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The commercial property puzzle: Real estate investors refuse to write down assets despite public market pain

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The Royal Bank Plaza, located on the northwest corner of Front St. West and Bay St. in Toronto’s Financial District, sold for $1.1-billion last year.Fred Lum/The Globe and Mail

A year into the fastest campaign to hike interest rates in decades, the commercial real estate sector is deadlocked.

In one corner, the world’s most sophisticated private real estate investors, including Canadian pension plans, say scores of properties they own are worth hundreds of millions of dollars each and have held most of their value. In the other, investors are dumping shares of publicly-traded real estate investment trusts (REITs), particularly those that own skyscrapers, because they don’t think such lofty values still make sense. In Canada, the national vacancy rate of office towers just hit an all-time high, and in New York, there are enough empty offices to fill 26 Empire State Buildings.

Who’s right? That’s the trillion-dollar question looming over private investors in particular as they gauge whether to start marking down the value of their property portfolios more aggressively. It is a complex puzzle: Not all commercial properties are equal; deals that set market prices are at a low ebb; and there is a healthy dose of discretion permitted in the way private investors weigh the matrix of variables.

Macro trends must also be factored in. The sudden runup in interest rates has collided with the long tail of a global pandemic that has altered how and where people work, shop and live – all of which is coupled with the threat of an economic downturn that could upend a sector that has been fuelled by cheap money for more than a decade.

“You see what’s happening with private real estate versus what’s happened to the price of REITs – there’s just a massive valuation difference there that isn’t easy to explain, quite honestly,” Bert Clark, chief executive officer of public-sector pension manager Investment Management Corporation of Ontario, said in an interview.

The answer impacts trillions of dollars worth of office towers, malls, warehouses and apartment buildings, affecting everyone from banks that lend to the sector – including U.S. regional lenders whose share prices are already under siege – to the millions of Canadians whose pensions are managed by major property owners such as the Ontario Teachers’ Pension Plan and the Ontario Municipal Employees Retirement System (OMERS).

Because so much is at stake, the standoff is getting testy. Pressed to justify their optimism for the real estate sector, private investors are starting to push back against the naysayers. “My honest view is people are overreacting quite materially,” Blake Hutcheson, OMERS’ CEO, said in an interview. “I think private valuations are much closer to reality than publics.”

Valuing real estate portfolios is tricky work, and private owners – as well as the outside experts they hire to vet their numbers – have leeway in how they appraise properties. By design, most private investors are patient owners with long-term leases who look not only at what a property would fetch today, but its future potential based on cash flows, replacement costs and the values of comparable buildings.

Over time, that makes their results less volatile. But it also raises eyebrows when markets plunge and private valuations don’t follow. The $21.2-billion real estate division of OMERS returned 13.6 per cent in 2022. Ivanhoé Cambridge, the Caisse de dépôt et placement du Québec’s real estate arm that manages $48-billion worth of properties globally, was not far behind with a 12.4-per-cent gain last year.

Those returns are at odds with the performances of publicly-traded REITs. Shares of Allied Properties REIT AP-UN-T, once viewed as one of Canada’s most desirable REITs because it owns offices in downtown cores of cities such as Toronto and Montreal, many of which are in heritage-style buildings that have charm, are down 62 per cent from their prepandemic high. And the Canadian REIT universe – which encompasses everything from skyscrapers to rental apartment buildings to suburban shopping centres – is trading around a 30-per-cent discount to its net asset value, according to research from CIBC World Markets.

MSCI, a financial market research firm, tracks the difference between publicly-listed and private, or unlisted, real estate in Canada and the U.S. Its latest figures show the gap in public and private values is 37 per cent in Canada, and 30 per cent in the U.S.


Comparing price movements for listed

and unlisted real estate

Price/asset value level (Index: Dec. 2019 = 100)

Canada listed

U.S. listed

Canada unlisted

U.S. unlisted

JOHN SOPINSKI/the globe and mail,

source: msci real assets

Comparing price movements for listed

and unlisted real estate

Price/asset value level (Index: Dec. 2019 = 100)

Canada listed

U.S. listed

Canada unlisted

U.S. unlisted

JOHN SOPINSKI/the globe and mail,

source: msci real assets

Comparing price movements for listed and unlisted real estate

Price/asset value level (Index: Dec. 2019 = 100)

Canada listed

U.S. listed

Canada unlisted

U.S. unlisted

JOHN SOPINSKI/the globe and mail, source: msci real assets

These value gaps are now so large that they are hard to ignore, yet few people are willing talk publicly about them. Multiple companies that specialize in commercial real estate valuations declined to comment for this story, citing tensions between their public and private clients.

Amid this chaos, private owners do occasionally acknowledge the winds have shifted. Last year Royal Bank Plaza, the tower that houses the headquarters of Canada’s largest lender, Royal Bank of Canada RY-T, sold for $1.1-billion to the Spanish billionaire behind the Zara fashion retail chain. Its sellers were OMERS’ real estate arm, Oxford Properties, and its co-investor, the Canada Pension Plan Investment Board. At OMERS’ annual meeting in April, Mr. Hutcheson told pension plan members that if they tried the same sale again now, “I would think we’d get $300-million or $400-million less.” That’s a 30- to 40-per-cent drop, in line with public market valuations.

The question, then, is at what point must these estimates be integrated into financial models, if at all? Private real estate owners have long argued that they are private by design, because it allows them to smooth out market volatility, but they can’t ignore public investors forever. Many institutional shareholders doing the public-market selling are just as large, smart and sophisticated.

What no one contests is that the recent rise in interest rates is a dominant variable for both camps. The real estate sector is one of the most sensitive to interest rate changes, and the speed at which central banks across the West have hiked rates is extremely rare.

Higher rates have, in simple terms, taken the punch bowl away from the real estate party. In the decade leading up to the COVID-19 pandemic, most commercial real estate was on fire because ultralow rates made mortgages extremely cheap. Central bank intervention to keep rates artificially low during the pandemic only exacerbated this trend.

Now that the pandemic is no longer a global emergency and benchmark interest rates have jumped at least four percentage points in both Canada and the U.S., investors are taking stock of all that has transpired. As the dust settles, with Canadian and U.S. central banks suggesting they are hitting pause, it is clear there are stark differences between the different asset classes of commercial real estate.

Industrial properties such as warehouses, manufacturing plants and distribution centres are hot – particularly in Canada, where the national vacancy rate fell to a record low of 1.6 per cent at the end of 2022, according to CBRE Group Inc., and is now only a tad higher. The supply of properties is so tight that some landlords have been able to raise rents more than 100 per cent in tenant turnovers and lease renewals.

Rental apartment building owners have also performed well, because their supply is constrained in many major cities across the U.S. and Canada. Boardwalk REIT BEI-UN-T, a major rental apartment owner in Calgary, reported earnings this week and its average rent increase when a tenant turned over last quarter was 15 per cent.

The office sector, though, is very clearly hurting, as are retail properties, albeit to a lesser extent. Office towers were among the hottest commercial real estate to own heading into the pandemic, with a vacancy rate of just 1.2 per cent in downtown Toronto, but white-collar workers have embraced hybrid work accommodations and the national occupancy for office buildings in Canada hit an all-time high of 17.7 per cent in the first quarter, according to CBRE.

“The fundamentals are brutal. Some of these buildings are never coming back,” Jeff Olin, the co-founder of Vision Capital Corp., which manages real estate investment funds, said in an interview. He still thinks some office towers are great, but when it comes to private owners’ estimates, “there’s certainly denial, that’s for sure.”

Despite the headwinds, major property owners, including Brookfield Asset Management and Blackstone Inc., argue the process of valuing commercial real estate today is nuanced. Even in the office sector, they stress that quality matters. Newer towers with modern amenities, known as Class A buildings, are seeing higher occupancy rates and rising rents, while older, less well-maintained buildings, often located in suburban areas – the Class B and C inventory – are emptying out.

There has been “an absolute bifurcation of the real estate market,” Connor Teskey, president of Toronto-based Brookfield Asset Management Ltd., said on a conference call last week.

To this end, Slate Office REIT SOT-DB-T and True North Commercial REIT TNT-UN-T, both of which largely own Class B properties predominately in Ontario, slashed their monthly payouts in recent weeks by 70 per cent and 50 per cent, respectively.

A dearth of property sales has also complicated things. Because there are now so few yardsticks to use when pricing a deal, even the most prominent and experienced investors can’t agree on what properties are worth.

In the first quarter of 2023, commercial property deal volume in Canada dropped 52 per cent year over year, according MSCI Real Assets, with the office sector plummeting 86 per cent and the retail sector dropping 66 per cent. In the U.S., first-quarter office deal volume dropped below the depths of the pandemic, hitting a pace not seen since the immediate aftermath of the 2008 global financial crisis.

Although property sales will eventually rebound, offering some new benchmarks, there is a wildcard in this valuation puzzle: a wave of mortgage refinancings. Although private holders have the financial wherewithal to think long-term, they finance their property purchases with shorter-term debt, often on five-year terms, and some of it comes due each year. Most of the new debt replacing it is more expensive because the previous mortgages were locked in when rates were lower, or at ultralow rates in some cases, and owners will have to ask themselves if it makes sense to put more money into their properties to stave off defaults or sales under duress.

Even Brookfield BN-T, which regularly touts the high quality of its properties, has already defaulted on two loans for office towers in Los Angeles worth a combined US$755-million in February, and on another US$161-million mortgage for a dozen office buildings in Washington in April. It is possible the defaults are strategic, in order to negotiate better deals with lenders, but they also likely wouldn’t have happened if the market was still hot.

The coming refinancing cycle will also affect banks, which are the dominant lenders in commercial real estate. In the U.S., recent deposit woes at regional lenders are already shrinking the pool of available credit for property owners, and in Canada the federal banking regulator has ranked commercial real estate as the third most acute of nine key risks it is tracking this year, citing offices as well as construction and development assets as those under the most pressure. About 1.2 per cent of all loans at Canada’s largest banks are underpinned by office buildings.

Banks have tougher lending standards than they did in past crises, and their risks are spread over multiple sectors of real estate, so Canada’s lenders are expected to withstand commercial real estate shocks, Mike Rizvanovic, an analyst at Keefe, Bruyette & Woods, said in a recent note to clients. But if they and their U.S. peers pull back on lending, it could force distressed sales for real estate owners who can’t refinance.

Private owners acknowledge this scenario is possible, and that it would push down real estate valuations. But they argue they have the financial heft and scale to withstand short-term shocks. “If you can stay at the table, time will be your friend,” said Mr. Hutcheson, the OMERS CEO.

Recalling his estimate of Royal Bank Plaza’s market value today, he stressed it would only be realized if the buyer was forced to sell now. “As a private owner, I think it’s worth everything they paid for it,” he said.

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Here are some facts about British Columbia’s housing market

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Housing affordability is a key issue in the provincial election campaign in British Columbia, particularly in major centres.

Here are some statistics about housing in B.C. from the Canada Mortgage and Housing Corporation’s 2024 Rental Market Report, issued in January, and the B.C. Real Estate Association’s August 2024 report.

Average residential home price in B.C.: $938,500

Average price in greater Vancouver (2024 year to date): $1,304,438

Average price in greater Victoria (2024 year to date): $979,103

Average price in the Okanagan (2024 year to date): $748,015

Average two-bedroom purpose-built rental in Vancouver: $2,181

Average two-bedroom purpose-built rental in Victoria: $1,839

Average two-bedroom purpose-built rental in Canada: $1,359

Rental vacancy rate in Vancouver: 0.9 per cent

How much more do new renters in Vancouver pay compared with renters who have occupied their home for at least a year: 27 per cent

This report by The Canadian Press was first published Oct. 17, 2024.

The Canadian Press. All rights reserved.

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B.C. voters face atmospheric river with heavy rain, high winds on election day

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VANCOUVER – Voters along the south coast of British Columbia who have not cast their ballots yet will have to contend with heavy rain and high winds from an incoming atmospheric river weather system on election day.

Environment Canada says the weather system will bring prolonged heavy rain to Metro Vancouver, the Sunshine Coast, Fraser Valley, Howe Sound, Whistler and Vancouver Island starting Friday.

The agency says strong winds with gusts up to 80 kilometres an hour will also develop on Saturday — the day thousands are expected to go to the polls across B.C. — in parts of Vancouver Island and Metro Vancouver.

Wednesday was the last day for advance voting, which started on Oct. 10.

More than 180,000 voters cast their votes Wednesday — the most ever on an advance voting day in B.C., beating the record set just days earlier on Oct. 10 of more than 170,000 votes.

Environment Canada says voters in the area of the atmospheric river can expect around 70 millimetres of precipitation generally and up to 100 millimetres along the coastal mountains, while parts of Vancouver Island could see as much as 200 millimetres of rainfall for the weekend.

An atmospheric river system in November 2021 created severe flooding and landslides that at one point severed most rail links between Vancouver’s port and the rest of Canada while inundating communities in the Fraser Valley and B.C. Interior.

This report by The Canadian Press was first published Oct. 17, 2024.

The Canadian Press. All rights reserved.

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No shortage when it comes to B.C. housing policies, as Eby, Rustad offer clear choice

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British Columbia voters face no shortage of policies when it comes to tackling the province’s housing woes in the run-up to Saturday’s election, with a clear choice for the next government’s approach.

David Eby’s New Democrats say the housing market on its own will not deliver the homes people need, while B.C. Conservative Leader John Rustad saysgovernment is part of the problem and B.C. needs to “unleash” the potential of the private sector.

But Andy Yan, director of the City Program at Simon Fraser University, said the “punchline” was that neither would have a hand in regulating interest rates, the “giant X-factor” in housing affordability.

“The one policy that controls it all just happens to be a policy that the province, whoever wins, has absolutely no control over,” said Yan, who made a name for himself scrutinizing B.C.’s chronic affordability problems.

Some metrics have shown those problems easing, with Eby pointing to what he said was a seven per cent drop in rent prices in Vancouver.

But Statistics Canada says 2021 census data shows that 25.5 per cent of B.C. households were paying at least 30 per cent of their income on shelter costs, the worst for any province or territory.

Yan said government had “access to a few levers” aimed at boosting housing affordability, and Eby has been pulling several.

Yet a host of other factors are at play, rates in particular, Yan said.

“This is what makes housing so frustrating, right? It takes time. It takes decades through which solutions and policies play out,” Yan said.

Rustad, meanwhile, is running on a “deregulation” platform.

He has pledged to scrap key NDP housing initiatives, including the speculation and vacancy tax, restrictions on short-term rentals,and legislation aimed at boosting small-scale density in single-family neighbourhoods.

Green Leader Sonia Furstenau, meanwhile, says “commodification” of housing by large investors is a major factor driving up costs, and her party would prioritize people most vulnerable in the housing market.

Yan said it was too soon to fully assess the impact of the NDP government’s housing measures, but there was a risk housing challenges could get worse if certain safeguards were removed, such as policies that preserve existing rental homes.

If interest rates were to drop, spurring a surge of redevelopment, Yan said the new homes with higher rents could wipe the older, cheaper units off the map.

“There is this element of change and redevelopment that needs to occur as a city grows, yet the loss of that stock is part of really, the ongoing challenges,” Yan said.

Given the external forces buffeting the housing market, Yan said the question before voters this month was more about “narrative” than numbers.

“Who do you believe will deliver a better tomorrow?”

Yan said the market has limits, and governments play an important role in providing safeguards for those most vulnerable.

The market “won’t by itself deal with their housing needs,” Yan said, especially given what he described as B.C.’s “30-year deficit of non-market housing.”

IS HOUSING THE ‘GOVERNMENT’S JOB’?

Craig Jones, associate director of the Housing Research Collaborative at the University of British Columbia, echoed Yan, saying people are in “housing distress” and in urgent need of help in the form of social or non-market housing.

“The amount of housing that it’s going to take through straight-up supply to arrive at affordability, it’s more than the system can actually produce,” he said.

Among the three leaders, Yan said it was Furstenau who had focused on the role of the “financialization” of housing, or large investors using housing for profit.

“It really squeezes renters,” he said of the trend. “It captures those units that would ordinarily become affordable and moves (them) into an investment product.”

The Greens’ platform includes a pledge to advocate for federal legislation banning the sale of residential units toreal estate investment trusts, known as REITs.

The party has also proposed a two per cent tax on homes valued at $3 million or higher, while committing $1.5 billion to build 26,000 non-market units each year.

Eby’s NDP government has enacted a suite of policies aimed at speeding up the development and availability of middle-income housing and affordable rentals.

They include the Rental Protection Fund, which Jones described as a “cutting-edge” policy. The $500-million fund enables non-profit organizations to purchase and manage existing rental buildings with the goal of preserving their affordability.

Another flagship NDP housing initiative, dubbed BC Builds, uses $2 billion in government financingto offer low-interest loans for the development of rental buildings on low-cost, underutilized land. Under the program, operators must offer at least 20 per cent of their units at 20 per cent below the market value.

Ravi Kahlon, the NDP candidate for Delta North who serves as Eby’s housing minister,said BC Builds was designed to navigate “huge headwinds” in housing development, including high interest rates, global inflation and the cost of land.

Boosting supply is one piece of the larger housing puzzle, Kahlon said in an interview before the start of the election campaign.

“We also need governments to invest and … come up with innovative programs to be able to get more affordability than the market can deliver,” he said.

The NDP is also pledging to help more middle-class, first-time buyers into the housing market with a plan to finance 40 per cent of the price on certain projects, with the money repayable as a loan and carrying an interest rate of 1.5 per cent. The government’s contribution would have to be repaid upon resale, plus 40 per cent of any increase in value.

The Canadian Press reached out several times requesting a housing-focused interview with Rustad or another Conservative representative, but received no followup.

At a press conference officially launching the Conservatives’ campaign, Rustad said Eby “seems to think that (housing) is government’s job.”

A key element of the Conservatives’ housing plans is a provincial tax exemption dubbed the “Rustad Rebate.” It would start in 2026 with residents able to deduct up to $1,500 per month for rent and mortgage costs, increasing to $3,000 in 2029.

Rustad also wants Ottawa to reintroduce a 1970s federal program that offered tax incentives to spur multi-unit residential building construction.

“It’s critical to bring that back and get the rental stock that we need built,” Rustad said of the so-called MURB program during the recent televised leaders’ debate.

Rustad also wants to axe B.C.’s speculation and vacancy tax, which Eby says has added 20,000 units to the long-term rental market, and repeal rules restricting short-term rentals on platforms such as Airbnb and Vrbo to an operator’s principal residence or one secondary suite.

“(First) of all it was foreigners, and then it was speculators, and then it was vacant properties, and then it was Airbnbs, instead of pointing at the real problem, which is government, and government is getting in the way,” Rustad said during the televised leaders’ debate.

Rustad has also promised to speed up approvals for rezoning and development applications, and to step in if a city fails to meet the six-month target.

Eby’s approach to clearing zoning and regulatory hurdles includes legislation passed last fall that requires municipalities with more than 5,000 residents to allow small-scale, multi-unit housing on lots previously zoned for single family homes.

The New Democrats have also recently announced a series of free, standardized building designs and a plan to fast-track prefabricated homes in the province.

A statement from B.C.’s Housing Ministry said more than 90 per cent of 188 local governments had adopted the New Democrats’ small-scale, multi-unit housing legislation as of last month, while 21 had received extensions allowing more time.

Rustad has pledged to repeal that law too, describing Eby’s approach as “authoritarian.”

The Greens are meanwhile pledging to spend $650 million in annual infrastructure funding for communities, increase subsidies for elderly renters, and bring in vacancy control measures to prevent landlords from drastically raising rents for new tenants.

Yan likened the Oct. 19 election to a “referendum about the course that David Eby has set” for housing, with Rustad “offering a completely different direction.”

Regardless of which party and leader emerges victorious, Yan said B.C.’s next government will be working against the clock, as well as cost pressures.

Yan said failing to deliver affordable homes for everyone, particularly people living on B.C. streets and young, working families, came at a cost to the whole province.

“It diminishes us as a society, but then also as an economy.”

This report by The Canadian Press was first published Oct. 17, 2024.

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