Economic Overview for Investors
Commercial real estate in Toronto’s Downtown Core is ideally positioned to offer investors an increasingly rare commodity; secure and robust yields, in the safety of the G7’s strongest economy. After the global financial crisis of 2008, Canada’s position as a safe harbour from widespread economic downturns was undeniable, and the country has since been reaping the benefits of conservative banking policies, a powerful currency, and, buoyed by demand from emerging markets, a surge in production of its commodities such as oil, grain, precious metals and lumber.
At the epicentre of Canada’s thriving economic system is a small piece of land, measuring just 24 square blocks in size. Within this limited space, large multinational corporations vie to stake their positions in trophy buildings, and emerging companies hope to succeed with the help of their prestigious class-A locations. Canada’s economy will surely expand, but Toronto’s Downtown Core cannot grow with it. The following document outlines the myriad of ways in which this finite area is poised for rapid rises in both commercial real estate values and leasing rates.
1. Canada’s Strong Economy and Currency
Canada is the best-positioned country in the G7 on a multitude of levels. It has the healthiest banking sector, which resulted in a limited impact on Canada’s economy from the recent credit crisis. Found within it is the largest cache of raw materials of any country, including the second largest oil reserves in the world, and it enjoys proximity to the world’s largest market as well as exposure to growing emerging markets such as the BRICs. Of the G7, Canada also has the most advantageous debt/deficit to GDP ratio, allowing room for further economic stimulus if required, although the government has declared that no further stimulus is warranted. A recent round of interest rate increases has been executed, leaving its financial system in a favorable position to handle any further global turmoil, should it arise.
The robust Canadian Dollar has increasingly become a commodity currency. In fact, in June of 2010 Russia announced that it would begin holding CAD as a reserve currency. Over the course of the last year, it has also been widely reported that China has dramatically increased its purchase of the CAD. Both countries sparked international debate in 2009 with calls for a new world reserve currency to replace the volatile USD. With its inherent stability, and strong position in the G7, the Canadian dollar will continue to be a safe haven and climb against most currencies, and in particular those currencies that will have to enact further stimulus and/or maintain low interest rates for longer periods (namely the USD and EURO).
2. Canadian Banking Conservatism
Canada’s banking system maintained its status as a safe harbour throughout the tumultuous global environment over the past two years. Unlike foreign banks, Canadian banks maintained Tier One capital reserves in line with the original Basel Accords (7%) and were not permitted to hold off-balance sheet assets such as SIV’s. As global banks struggled to recapitalize to levels even sub-Basel Accord levels, Canadian banks were positioned to raise capital up to 14% (Royal Bank). Markets are now in a far safer position, and OSFI (the bank superintendant) has made foreign takeovers extremely difficult. Compounded by the targets Basel III has established for Tier One capital requirements at only half of current reserves by 2015, the bank’s excess capital is now set to be deployed domestically.
Canada’s commercial banks have not held significant levels of commercial real estate for the past 20 years, instead acting as an intermediary between the consumer and the ABCP (asset-backed commercial paper) market. However, evidence that this will change is mounting. Banks have historically held a weighted average of 20% of their assets in mortgages (residential and commercial). During the crisis, Canadian government purchased nearly $70 billion in mortgages from the banks through CMHC (Canada’s lesser-known equivalent to TARP). When it became clear that Canada would not be suffering the same fate as its G7 counterparts, the banks were unable to originate enough residential mortgages to return to their traditional weighting. Furthermore, new lending restrictions imposed by the government have further reduced the pool of available residential mortgages. This leaves only commercial real estate for the banks to recalibrate their asset mix.
3. The Scarcity of Yield
Since 2008, there has been a paucity of vehicles for investors to achieve safe, stable yields in excess of the nominal returns offered by financial institutions to depositors. Money has poured into bonds, resulting in low yields that do not justify their risks. For example, Mexico, which received a credit downgrade last year, has recently issued a hundred-year bond with just a 6% yield. This offering was quickly oversubscribed. Gold has also benefited greatly from the new high-risk, lower-return environment, and driving its emergence as an investment class is the hedge it offers against the threat of inflation, the outside risk of deflation, and as a sideline position in case of a further global economic crisis. Commercial real estate in stable venues is an ideal alternative, and will offer the same benefits and more.
This growing desperation for yield will only be compounded by slow growth (or further decline) in the economy of the United States, and additionally, the urgent need for yielding retirement investment vehicles for the more than 85 million “Baby Boomers” in North America. Canada’s REITs have seen this urgency. As of 2010, these trusts have taken on a record amount of capital and, in return, promised returns far in excess of bonds. These funds have remained largely un-deployed. Due to the predicted inflow of capital from both the REITs and major banks, there are calls for a significant cap rate compression.
4. The Microeconomics of the Downtown Core
Toronto’s Downtown Core is the sought-after financial centre of the Canadian economy. This market has undergone substantial changes during the last decade or so that have compounded the rise in property values. In the late 1990’s, there were approximately 130 owners of properties in the core. As of 2010, there are less than 20, of whom virtually all are major institutions such as Brookfield Properties, Cadillac Fairview, Slate Properties, and Oxford Properties. This dramatic consolidation has provided stability, but has led to far higher prices due to decreased competition from sellers, and a shortage of availability as these institutions tend towards long-term holdings. The high capital requirements and quiet nature of property sales have also posed an impenetrable barrier to entry for most non-institutional investors.
Current demand for commercial real estate heavily outstrips available supply, with a very small number of properties coming to market annually. Since 2007, just one or two Class A buildings have been on offer each year. Bidding wars have become common. This year, one building in the core (100 University Street) reportedly received more than ten bids, and is now said to be under contract at a cap rate of 5.75%, despite that half of the building will become vacant in 2011. Further limiting the supply of available properties, Canada’s current tax regime makes the holding of real estate assets more advantageous than selling.
This scarcity notwithstanding, Toronto is still the least expensive market for the purchase of commercial real estate when compared internationally to other major urban centres with a key stock exchange. By way of examples, 510 Madison Ave. (NY) sold for USD $1,000/psf (after cap-ex requirements); Mitsubishi Estates sold their 165,000/sf facility in London (wholly leased to the Bank of Ireland) for USD $212 Million ($1,284/psf) and the Aoyama Rise Square building in Tokyo sold for over USD $1700/psf.
The aforementioned consolidation of office buildings in the hands of major institutions has also limited the incentive for discounted rents, providing a steady upward pressure. However, Toronto’s commercial real estate market remains undervalued compared to other world-class cities. Occupancy costs in Toronto are less than one-fifth of those in London (West End), and this disparity is swiftly decreasing. Toronto is gaining prominence as one of the premier world financial centres, and already hosts the global mining exchange of choice. The growing requirements of international and multinational corporations for a substantial presence in Toronto will provide a strong upside on leases relative to other global centres.
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