Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
Real estate as an asset class affects Canadians profoundly. We live in homes that we own or rent. We work in buildings. We shop in stores that exist in physical buildings on land. Products are made on properties and even Amazon has to store its stuff somewhere. Whether we are conscious of it or not, real estate supply, demand and prices affect our daily lives.
The question Canadian real estate investors should ask themselves: Am I too exposed to the Canadian market, and might some geographic diversification be a good idea?
I would answer that question in the affirmative. When discussing real estate, it is important to remember that it is a diversified asset class. Although subject to the same realities of demand, supply, price and the cost of capital as any other asset class, different sectors and geographical areas can be unique in value and outlook. A 600-square-foot condo in downtown Toronto selling for $800,000 is very different than a small farm in Idaho with a 3,000-square-foot single-family home on 30 acres for the same price.
Geography matters even within the same country. Consider that single-family house prices in Toronto have more than doubled in a decade and in some cases have tripled. A single-family home in Winnipeg rose about 50 per cent in price over the same period.
In addition to residential real estate, there is the commercial sector, which includes offices, warehouses, farms, factories, storage facilities, retail, data centres, hotels and other assets. One of the most important factors for the outlooks of these segments is their location in global markets. Generally, growing and prosperous countries tend to have more profitable real estate. This is where market values increase the most, as does rent.
Of course, sometimes property prices can reach super-bubbles situations. In the late 1980s, the land under the Emperor of Japan’s palace was worth more than all the land in the state of California, an economy now significantly larger than Canada’s. It is worth noting that soon after, Japan went into a 30-year period of economic decline.
Canadian residential real estate is nowhere near those levels of hypervaluation, but things are unprecedented by historic levels, particularly in Toronto and Vancouver. There are cheaper areas in the country but they may be cheap for a reason. The economy in those areas may be in a state of semi-permanent anemia.
Importantly, interest rates have risen dramatically and the full effect of this on real estate is only in the top of the third inning. The market will get volatile as ever-increasing amounts of debt are rolled over at higher rates.
Economic growth and prosperity are crucial to the outlook for real estate. Sadly, the Canadian market is beginning to look unattractive relative to other places despite being artificially fuelled by immigration. This is true in all sectors of real estate in the country. A weaker economy means owners will lose rent as businesses and jobs are lost. I concur with those economists who now believe that Canada will underperform most developed economies for the next decade, at a minimum. This trend has been going on for some time and is accelerating.
In the postwar period Canada was a top-five country in terms of GDP per capita. Part of the reason for this was that North American industry was not bombed to ashes as were those in the rest of the then-industrialized world. We now rank in the mid-20s and, at current growth rates, many economies will overtake us in the next decade.
When baby boomers entered the work force, the standard of living of Canada was only slightly below that of Americans, and effectively equal when excluding the Atlantic provinces and rural Quebec. Now our standard of living is 30 per cent or more below the United States’ in terms of GDP per capita. Provinces rank with the poorest of U.S. states except for Alberta. Central Canada and the Maritimes have the GDP per capita of the Deep South.
Many opportunities exist outside Canada in real estate. The largest and probably most familiar market is the United States. Given its more capitalistic system, the American economy will outperform Canada’s despite all the social and political problems it currently faces. Also, the U.S. economy is 12 times the size of Canada’s. There are far more opportunities in the U.S.
Still, some sectors have better outlooks than others. Office buildings in decaying cities are probably best avoided. There is a massive societal change occurring in the U.S. People and businesses are fleeing states such as California and New York that are in economic and social decline in favour of states such as Texas, Tennessee, Florida and less populated Western states. Many of those states now favoured have lower taxes, crime rates and housing costs.
There are numerous REIT exchange-traded funds and mutual funds in the U.S., especially compared with Canada. Although I usually prefer passively managed funds, real estate may be an area in which it’s worth paying extra for active management. When I was managing income funds that emphasized REITs, I found it almost as important to avoid losers as to pick winners. This was partly because of the lack of variety in the Canadian market. Passive ETFs in Canada do not have the luxury of avoiding dogs.
Europe and Asia might be worth considering. Some funds are global, such as the TD Active Global Real Estate Equity ETF TGRE-T, for example. The fund has a heavy U.S. weighting of about 60 per cent, just over 20 per cent in Asia, but less than 5 per cent in Europe. The fund has not done well over the past two years but will benefit in a turnaround. There are almost unlimited choices for investors all over the world. Europe should be looked at for the longer term.
Timing is always difficult. REITs have struggled the past few years because of rising rates and weak economic growth. Adding conservative, income-oriented real estate soon, and gradually adding more growth, is a prudent way to gain exposure. REITs have endured a difficult period since the lockdowns and equity valuations are still historically high. Selling some equity and buying non-Canadian REITs may seem foolhardy right now. However, I have learned that some of the best asset allocation opportunities in my experience were preceded by derision and ridicule. When the experts say, “Only an idiot would do that trade,” it’s time to act.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.