First, it was Canada's housing sector. Now, it's the country's commercial real estate market.
Pundits around the world are still immersed in a vigorous debate about just how overheated the residential real estate market here is, and whether it's destined for a crash. Now some are also training their sights on Canada's commercial real estate market – the wide array of office towers, shopping malls, and factories that have become hot commodities in recent years.
The key players in this sector – including Canadian pension funds, real estate investment trusts and insurers – have been saying for at least a year that the market, which has always been cyclical, appears to be near its peak.
But questions are being raised about whether they've done enough to prepare for a potential softening.
Richard Johnson, a Zurich-based managing director of UBS Global Asset Management, held a meeting with pension funds in Toronto last month and told them that UBS is concerned about their level of exposure to Canadian real estate.
"With most Canadian institutional real estate investment focused on domestic real estate, pension funds could be seriously overexposed in the event of a downdraft in the market," he says.
Canadian commercial real estate boasts a 10-year annualized total return of 11.9 per cent, according to Investment Property Databank Ltd. That's the highest of all countries covered by IPD, except for South Africa.
It compares with a return of about 8 per cent on equities and 5.6 per cent on bonds.
A number of factors have driven Canada's commercial real estate market to outperform expectations over the past five years. Local landlords, such as pension funds and REITs, have had a lot of capital to invest, leading to stiff competition for prized assets. And Canada's status as a safe haven in the wake of the financial crisis caused foreign players to look for places to park their money here.
UBS expects the total return on Canadian commercial real estate in the next three years or so will be in the neighbourhood of 6 per cent. But William Hughes, head of UBS's global asset management real estate research and strategy group, says that the market's performance will be impacted more by perception than any fundamental changes. And he says that if investors decide they're ready to take on more risk to seek higher yields, then some of those who were attracted to Canada by its safe-haven status could look to invest their money elsewhere, hurting real estate values here.
"Pricing is a concern," says Leo de Bever, the CEO of the Alberta Investment Management Corp., or AIMCo. "Real estate has been the best-performing asset class since 2000. I'm not sure that will be the case going forward. That said, all asset classes are fully priced, or in the case of bonds, riskier than they have been since the 1950-1980 period."
Most of the major pension funds have been diversifying their portfolios, and increasingly looking for investment opportunities abroad. A number of pension funds and other institutional players are also shifting toward building new office towers and other commercial real estate developments in Canada, rather than paying top prices for existing ones.
"The development cycle is working well right now for sure, a lot of us are finding it easier to manufacture profits than to buy them," says Blake Hutcheson, CEO of Oxford Properties, the real estate arm of the Ontario Municipal Employees Retirement System (OMERS).
But he adds that he believes supply and demand are in check, and "I don't think in any way Canada is overpriced. The real estate fundamentals in Canada have remained as strong as any in the world."
There is some concern that too many new office towers are being developed. More than 15 million square feet of new office space is scheduled to be built across Canada in the next four years, with the country in the midst of the most active downtown development cycle in 20 years, according to brokerage Cushman & Wakefield.
But Cushman CEO Scott Chandler noted that the pension funds are developing much of the new supply – and the new towers are likely to do well, at the expense of the older ones.
Similarly, market players note that in a softening market the best assets will still hold their value, and many of those – such as landmark shopping malls – are owned by the pension funds.
Amy Erixon, a managing director in Avison Young's investments business, said that pension funds in Canada tend to have a large allocation to real estate as a means of diversifying, in part because the stock market is so concentrated.
Lorenz Reibling, chairman of Boston-based Taurus Investment Holdings, says that the real estate investment firm has sold more than $150-million in Canadian real estate lately, including shopping centres and office space.
"The best time to sell is when everyone else wants to buy, so that's what we have done," he says.
Taurus still owns some shopping centres in Canada, and Mr. Reibling says it's looking for more Canadian assets to buy. But they will be "riskier" assets – i.e., fixer-uppers – because the rest, he says, are fully priced.