This will be a pivotal year for Canada's real estate sector, which saw its status as market darling challenged during the second half of 2013.
"The Canadian public real estate market went through a period of very substantial growth beginning in the early 2000s, with a brief interruption during the credit crisis," says Stephen Sender, industry head of real estate in Bank of Nova Scotia's global investment banking unit. "Like all things where you have a period of substantial and fairly rapid growth, at some point there will be a time for a breather. And that's what we're at right now."
The sector's current state provides a stark contrast to 2012, when the industry was on a roll. The S&P/TSX REIT index, which tracks real estate investment trusts, posted a total return of about 17 per cent that year, outshining the seven per cent return of the S&P/TSX composite index, which tracks the broader market. Real estate firms issued more than $7-billion worth of equity and private firms in the sector were lining up to do initial public offerings.
As the year drew to a close, market experts sensed the good times might not last. "There were clear signals towards the end of 2012 that the public equity side was facing signs of fatigue," Mr. Sender says.
One challenge was that the industry's rise wasn't entirely explained by the appeal of real estate alone.
"When you step back and say, 'What's going on here?,' I don't think you can say real estate is a really undervalued asset class right now, because it's not," Andrew Phillips, team head of the real estate group at TD Securities, told The Globe and Mail at the start of 2013. "What's driving it is there's this demand for yield," which made REITs, with their high payouts, an easy sell to income-seeking investors.
Market sentiment began to change last May, when long-term interest rates started to rise. Investors in search of higher yields suddenly had alternatives to REITs. Higher rates also threatened to raise REITs' mortgage costs.
The shift dealt a blow to the REITs – and an even bigger one to the bankers and lawyers who advise them. From May to August, the REIT index sunk 18 per cent, and its full-year showing ended a four-year winning streak against the TSX, notes Royal Bank analyst Neil Downey. The total return for the REIT sector was a loss of 5.5 per cent in 2013, while the broader index rose by 13 per cent.
New equity issuance peaked in the first quarter of 2013, according to National Bank analysts. After ten straight quarters in which real estate entities issued more than $1-billion worth of equity, the fourth quarter of last year saw just $330-million issued.
Bankers shelved about half a dozen potential IPOs toward the middle of last year, Mr. Phillips says. "The market wasn't conducive for it, so everyone pulled back." High-profile spinoffs by Loblaw and Canadian Tire were the exceptions.
The upward trend in interest rates has recently taken a breather, and the sector is waiting to see what 2014 brings.
One thing is clear: "The outlook is definitely slower for 2014 than what we've seen the last couple of years," says William Wong, managing director at RBC Capital Markets.
Despite REITs' waning appeal for investors, industry players say the companies themselves continue to be in fine shape.
"The REITs are in excellent financial condition and are using this time to become a little bit more inwardly focused," Mr. Sender says. "These things are cyclical, they come and go, and they will come back."
One encouraging sign is that "cap rates" have barely moved. Cap rates, or capitalization rates, measure the return that an owner is likely to 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.
With the market under stress, a number of analysts had expected an increase in cap rates. They assumed that, in an environment of rising rates, REITs, pension plans and other players would no longer be so eager to bid up prices for assets like shopping malls and office buildings.
But cap rates haven't yet budged much, in part because of steady demand from pension funds. Those players don't face the same pressures that REITs do from higher interest rates because they tend to put up more capital of their own and so don't have to borrow as much; in addition, they don't have to cater to yield-hunting investors the way that REITs do.
With many REITs now trading below their net asset values, some bankers are expecting to see takeovers if the stock prices soften further. "There are a number of organizations, both public and private, that are identifying their targets, they're doing their homework, and they're preparing should the REIT market continue to weaken," says Ashi Mathur, head of Canadian real estate at BMO Capital Markets.
Pension funds are hunting for opportunities. "Pension funds remain relatively underweight in their real estate allocations relative to targets, and their desire and motivation to increase their real estate allocations in the face of limited private market alternatives could create some tension for real estate M&A in the public world," says Chris Bell, co-head of real estate investment banking at Canadian Imperial Bank of Commerce.
REITs, meanwhile, are likely to sell off some of their non-core assets as they increasingly focus on improving their current real estate portfolios and developing new properties.
One notable bright spot: Canadian property companies had a record year last year for issuing unsecured debentures – essentially loans that are not backed by specific assets. REITs and real estate operating companies issued $4-billion worth of debentures in 25 transactions, RBC analysts note. That comes as more REITs receive investment grade credit ratings and the sector matures. More than $1.2-billion worth of unsecured debentures have already been issued this year, kicked off by First Capital Realty.
First Capital CEO Dori Segal notes that the U.S. REIT market is already making much more use of unsecured debentures.
Asked how he would characterize today's market in Canada, he says, "it's less a market of momentum and more a market of actual performance, actual value creation and actual quality. I think investors are going to be more selective than they've been in the past."
Editor's Note: An earlier version of this article referred to an expected fall in cap rates. This story has been amended to show that the expectation was for an increase in cap rates.