PwC Capital Markets Flash

Volume 2, Issue 28: November 12, 2009 — Special commercial real estate (CRE) Industry Briefing

In this issue:

Notable economic news | Notable M&As | Notable capital raises | CRE Industry Briefing — "Then I'll huff and I'll puff and..."

Highlights

North American commercial real estate (CRE) property values remain fragile due to upward pressure on capitalization rates and downward pressure on operating incomes (from higher vacancy rates and lower rental rates). However, unlike the US, Canadian property valuation trends are highly differentiated by geography and property type, with some notable pockets of weakness and resilience.
Dynamics in the commercial mortgage-backed securities (CMBS) market foreshadow refinancing challenges ahead, especially in the US. With a defunct securitization market, the key question on both sides of the border is: "Who will step up to fill the financing gap?"
Public Canadian REIT balance sheets are in relatively good shape and, on average, exhibit lower leverage and higher liquidity as compared to US REITs. Recent fundraising activity by Canadian REITs is setting the stage for opportunistic acquisitions both north and south of the border.

PwC Capital Markets Flash — November 12, 2009 — Special CRE Industry Briefing (99 KB)
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Capital markets continue to bewilder and have trended both upward and downward since our last Capital Markets Flash. Overall, indicators ended the period up over our last issue. The real news in recent days, however, has been a flurry of blockbuster M&A deals — a strong vote of confidence in global economies.

This week, in conjunction with the release of the PwC/Urban Land Institute's Emerging Trends in Real Estate 2010® report, we assess the current state of the Canadian Commercial Real Estate market.

	Nov 12, 2009	Crisis Extreme	Sept 1, 2008	Pre-Crisis Extreme¹	Week-over-Week
CDN$ / US$	$0.947	$0.771	$0.936	$1.091
S&P 500	1,087	677	1,278	1,565
S&P / TSX	11,360	7,567	13,300	15,073
LIBOR²	0.27%	4.82%	2.81%	1.11%
TED Spread³	0.22%	4.64%	1.10%	0.14%
OIS Spread	0.24	1.85	0.47	0.14
S&P / LSTA⁴	1,369	895	1,293	1,335
CBOE VIX⁵	24	81	21	10
Baltic Dry Index⁶	3,748	663	6,691	11,793
WTI Crude Oil⁷	$76.94	$33.87	$111.55	$146.85

Notable economic news

Employment

The so-called "jobless recovery" continues. The Canadian economy sheds 43,200 jobs in October, pushing the unemployment rate up to 8.6% and erasing September's 30,000 gain.
- The only silver lining in the dismal data is that all the jobs lost were part time and concentrated in the lower-paid retail services sector, suggesting a relatively small hit to overall labour income.
South of the border, the employment picture is even bleaker. Payrolls surprised on the downside last month, with the US economy eliminating 190,000 jobs and the unemployment rate skyrocketing to 10.2%, its highest level since April 1983. Ongoing uncertainty in the labour market will likely keep many consumers on the sidelines, preventing a much-needed jolt to consumer spending.

Monetary policy

Fragile economic recovery and low inflation in the US and Europe prompt central banks to keep rates steady. Bucking the trend, Australia raises rates for a second time.

The US Federal Reserve holds its target rate at 0% to 0.25%, and states that current economic conditions and stable inflation expectations are "likely to warrant exceptionally low levels of the federal funds rate for an extended period." The Fed commits to continued injections of liquidity into mortgage markets through massive purchases of agency debt and agency mortgage backed securities.
The Bank of England follows suit and leaves the official bank rate unchanged at 0.5% while expanding asset purchases from $175 billion to $200 billion as part of its ongoing quantitative easing strategy.
Marking the first move by a central bank to reign in monetary stimulus, the European Central Bank notes that enhanced liquidity operations may not extend beyond 2009. The ECB however, leaves rates untouched at 1%.
The Reserve Bank of Australia again breaks with its global counterparts and raises rates by 25 bps for the second consecutive month. The RBA's so-called "cash rate" now stands at 3.5%.

Economic activity

Residential construction, a key barometer for economic recovery, continues its slow road to recovery with Canadian housing starts rising 5.2% month-over-month in October. Although housing starts are generally trending higher, they remain close to 25% below historical average.
Green shoot or yellow weed? RealtyTrac releases its October 2009 US Foreclosure Market Report which shows that foreclosure filings on US properties decreased 3% from the previous month but are still up nearly 19% from October 2008. The report also shows one in every 385 US housing units received a foreclosure filing in October. "Three consecutive monthly declines is unprecedented for our report, and on first blush an indication that the foreclosure tide may be turning."
The October ISM US manufacturing index comes in better than expected (55.7 vs. 53), showing a healthy increase over September. According to the chair of the ISM: "The jump in the index was driven by production and employment, with both registering significant gains. Production appears to be benefiting from the continuing strength in new orders, while the improvement in employment is due to some callbacks and opportunities for temporary workers. Overall, it appears that inventories are balanced and that manufacturing is in a sustainable recovery mode."

GDP & growth

Canada's economy contracted by 0.1% in August, casting doubt as to whether the economy actually escaped the recession in the third quarter. The weak showing, caused by declines in the oil and gas and manufacturing sectors, comes after no change in July.
A vote for "L": TD economists forecast a slump in Canada's average annual potential growth to 1.6% over 2009-2012 (a near halving of its historic pace) with a return to an average of 2.1% across 2013-2019. "It is critical to recognize that things will not simply return to how they were..."

Exchange rates

Volatility is still the order of the day in currency markets.

A temporary US dollar rally, jawboning by the Bank of Canada, fluctuating commodity prices and a worse-than-expected jobs report have pushed the loonie far off of its year-to-date high of 98 cents. After dropping to nearly 92 cents, the loonie has rebounded and is now trading at 95 cents.
Continued currency volatility adds fuel to the gold rally and the metal closes the day over $1,100. Gold, which is up more than 25% this year, has been on a tear since prices rose firmly above $1,000 per ounce last month. Analysts say the metal's recent strength has attracted many short-term market participants who may be trading based on bleak US dollar prospects.

Notable M&As

The Oracle of Omaha makes a controversial bet. Warren Buffet's Berkshire Hathaway announces it has agreed to buy Burlington Northern Santa Fe for $26 billion. Berkshire's largest purchase to date will cost $100 a share in cash and stock for the 77.4% of the US rail operator it doesn't already own. Including his previous investment, the deal is valued at $34 billion plus debt assumption of $10 billion. In announcing the purchase, Buffett declared that the acquisition is "an all-in wager on the economic future of the United States... I love these bets."
Canadian pension and private equity funds are active on the M&A front:
- Health care data company IMS Health Inc. agrees to be acquired by TPG Capital and the Canada Pension Plan Investment Board for $5.2 billion, including the assumption of $1.2 billion of debt. IMS will receive $22 a share in cash, a 31% premium over November 4th's closing price. If completed, the transaction would be the largest North American private equity deal of the year.
- TPG Capital agrees to pay $500 million for a majority stake in Valerus Compression Services, a Houston-based maker of equipment used to process natural gas.
- CPPIB and the Ontario Teachers' Pension Plan Board offer $6.2 billion for Australian toll road operator Transurban Group, although the bid was subsequently rejected.
Cossette accepts a bid to be acquired by Connecticut-based investment firm Mill Road Capital. The deal, worth about $131.5 million represents a 50% premium to the unsolicited bid last month from Cosmos Capital. Mill Road Capital plans to take Canada's largest independent advertising and communications agency private, but will leave the current management in charge and the head office in Quebec City.
Google announces it is acquiring mobile advertising company AdMob for $750 million in an all-stock deal, furthering the company's move into the fast-growing market of web-enabled cell phones. AdMob makes technology tracking ads and usage activity on mobile phones. Most view the deal as a bet that the next great advertising medium is mobile.
Technology heavyweights may face off. Hewlett-Packard (HP), the world's biggest personal-computer maker, announces it will buy 3Com Corp. for US$2.7 billion to challenge Cisco Systems in the computer-networking market. HP will pay US$7.90 a share in cash for 3Com, 39% more than 3Com's closing price Wednesday.
IESI-BFC, a major North American trash hauler, will acquire fellow Burlington, Ontario-based trash hauler Waste Services in an all-stock deal worth $370 million, a 7.2% premium to Tuesday's closing price. The merger will create North America's third-largest solid-waste management company and expand IESI-BFC's geographic footprint into Canada.

Notable capital raises

NEC Corp. plans to raise up to ¥134 billion ($1.48 billion) through a new share issuance. The Japanese computer and network equipment maker is planning a public offering of 537.5 million new shares, which will make up more than a quarter of its shares outstanding. NEC said it will spend the fresh capital on computer and network services, automotive battery-related operations and will also use the funds to reduce debt.
Grainger Plc and Quintain Estates & Development Plc, UK-based property companies, plan to raise a total of £441 million ($729 million) from rights offerings', with proceeds earmarked to repay debt and make acquisitions. These sales would bring the combined amount that UK real estate investment trusts and property companies have raised in capital this year to about £6.6 billion.
Toys 'R' Us subsidiary Giraffe Properties raises $725 million in senior secured notes, exceeding the originally planned issue of $650 million. The notes, which will mature on Dec. 1, 2017, offer a coupon rate of 8.5%. Giraffe Properties primarily issued the debt to refinance a $600 million senior secured real-estate loan.
Cisco Systems, the world's largest maker of computer networking equipment, announces it will sell three series of senior unsecured notes worth a total of $5 billion. Of these notes, $500 million will mature in November 2014 and will bear interest at an annual rate of 2.9%, $2.5 billion will mature in January 2020 and yield 4.45%, and $2 billion will mature in January 2040 and yield of 5.5%. The company is coming out of the recession with the largest cash balance of any technology company, at $35 billion.
Debt capital markets embrace two major Canadian media companies. Rogers Communications raises a total of C$1 billion from the issue of C$500 million of 10-year bonds and C$500 million of long bonds. The 10-year bonds were priced to yield 5.389% while the long bonds were priced to yield of 6.688%. Rogers is expected to use part of the proceeds to refinance a US$400 million note that it called earlier in the month. Rogers' issuance follows Shaw's issuance of C$1.25 billion 5.65% senior unsecured notes due 2019 last month and was followed early this week by a second offering by Shaw of C$650 million 6.75% senior unsecured notes due 2039.

In Focus — Special edition

CRE Industry Briefing — "Then I'll huff and I'll puff and..."

At the height of the economic crisis, many thought that an abrupt correction in the commercial real estate (CRE) sector would prompt a second financial system meltdown and result in further economic malaise. Now that we are in the midst of a recovery, is it safe to say that this CRE scenario has been avoided?

This week, in conjunction with the release of the PwC/Urban Land Institute's Emerging Trends in Real Estate 2010® report, PwC assesses the current state of the Canadian CRE market.

Canadian CRE valuations today - Straw, sticks or bricks?

CRE value drivers

Essentially, the value of a commercial real estate property = net operating income/capitalization rate. What has happened to these two CRE value drivers this year? By and large, capitalization rates are up and net operating incomes are down, albeit less severely in Canada.
- Upward pressure on capitalization rates is due to a considerable increase in perceived CRE risk.
  - In the US, capitalization rates have increased at least 200 bps over the prior year and are typically in the range of roughly 8% to 10% across all properties and geographies.
  - In Canada, capitalization rates vary widely depending on property type and geography. A lower bound of roughly 4.5% is observed in lower-risk geographies and types while an upper bound of roughly 11.5% is observed in higher-risk geographies and types. Since Canadian capitalization rates never contracted to the low extremes seen in the US, upward capitalization rate pressure for higher quality properties is only 100 bps over the prior year, with lower quality properties experiencing increases of 150+ bps.
  - Typically, an increase in capitalization rates is primarily driven by an increase in interest rates (although other factors, such as competition and rental rates are also important). Since interest rates remain relatively low, current CRE risk premiums are suggestive of perceived sector risk.
- Downward pressure on operating incomes is due to weak macroeconomic fundamentals.
  - Overall, high unemployment, stagnant industrial production and a "paradox of thrift" indicate that it is challenging for property owners, especially in the US, to find enough tenants with the wherewithal to pay market rents.

A closer look at Canadian valuations by property type

*Rate data has been generously shared with PwC by the research team at CB Richard Ellis.

Multi-housing or apartment market*

Apartment properties are currently the strongest property type in Canada.
- Capitalization rates range from a low of 4% for high rises in Vancouver to a high of 8.5% for low rises in Halifax, with most rates in the range of 5.75% to 6.5%.
- The national apartment vacancy stands just over 3%, well below 7%+ rates observed in other sectors.
  - One troubling development for this subsector is the recent 0.5% decrease in national average rental rates. Although the drop is slight, according to CB Richard Ellis, it is the first decline in national average apartment rental rates in 25 years.

Office*

Suburban office space is experiencing significant downward valuation pressure, while office property valuations in prime downtown locales have only moderately weakened. Capitalization rates range from a low of 6% for downtown Vancouver "AA" space to a high of 9.5% for suburban Montreal and Ottawa spaces. Most downtown office capitalization rates across Canada are in or around 6.5% to 7.75%, with a minimum 100 bps risk premium for suburban office space.
The national overall office vacancy rate reached 8.3% in the second quarter, up 80 bps from the last quarter and 200 bps higher than the prior year. Sublet space now represents 22.9% of all vacant space nationally, up from 17.6% in the same quarter in 2008. In downtown Calgary, sublet space represents an even larger share of vacant space, currently standing at 54.8%. To compete with sublet space, some landlords have started to offer lower rental rates and are accepting shorter terms.
Looking forward, a high level of new construction activity may dampen the office markets of downtown Toronto and Calgary. More than 4.5 million square feet, or 62.9% of all new supply in the second half of 2009, is expected to hit urban centres, 48.4% of which will be delivered to downtown Toronto. Such a supply shock would normally result in reduced rental rates.

Retail*

Retail property valuations are notably fragmented across types and geographies.
- Vancouver regional retail malls have capitalization rates of approximately 6.25%, while non-anchored strip retail properties in Halifax and Montreal have rates hitting 10%.
- Overall, regional retail centres are exhibiting average capitalization rates of 6.5%, while non-anchored strip retail properties are exhibiting average rates of 8.5%. Neighbourhood and strip retail properties across all geographies have rates of between 7.3% and 7.8%.
Consensus is that Canadian retail space in "secondary cities with shrinking, aging demographics" are the most vulnerable retail properties. In contrast, properties in core areas in the West are faring much better, due in part to an expected inflow of travelers to Vancouver and surrounding areas for the Olympics.
Looking forward, there are two key risks in the retail space.
- The first risk is the record amount of new property coming online. During the first half of 2009 alone, 6.8 million square feet was completed across the country, the most notable of which were a 450,000 square foot shopping centre in Toronto (Don Mills) and a 235,000 square foot power centre in Surrey. While an additional 3.6 million square feet is scheduled for delivery for the remainder of the year, a number of projects are being pushed back.
- A second risk is a continued "paradox of thrift." Economic uncertainty may encourage prolonged consumer frugality which, may in turn, soften retail sales. This effect is expected to be more pronounced south of the border, where consumers have been hit harder by unemployment and credit tightening.

Industrial*

Industrial property valuations are amongst the hardest hit in Canada, with most geographies and sub-types exhibiting capitalization rates in excess of 7.75%.
The overall national availability rate has increased by 70 bps to 7.4% on negative net absorption of 8.2 million square feet, the highest negative absorption since 1991. The GTA recorded 5.9 million square feet of negative absorption, the lion's share of the total. Average net rent decreased by $0.16 per square foot to $5.87 per square foot in the second quarter after it had been unchanged during the past two quarters.
Continued weakness in manufacturing, especially the automotive sector, accompanied by a strong loonie and a potential "buy America" provision, may exert further downward pressure on Canadian industrial properties. In fact, according to experts surveyed in our Emerging Trends in Real Estate report, some industrial properties are expected to lose a further 30% to 40%, with only "well-capitalized" owners weathering the storm.

Hotels*

By and large, Canadian hotel properties have been the hardest hit with capitalization rates north of 8% across all geographies. Amongst the weakest hotel properties are suburban limited service hotels in Halifax, which currently carry capitalization rates of up to 11.5%.
According to PKF Hospitality and Tourism consultants, nationally, revenue and net income per available room are expected to decrease a further 12% and 35% respectively in 2009 over 2008, with an expected turnaround of 4% and 5% respectively for 2010, suggesting that while further weakness is expected in the near term, the worst may be over by next year.
Until the Canadian travel industry rebounds, this market segment is anticipated to remain weak. The one bright spot in Canada, however, is a steep uptick in travel expected for the Vancouver 2010 Olympics.

While Canadian CRE property values remain fragile, unlike the US, valuation trends are highly differentiated by geography and property type. Overall:

Apartment, regional retail and urban office properties are exhibiting resilience with expected increases in capitalization rates of 0 to 30 bps by the end of this year;
Weakness is significant in the non-anchored retail, suburban office, industrial and hotel segments with expected increases in capitalization rates of 30-50 bps by the end of this year;
There is a notable divide in geographies. On the whole, western Canada is generally faring better than eastern Canada and urban centres are outperforming tertiary geographies and border towns; and
Risks of oversupply in retail, office and industrial spaces in Toronto and Calgary threaten the continued resilience of these key cities.

Commercial Mortgage Backed Securities (CMBS) — A wolf in sheep's clothing?

Overview of the CMBS market

In recent history, CMBS have been most commonly generated by "conduit" lenders, who originate commercial mortgages with the aim of securitizing them, arranging them into asset pools, and selling standardized sections of these pools to investors on the open market. Such lenders have been a key source for CRE term loans.
- At its peak between 2006 and 2007, the CMBS market accounted for over 30% of new CRE debt in the US, up from only 4% in the early 1990s.
Although large, the Canadian CMBS market is relatively small when compared to its US counterpart. There are currently 56 Canadian CMBS conduits outstanding versus 477 in the US.
- Across all open conduits, there are 3,008 individual loans with an aggregate outstanding balance of $16.8 billion in Canada, versus 59,779 loans with an aggregate value of $674 billion in the US (as of September 30, 2009).

What's happening with CMBS today?

The Canadian market has not seen a successful CMBS issuance since 2007, while the US has not seen a successful issuance since early 2008. Most banks have abandoned the use of securitization and moved from an "originate" and "sell" model to an "originate" and "hold" model.
In both geographies, it remains unclear how loans in CMBS conduits will refinance without a functioning securitization market.
- Through 2008-2010, the value of maturing CMBS notes in Canada will be approximately $1 billion per year, although the peak is expected to be in 2012, when $1.6 billion of CMBS notes are due.
CMBS loans in Canadian portfolios are performing stronger than their US counterparts.
- In its most recent market commentary, DBRS noted that only seven loans within Canadian CMBS portfolios are delinquent more than 60 days.
- In contrast, as set out in the graph below, the US CMBS delinquency rate > 60 days is up fivefold in just one year.
- While DBRS expects that the Canadian delinquency rate will climb, the ratings agency does not expect the Canada-US gap to close. This is due to the fact that Canadian underwriting and leverage levels in the period 2004-2005 were conservative relative to US levels.

Loose legal structures in the US CMBS market are resulting in chaotic legal disputes over who owns how much of whatever remains of any collateral. In contrast, because Canadian loans were well documented and originated with a clear exit strategy in terms of loan structure, this is not the current case or expectation in Canada.

Who will fill the funding gap?

Without any other pressing issues posed by the Canadian CMBS market, the key question is who, if anyone, will step up to fill the financing gap left by a defunct securitization market? There are a number of options, including:

Banks and insurers

While Canadian banks have balance sheets that are the envy of the world, they remain extremely conservative in the real estate sector, selectively financing properties with the highest credit quality. US bank lenders are effectively "shut down" for CRE lending until increased equity and earnings permit.
Life insurers have the financial wherewithal and expertise to underwrite real estate portfolios; however, they are expected to continue their concentration in higher quality, large commercial properties owned by investors with sound balance sheets.
According to our Emerging Trends in Real Estate survey, pricing is expected to be 60% to 65% loan-to-values, 7.0% to 7.25% interest rates, and at least 1.4 debt service coverage where borrowers can find loans.

Mezzanine debt providers

A select group of specialized mezzanine real estate lenders are expressing a high degree of interest in the CRE sector (in contrast to traditional mezz funds, which largely exited the Canadian market).
A back-to-basics approach is expected with 400 to 500 bps spreads inside of equity.
Such lenders are most likely to transact with experienced CRE owners of properties that offer attractive return prospects.

Private investors

High-net-worth investors are collaborating to make opportunistic acquisitions.
Although such investors are a viable source of capital, accessing the right pool of investors may be challenging for many small- to medium-sized real estate owners.
Well-known private property companies with established track records may be the only likely parties with whom private investors will transact.

Private equity and hedge funds

The relative size of Canadian private equity funds mean that any one fund is unlikely to be a major player in providing real estate funding.
While funds remain flush with cash raised during their peak fundraising years, prospects for new fundraising are dismal. According to the research firm Preqin, real estate private equity fundraising in the third quarter hit a six-year low of just $4.9 billion, down from $40.5 billion a year earlier.
Notwithstanding restrictions on CRE investing, select players may be a potential source of funding for select Canadian properties with attractive internal rates of return (IRRs).
Most US funds are expected to focus on "vulture" investment opportunities in the US, where values have been hit harder. In fact, Lone Star Funds, one of the country's largest real estate private equity players, recently announced plans to raise $20 billion for distressed real estate investing.

Pension funds

Due to underlying weakness across pension portfolios, most expect the funds to remain extremely conservative about new allocations, generally focusing on reworking existing portfolios.
Those funds who do pursue investment opportunities are expected to remain within their typical "comfort zones" - well known urban office and large regional retail spaces.

Public markets

Those with access to public markets may raise capital via issuance of trust units, equity, convertible debentures and a variety of other hybrid structures.
While these activities may relieve refinancing pressures, the degree to which public markets can close the financing gap is entirely a function of continued capital market buoyancy.

Overall, there is no one funder or group of funders that appear ready to lead the charge on filling the financing gap left by a defunct Canadian CMBS market. While dynamics may be such that these groups collectively band together to provide sufficient financing, the more likely scenario is that there will be a further split between high- and low-quality properties across Canada, as funders will selectively pick off high-quality properties that offer attractive return prospects with minimum risk and pass on lower-quality properties fraught with risk and uncertainty. Overall, we expect most of the "vulture" real estate investors to feast on corpses south of the border where valuations have contracted much more severely.

Canadian REITs — Solid structures and sound foundations save the day

By far, the real success story in Canadian CRE is the state of Canadian REITs.

Canadian versus US REITs

As set out in the accompanying table, across a representative sample of 11 Canadian REITs in each of the next three calendar years, debt maturities as a percentage of total debt are, on average, 2.1%, 8.0% and 9.5% respectively. In other words, 20% of debt will mature within three years, the majority of which will need to be refinanced in 2011.
In contrast, across a comparative sample of US REITs in each of the next three years, debt maturities are, on average, 4.4%, 12.2% and 24%. In other words, just over 40% of debt will mature in the next three years, half of which will need to be refinanced in 2011 — close to double the refinancing burden of Canadian REITs.
Within this sample, Canadian REITs have drawn down an average of 5.2% on their lines of credit, whereas US REITs have drawn down an average of 17.8%.
Clearly, Canadian REITs are, on average, less leveraged and more liquid than their US counterparts.

REIT capital markets activity

US REITs have raised more than $20 billion in new capital year to date, the bulk of which was equity, but also included secured and unsecured debentures. By and large, new capital is intended to strengthen liquidity and reduce leverage.
Canadian REITs have raised close to $2 billion year to date, of which close to half was equity. Since Canadian REITs are well capitalized, fundraising proceeds are largely being earmarked for opportunistic acquisitions both in Canada and south of the border. According to AMP Capital Brookfield chief investment officer Kim Redding, "they are one of the few investors in the world that have capital."
- We have started to see the beginnings of a Canadian REIT shopping spree. Last week, RioCan Real Estate Investment Trust made its first US acquisition, a $181-million deal to acquire shopping malls in the northeastern and mid-Atlantic states as well as a minority stake in a US developer. In addition, Dundee REIT announced it has earmarked $140 million to buy office buildings in Toronto and Ottawa.
Perceived refinancing risk for REITs has diminished instep with this fundraising. In Canada, the S&P/TSX Capped REIT index has rallied close to 30% year to date while in the US the MSCI US REIT index has rallied close to 16%.

Overall, despite a difficult market, Canadian REITs have their "houses in order" and are well positioned to either make opportunistic acquisitions or simply manage through sector challenges. We expect REITs to continue to take advantage of the perfect storm of buoyant capital markets and fragile property values with continued M&A activity through to Q1 2010.