There’s still so much capital seeking investment, any major change is unlikely in the near term,” says Jones.

Better asset management

Interestingly, investors’ supply of money is driving prices up in many markets, independent of the actual performance of the office leasing markets. In Toronto and some other markets, for instance, vacancy rates have increased, building incomes have been flat or declining and yet values have been going up over the past five years. There are exceptions, of course.

“At the end of last summer, the market in Calgary seemed to tighten up over night,” says Pierre Bergevin, VP of corporate services for Royal LePage Real Estate. At the end of 2004, downtown office occupancy levels were at 91.5%, the best state the city had been in since 2000. 

“Vancouver has also gotten tighter in the last 12-18 months,” says Bergevin. “If you’re a small tenant looking for space, that’s not a big deal, but for big tenants in cities like Calgary, Vancouver and Toronto particularly, there aren’t as many options as you may think.”

Even in cities where vacancies are a bit higher, for owners to keep prime tenants and get the return on investment they’re looking for, there has to be continuous local investment. Perspectives are changing on that front as well. Real estate is a local business — the buildings have to be managed, leased, maintained properly. It helps when owners have global reach, but they also need local knowledge — a consistent approach deployed with local expertise.

“It used to be that ‘economies of scale’ was the big catch phrase,” says McNair. “That’s partly true, but the cost of toilet paper isn’t going to move very much past a certain point. ‘Competencies of scale’ — better, not cheaper — is becoming more important. Lots of organizations emphasize the wrong issue. Even Wal-mart isn’t really the master of cheap — it’s the master of information systems. People don’t choose to be at First Canadian Place or Royal Bank Plaza because it’s cheaper. Presumably they do it because it’s better.

“Companies should be talking to tenants about employee retention rather than tenant retention — if it’s all about being cheaper, the relationship is going to be a loser for everyone. With all of the money around right now, companies are going to be spending more to see that their assets are worth the investment.”

Pension funds are leveraging effective management know-how by purchasing properties in partnership with companies that can effectively manage their assets. The consortium of CPP with Brookfield is a perfect example of this. The sale of half of Place Ville Marie to Alberta Pension Plan is another example. Société immobilière Trans-Québec (SITQ) sold half of its interest but remained on hand to manage the asset.

“It’s all about diversification by city, asset type, manager, country... the list goes on,” says McNair.   

Strategic diversification

Real estate services companies, meanwhile, are trying to keep up with this globalization and the push for better services and management.

“Borders are starting to disappear,” says Ken Jones of JJ Barnicke Winnipeg. “Companies aren’t just asking for an organization that can buy and sell properties. Because corporations are becoming larger and larger, with so many global assets, providing service to clients around the world, they are starting to outsource their real estate needs. For instance, many Canadian companies are moving into the U.S. because of the strong Canadian dollar. But figuring out where to set up shop — in a market with the appropriate labour force, raw materials, customer or incentives — can be a substantial challenge.”

JJ Barnicke has partnered with the Trammell Crow Company in the U.S. to provide such services to its clients. Jones considers this type of diversification and expansion essential.

“It’s all about the strategic management of services — from relatively simple tasks such as relocating people to different facilities, to complex solutions like development and project management, facilities management, and brokerage. Trammell Crowe handles these challenges and more for companies like Bank of America and IBM,” says Jones.

John Renneberg, CMA, a director at CB Richard Ellis in Alberta, sees the need for a similar broadened scope for his company’s business. “As vacancy rates get lower, the brokerage business eases,” he says. “To offset that, we are expanding our property management business, which is responsible for about 4.2 million square feet right now, up from 3 million square feet last fall. Although people don’t change management that easily, when we sell buildings, we try to get new customers to come on board at that stage.”

Both companies are looking for new strategic advantages in tight but broadening markets.

The tight market has welcomed some new construction. Renneberg notes that several new office buildings are under construction in Calgary, including one speculative play, and two substantial additions are underway on Vancouver’s skyline. But don’t expect any rash of new development anywhere soon.

“There’s a lot of discipline in the market,” says Pierre Bergevin. “There are such deep-pocketed developers and pension funds, I think that with a 40% tenancy rate, that would be enough to kick off construction.” However, he also notes that any development process works from two to three years out, so we shouldn’t expect anything too soon.

Robert Colman is editor-in-chief of CMA Management.

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