For the first time in a year, real estate executives report they are feeling like things are looking up for their industry.
That’s not to say that the commercial real estate business is all sunshine and roses right now – far from it. But the gnawing anxiety that characterized the latter half of the past year seems to have eased.
As a result the REALpac/FPL Canadian Real Estate Sentiment Survey rose slightly in the first quarter of this year, on the back of three consecutive quarterly declines. The survey, which is done by the Real Property Association of Canada and FPL Advisory Group, questions CEOs and other industry executives about their current level of confidence in the business.
“The spectre of higher interest rates in the future is still causing some concern, and there are concerns about over-building,” Mark Rose, the CEO of Avison Young, said in an interview. “But at some point you come to the realization that you can still do business no matter what part of the cycle we’re in.”
The cycle started to turn last year, notably when long-term interest rates began to rise, a development that dealt a blow to the publicly-traded real estate investment trusts in particular.
REIT investors were spooked by the prospect of higher mortgage costs down the road, and yield-hungry investors found themselves with more options. For the first time in years total returns from the S&P/TSX REIT index – which dropped 18 per cent between May and August – didn’t outdo the S&P/TSX composite index. Activity cooled as real estate firms battened down the hatches.
The rise in interest rates spurred analysts to forecast an increase in cap rates. Capitalization rates measure the return that an owner will likely receive from a real estate investment by comparing the operating income (the rent that tenants pay minus the landlord’s expenses) to the price that was paid for the asset. They had been falling as commercial real estate owners, from REITs to pension funds, competed for assets, driving up prices.
But as the year drew to a close it became evident that the upward trajectory of long-term interest rates wasn’t quite as steep as some players had feared, and cap rates were “sticky.”
“My sense is that things are still very strong by historical standards,” one anonymous executive told the sentiment survey. “There seems to be continued interest in real estate from large capital pools. Cap rates are even lower than they were a year ago.”
“There is a continued shortage of good product and very quick absorption of good products that do come on the market,” another executive stated.
Mr. Rose said he feels like the wall of worry is coming down a bit.
“We’ve been telling our clients we have a stable country,” he said. “Quality real estate is quality real estate. The country is sound, the financial system is sound, growth is sound, the government is sound.”
That’s not to say that we’re not heading into a downturn. “I do think that over the next three to four years we are going to have a change in the marketplace, particularly stemming from interest rates, which only have one way to go – up,” Mr. Rose said. “But I’m an optimist. I think if there is a change in interest rates that affects cap rates, that’s healthy. It allows new money to come in, and takes a little bit of the pressure off.” Like any financial market that goes on a tear, a bit of a correction can be a good thing, he suggested.
And while the sentiment survey found that executives are a little more optimistic overall, they still have plenty of concerns – and some are more optimistic than others.
“If the economy improves, it should offset any increase in interest rates,” one executive told the survey. “If the economy is sluggish, then even with low interest rates the market could be somewhat worse than what we have seen in the past.”
“The resource boom is over, our manufacturing sector remains weak, growth in financial services has slowed dramatically, housing is weakening, and the consumer is overburdened with debt,” said another executive. “Add the Internet revolution in retail, space rationalization in office, and a pending over-supply of condos for rent in Toronto and Vancouver – it is time to be strategic and careful with your bets!”