Commercial Real Estate: Emerging Trends
Helen Mallovy Hicks
Guests Holly Allen, a former partner in PwC’s Commercial Real Estate practice, and Chris Potter, leader of the Canadian Real Estate Tax practice, explore the ups and downs of commercial real estate in Canada.
Dean: Welcome to Strategy Talks with Dean and Helen, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, co-head of our Restructuring and Distress Strategy Group, and a member of our Credit Crisis Task Force.
Helen: And I'm Helen Mallovy Hicks, a Partner in the Advisory Practice of PricewaterhouseCoopers in the Dispute Analysis & Valuations group.
Dean: The current state of the economy is understandably of great concern for most Canadian businesses. This series of audio podcast discussions with a variety of subject matter and industry guests are designed to help your business weather the storm by exploring some of today's hottest issues related to the economic crisis.
Helen: There's no denying that the commercial real estate market certainly has gone through some changes in the past year, but over all Canada has faired much better than the US. Today we are joined by Holly Allen, partner in our PwC debt advisory practice and Chris Potter, tax leader in the Canadian real estate practice. They will talk about the differences about the two markets and lesson learned and also what opportunities might lie ahead. Welcome Holly; welcome Chris.
Holly: Thank you
Chris: Thank you, good morning.
Dean: Recently PwC, Chris and Holly, has come out with an emerging report that looks at both at the US and the Canadian markets, and paints a pretty clear contrast between the two of them. Perhaps we can just hone in for our listeners on what the real differences are between the two markets and maybe we can give some insight about why Canada has weathered the storm better.
Chris: Thanks Dean. I think that first of all in terms of the emerging trends, it's probably important for everybody to realize that this is the 31st year that the publication has been out there in the marketplace. It's the longest and the most respected in the industry for a forecast publication of its kind. It covers all the sectors and it really is a great of piece of work. We interview and surveyed this year over 900 respondents - which is a record for emerging trends — a number of face to face interviews as well as electronic surveys. The question that you ask, Dean, is a good question because you know what it's been developing for the last couple of years, the difference between Canadian and US marketplace and it seems to be that much more pronounced this year.
As we talk to people in the industry and as we look around we found that how real estate has done in the states is very different from up here. Some of it is an attributable to the conservative nature of our banking system. If you take a look at what's happened a number of banks as we all know and very large financial institutions have gone by the wayside, gone into bankruptcy or been absorbed in the US system. We've not had any real problems in the Canadian banking system and it's interesting as I try travel around the world and hear how things are faring in other countries, the Canadian system is being held up as being a quite robust and really being looked at as perhaps a model for all. I think the other aspect and it's related to the banking system, is the fact that there's been a lot of leverage, a lot of over leverage and we're hearing that term in media used more and more.
A lot of over leverage has been used to characterize in the media and in the states and we haven't had that situation in Canada. Things have been a lot more stable; real estate hasn't had the same huge upswing except with a couple of markets. I mean Vancouver has always been a little bit more robust and a little bit more exuberant than the other markets, and more recently, Calgary, but when you look at the marketplace over all, we haven't had those big ups and as a result - we've been a little been insulated from the big downs.
Dean: Holly, just a pick up of something that Chris said about over leverage in the US and contrasting that against Canada. Obviously we all know that real estate is based on loan to value and things of that nature. If you were to look at the two markets at their peak, how much of a difference would there have been between the two and then on top of that we had a number of US lenders participating in the Canadian marketplace and why didn't that infiltrate here as much as it did in the US?
Holly: Well if I contrast Canada versus the US, the Canadian reads really lower loan to value, than the US reads - and I am thinking of some of the big ones. But if I looked at the US, there are layers of debt, all different security and non security. And they have just a higher leverage that they went for a multi lender structure. Where the Canadian has much more of a simpler approach with a non-recourse mortgage and maybe some convertible debentures and bonds on top of that.
Dean: So the US was kind of leverage on top of leverage, so it was just kind of layered in whereas Canada was a bit more traditional?
Holly: Yes, and in the leverage-on-leverage is just hard to restructure or hard to make some changes and hard to make amendments, and I think that's resulted in some of the difficulties that some of the larger companies have had. It's affected their value on their unit price when you're looking at some of the swings that Chris alluded to: when you're looking at it from an investor, you know, if this company has in issue or maturities, how does it work through all the difference and security packages. Some of the real estate LBOs (leveraged buy-outs), you know - I can name a couple; they had about 32 tranches of debt, so when you look on the leverage side, working through those in a case of the company does have issues, it's just hard to think through them.
Chris: Holly, it's interesting that you're making that comment about the REITs (real estate investment trusts). I think that in my observation and I don't see the market in quite the same perspective that you do, the complexity of the debt that you're talking about really does seem to be endemic to the US rather than Canada. Not just in the REITs, but sort of the rest of the marketplace, you mention the REITs and we see more loan devalues - more in the 50-60 percent range. Within the REITs, without sort of the other layering, but wouldn't you say that the same was true in the rest of the market, on the private side as well and on the public?
Holly: On the private side, you know I think that it depends on how long you've been through the cycle. We've seen some companies that really went in and acquired a lot of real estate in the last few years, so paying the lower cap rates and using debt. Having the first time through the cycle, we've seen some issues on their private side and we've seen more seasoned investors be able to ride the cycle a little bit more and using the cycle more of an opportunistic time versus getting into issues. So you know I think that throughout the real estate we really see a division between the companies that have issues and the real estate that has issues, and then having a lot of money on the side lines in the REITs where there's a lot of liquidity and you know it's a good buying time. It is a bit of a bifurcated market, whether it's public or private; we're finding it a very bifurcated structure in the real estate ownership.
Dean: It's funny because we're talking about leverage on leverage in the US being much more leverage. Just thinking back to meeting back Holly and I had about three weeks ago with an executive in the real estate business. He was talking about properties that he was getting financed just before the bubble came down 50-60 percent loan to value was the way he liked to structure it. He had US lenders coming up saying 'Okay, we can give you 50-60 but if you take 80 percent we'll actually give you a lower pricing.' Which kind of doesn't make any sense because the risk is going up, which I think just really kind of heightens and clarifies the situation that we find ourselves in.
Holly: And that's a great example of someone that's been through the cycle, who understands that when the music stops, 85 percent is really hard to refinance out.
Chris: It's interesting that you've seen in the paper that a lot of people have a lot of money to spend and not having a lot of product to choose from.
Holly: You know I think it comes down to value. And I think that everybody expected the values to go down a little further and people have been waiting and waiting and nothing has come. So you have a decision to make - you can have your money sitting there and having very low returns or you can take an 8-11 percent return on leverage basis. Which you know now in the last market, when debt was trading at 15 it didn't seem like a good strategy. Now unless the other shoe drops, I think that people are thinking it may not be a bad time to transact.
And you have to keep in mind that throughout the cycles if you can get a portfolio premium — you can't get it now — but if you're buying without a portfolio premium and you're being strategic about it, eventually you can put together a combination that may get a portfolio premium to sell out in another market. So I think that people are thinking, 'What can I do now? And what happens when the market turns?'
Chris: It's interesting one of the things that you said Holly, struck a chord. I did a number of face to face interviews for merging trends with a number of the real estate leaders in Canada. It's interesting how many of them made the observation of the impact on values was nowhere near as severe as was expected. There was some cap rate movement but many of them suggest that it wasn't enough.
Dean: Didn't create opportunity for them I guess, right?
Chris: That's exactly right Dean. They're looking at it and there's a great deal of discussion about what's been referred to asset gap, which really gets to the heart of that and related to the issue of this particular issue is that looking at the cap rates that's one aspect of it, but they're also concerned about underlying fundamentals. We've talked about this in another forum Dean, you and I, about how people are looking at the underlying fundamentals about real estate now and how that contributes to value. But the concern that folks with money are having is that there just haven't been enough movement on total value. I guess there are still people holding back product suggesting that they're going to wait.
Helen: Chris, what's different in this real estate recession than the one in the 1990s?
Chris: What's different? I think it comes back to the debt. You know Holly alluded to players that have been through a cycle or two and I think as we look at the market place and there's a different level of maturity in the real estate business in Canada this time around. When we look at some of the downturns in the past, leverage had a very large impact, and you saw some very big names fall when you look back a couple times. We haven't seen that this time. And when you really look at the underlying aspect I think that there are a couple of significant factors. One is the proportion of the marketplace that is owned by deep institutional investors - or very large, very well capitalized investors — I think that's a little different this time around. As well as the proportion of leverage I think whether you look at private clients or private companies or whether you look at the reeds and other publics, the amount of leverage that's been put on the properties, is very different in Canada this time around.
Helen: I was just going to ask what about the residential real estate market and predominance of condos?
Chris: I think that one of the things that should be well known, that Toronto is the largest condo market in North America, which often surprises a lot of people. It has been for some time - and it's interesting that there's always a question of whether or not it's sustainable. And, for as much as that question has cropped up, if you look at a curve or if you look at graph going into the early '70s as to what's happening in the condo market in Canada, you'll find that you haven't had a lot of swings up and down and you'll see a very, very stable rise. Not terribly dramatic, and it's fueled by a number of things. I think that many people would point to immigration; GTA tends to get a line share of immigration coming into Canada, let alone Ontario.
So there's that constant need, as well as growth within the city itself which is providing a need for places for people to stay. Low rise is going to be subject to some constraints with the green belt legislation, there's just not that much further for people to develop and so the condo market has remained relatively stable as to how the future is going to hold - we don't know obviously. But at this point it seems to have been doing quite well.
Helen: I wouldn't have known that actually.
Dean: It's amazing you look out our window and you see cranes everywhere — the only place I've seen so many cranes is either Middle East or China. So it makes me wonder what the stability of the market here, I guess time will tell as you say Chris.
Holly: It seems that construction cost has come down as well so you know it's a balance. So when you were constructing the banks would force you to sell out your units, and by the time you constructed — the costs were different. So that's a change.
Chris: It is a change and some of the established players have been able to work with that, and I think that the current market activity has created a bias in favor of established builders: people that have a balance sheet and have a track record. And some of the projects that may have been undertaken by folks late in the cycle, who thought they'd try to ride the wave but didn't really have a lot of experience, and maybe didn't have as much backing as they should. I think that's where we are seeing some activity: people being able to go in and help them with alternative financing or go in there and take over the project.
Helen: What I'd like to know is where the main areas of weakness in Canada, and where is the biggest opportunities?
Chris: In terms of weakness in the Canadian marketplace, we're seeing weakness in the industrial sector, particularly in Ontario, GTA and the Golden Horseshoe. I think that's going to continue. Hotel and other sort of entertainment are going to continue to be an area of significant weakness. That's really not going to turn around until we see a much more dramatic turn in the market and the economy in general.
Dean: Chris, just one further question around industrials because I think particularly, as living in Ontario and looking at the Canadian dollar and what it's been doing over the course of the last few weeks, I guess there's been a lot of discussion whether the Ontario economy is shifting away from manufacturing based economy to more services, financial services, etc. So last week I was driving down the QEW here in Toronto and noticed all this property for sale and for lease - and there was a glut of them. You know, listening to everything we're hearing today, it doesn't seem to be that a lot these pressures are in other sectors. So is there really a value play and do we expect that valuations in industrial in Ontario to continue to decline?
Chris: Are they expected? I think the folks that I've spoken to, certainly as part of the emerging trends interview process, there are expected to see some form of a bottom in the industrial hit in the 2010, and that we will see some value plays perhaps emerge. The issue I guess on the positive side Dean, Ontario and in particular the Golden Horseshoe is really the gateway into Canada. There is still, from a logistics perspective, warehousing. No matter what happens to the broader manufacturing market, there is still going to be a demand for space. Now how that demand corrects giving the changes in the manufacturing base in Ontario and in the broader US there will be obviously some impact from that. But longer term, this is still reasonable safe bet, in the sense that things need to come through Ontario in order to get into the country.
Helen: Do you think real estate... commercial real estate investors have learned a lesson from all of this?
Holly: I think that there have been lots of lessons throughout the years. And the seasoned investor learned that leverage is not your friend. But I think that the lesson is to understand the structure where there is more synthetic mortgages, CMBS (commercial mortgage-backed securities), understanding who your lender is and who is making your decisions has been a great lesson for many real estate companies.
Helen: Well thank you very much Holly and thank you very much Chris. For more information please download our most recent Merging trends in the Real Estate report at pwc.com/ca/realestate.
Dean: This concludes this episode of Strategy Talks, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, thank you for listening.
Helen: And I'm Helen Mallovy Hicks. We hope you'll join us again soon for another episode. To download or to subscribe to this podcast series or to find more information on this topic, please visit our Managing in a Downturn website at www.pwc.com/ca/managinginadownturn.
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