Real estate is a popular asset class for investors right now, especially unsophisticated investors who are sitting on a lot of cash. We discuss recent trends in retail, multifamily (residential real estate rented out for commercial purposes) and hotels and some of the drivers behind why they are moving in that direction.
REIT Activity in Canada
As of late 2017, many real estate investment trusts (REITs) have been dumping tertiary assets to retrench in their core areas. For instance, Cominar REIT is retrenching in Quebec City, Montreal and Ottawa-Gatineau, selling all assets outside those markets for $1.2 billion to reduce debt and strengthen the balance sheet.
Likewise, RioCan REIT is selling 100 assets for $2 billion as they shift towards prime areas and focus on derisking “going it alone” by entering into select joint venture development opportunities with other REITs and private developers. Mixed use projects in prime, centralized areas are becoming the norm and the situation is getting more difficult as major pension funds are stepping up their real estate allocation in their asset mix – bidding up premier asset prices.
Why is there a flight to quality? Here are some factors:
Retail Real Estate Trends
Retail, once a steady cash cow, is continuing to decline due to the increased penetration of online shopping. A store that pays for labour (and overtime), rent, electricity, HVAC and shrink is not competitive against Amazon or TMall.
Prime mall real estate loses value as big box anchor stores become less attractive. The mall concept is evolving, from a major purchase location to a social centre. Store space that will not be renewed will give rise to active entertainment outlets. Escape rooms, showcases and gaming hubs (internet café) will take over. While clothing, toy and bookstores will continue to thin out, a great opportunity arises for gyms, luxury good stores with a shopping experience (Holt Renfrew where you receive attentive and knowledgeable staff), and restaurants.
In the 21st century, machines are getting smarter and more and more jobs are becoming automated. Anything without a strong intellectual or relationship component is getting replaced – while the repetitive tasks in everyday jobs will also be outsourced to computers. This leaves people with a lot of free time, which means that they will have more time to seek experiences, gaming and other time wasters (as opposed to starting a website). Grocers have until now been in the protected basket, but Amazon is quickly learning how to move fresh produce efficiently and cheaply, augmented by their acquisition of Whole Foods Market.
From a investing or valuation perspective, retail real estate values should decline in real terms, driving up cap rates as the value of leases fall and the threat of tenant defaults loom. Prime retail real estate in marquee locations connected to transit hubs (metro stations) continue to hold steady, but lower quality assets such as in strip malls and in isolated areas will struggle to see the revenues needed to justify the rent.
Certain retail outlets are still immune – home improvement, laundromats and other services that are not able to be shipped.
Ironically, the disruptors who pushed out the original retailers are now setting up smart retail outlets. Amazon and Alibaba have opened connected stores that are smartphone interactive – cashless payments, scanning and ordering from the showroom and pre-ordering live lobster to be cooked for the conclusion of the shopping trip.
Relative to the USA, Canadian retail has not been as impacted due to the relative density of urban centers while the country itself is sparsely populated – the Canadian population is very concentrated near the US-Canada border and within cities such as Vancouver, Toronto, Montreal and Calgary. There is less retail space due to consumer spending being not as an aggressive of a driver as south of the border. Also, shipping and delivery is more expensive due to the space in between major cities as well as custom duties – Canada does not have the scale advantages of the US so cost cuts cannot be passed on via online shopping and thus malls can still have cost advantages to Amazon.
Trends in Multifamily Assets in Canada and the US
Multifamily assets are residential rental assets with four or more units. Vacancies are low in most urban centres and multifamily assets are perceived as safe, cash flow generating assets that can comfortably service debt. Given the abundance of cash that uneducated investors feel the need to deploy, money has continued to pour into multifamily real estate.
Multifamily assets have been bid up in North America to the point where most sophisticated investors and real estate analysts consider it to be extremely overvalued. Cap rates for multifamily assets in tier 1 areas in cities such as Vancouver have gone below 2% – a nonsensical figure as it is now yielding less than the 10-year government bond, widely seen to be the least risky asset you could hold, whereas in real estate there is operational and vacancy risk as well as carrying costs (property tax, overhead, a possible vacancy tax). As such, the only reason to purchase multifamily real estate given the near zero cap rates is to bet on the price appreciating in one year.
With such low cap rates, leverage – a key component to making real estate an attractive asset class, is impractical because rent will not cover interest and principal payments. Putting on debt on an investment asset diminishes returns rather than magnifying them. As renting out becomes less attractive and people just bet on appreciation, development of multifamily units for rental is not at all sensible and developers are switching out to condos and pre-sales.
Hotel Trends in Canada and the US
Relative to income, hotels have always been the cheapest properties to purchase (highest cap rates) because of the higher risk associated with the asset – hotel stays are essentially very short term, one-day leases and the leases can be cyclical in nature, moving with the economic cycle (or the weather, for vacation properties).
Airbnb has changed the dynamic by allowing for a better supply-demand imbalance via an abundance of supply. Like how Uber has taken the power away from cabs for transport, Airbnb effectively eliminates price gouging because a swath of supply can rush into the market when supply is short for a major conference in the city or sporting event. Standalone hotel properties will certainly have gone down in value for two reasons – lower rents/income driving down the denominator (the price) for a steady cap rate, and a higher cap rate to justify the heightened vacancy risk and the reduced “call option” of a supply shortage accompanied with price gouging mechanisms.
Depending on regulation in each city, the effects of Airbnb can be very pronounced in driving down hotel prices – although not in absolute terms. Making lodging accessible and cheaper will increase numbers for travel itself, increasing the size of the pie instead of just taking market share – net-net, AirBnB is a plus for the economy.
Luxury hotels, although Airbnb and competitors will look to service this space in the future, are safe because they offer a product that cannot be replicated easily. In addition, the commercial component such as restaurants, bespoke service and concierge offer a package that is differentiated from AirBnB. Relationships and customer reward systems (Starwood Points) will also keep business travel in the pockets of luxury hotels, so stocks such as Marriott International and Hilton will continue to have a business moat.
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