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Colin Johnston, President of Altus Group’s Research, Valuation and Advisory division, joins Marlon Bray and Raymond Wong to discuss discuss some of the key takeaways from a recent national survey of CRE leaders and professionals regarding the Bank of Canada’s interest rate hikes, what options are available to address this latest addition to the market’s challenges, and what predictions can be made about CRE in Canada for 2023.
Welcome to Altus Insights Podcast Series. This podcast brings together some of our leading brainiacs at Altus Group to discuss, debate, and on occasion complain about the evolving state of Canada's residential and commercial real estate. Join Ray Wong, Marlon Bray, and Avi Zelver for monthly podcasts covering the latest market and construction cost trends across major markets in Canada.
Welcome to Altus insights podcast series with Ray and Marlon hosted by me Avi. This podcast will cover monthly market updates and construction cost impacts across major markets in Canada. On today's podcast, we have Colin Johnston, who is the president of research valuation and analytics for properties. So in the past we've talked about challenges with respect to the additional costs with construction, the regulations and some of the challenges with not just increased costs in materials and labor, but as well as increased development charges and levies with municipalities. Today we thought we'd take a different approach and share our results of the recent survey on the impact of rising interest rates on CRE. So we just to go over some of the highlights with the survey and the survey we actually conducted in the month of August and we received about 131 responses, and that's pretty good considering that it took place between August 6 to 16th with a lot of people on vacation. But we got enough sample size to give us a good cross-section of the market. And almost 90% of the respondents believe that the Canadian recession is either very somewhat or likely in the next six months. And I think judging by what's happened in the last few weeks, I think we're a lot closer to that. The majority of respondents or indicated that they've adjusted the cap rate and their add or their internal rate of return expectations with expectations of possible further increase in interest rates by the end of this year. And 62% of the respondents indicate that they believe the bank channel will continue to increase between 50 to 75 basis points. Again, I think we have one, two or three more opportunities for the bank to do that in this year. But survey respondents also agreed that the assets and sector markets are a little bit more vulnerable to rising cap rates as the result of increased interest rates. And similar sentiments were mirrored in the survey results that examined the expected impact of rising interest rates on internal rate of return. So we'll just turn it over to Colin. Colin, what do you think was the key takeaways from the surveys, as well as what type of feedback have you been getting versus the results? Sure so Thanks. Thanks for having me. Marlin and ray, I think what's interesting is we didn't decide to take on this survey. It was our clients in August or a rather late July who came to us. And I think we all know that. I seem to remember July 16 or maybe it was June 16 when the 10-year bond rate was over 3 and 1/2. And we were doing midyear valuations for a lot of clients. And they were and they were all very concerned. And what had happened since the beginning of the year is interest rates had gone up, bond rates had gone up, inflation was rising. And there was a bit of a pause in the market the first two quarters, lots of investment activity, lots of transactions to look at and benchmark. But then it sort of became hands down for a while. And it wasn't just because it was the summer, because the summer, typically is a little bit quieter from an investment perspective. But it was a pause in the market. The Lenders put their pens down. We saw some deals that were in the process of transacting, pausing a little bit. There was discussion of repricing on deals. And so that's why our clients said, listen, not a lot of transaction activity. Can you survey the marketplace on this? So we're happy to do that. And I think what's interesting is sometimes you get different responses when you talk to investors or brokers or Lenders or developers. But this survey, the answers were pretty homogeneous, as in everyone was like, yep, there's, you know, like you said, 62% said a recession was likely or was going to be coming. I guess we can say those other 38% are now wrong because it obviously is going to be coming. I think we all expect because it's been signaled at least two more interest rate hikes. The smart money is on 50 and then 25 getting us to an overnight rate of 4% by the end of the year. So things have evolved since our survey in August, but I think the reason we did it is because there was a bit of a pause in the market. And so again, most people, you know, yep, we expect that interest rates will continue to go up. Yes, we expect inflation to continue to rise. So For me, it was interesting to see that people were if we're putting our cap rates and our HRAs up and. Not all asset classes are. Are viewed equally these days. I think we all know that retail, unless it was grocery anchored or essential retail and closed retail was kind of hard hit by the pandemic, but has rebounded in 2022 since we've opened up and even the restaurant and bars have come back. But retail there's been some question marks structurally office, a lot of question marks with regards to activity based work and return to return to the office or rather lack of return to the office. So those were already a little bit questionable, but asset classes such as multifamily and industrial have really had some really strong tailwinds. And I think it was interesting for me to see that even people who are looking at those asset classes were saying, yeah, we expect some yields to increase. And so that was an interesting point in the survey for me there, as in all assets really weren't immune to this. And I think it's because quite frankly, the cost of debt was rising. So how could you how do you justify buying even a great industrial building at a four cap when you're financing it North of a five cap or North of a 5%? Right so it's negative leverage. And to do that, you really have to believe in the rental growth in the near term. And so that's and that was sort of the story with multifamily as well is can you get to the rental growth in can you get enough suite turnover to justify paying those low cap rates? And so for me, I think that was an interesting point in the survey is that, you know, all assets are going to be impacted by the rise of interest rates because quite frankly, most people, when they're buying an asset, are utilizing financing and the cost of debt is up for all assets. And not only the cost of data, but I think loan to value ratios are also up. And I mean loan to value, I should say down. In other words, you can't get 75% loan to value anymore. You are going to get 55% less in assets because Lenders are being a little bit more conservative in their underwriting. And so that would be the big sort of takeaways from me. Right well, when we look at some initial investment numbers and we know that the first half of this year has outpaced first half of 2021. But as we sort of thought and what the survey indicates and your earlier comments, that investment transaction is starting to slow, slow just because I'm not sure if it's with the anticipated increase in cap rates, whether or not we're going to have that bid ask issue expectations from purchasers and and vendors in the marketplace. And that may cause more of a stall. So are you seeing any of that in the market right now? Yeah, I think we're in a little bit of a period of price discovery, which is a nice way of saying there's a bit of a gap. And if you're a potential purchaser, why are you going to pay what you were willing to pay two months ago? And given that your cost of financing has gone up? Right and so and if you're a vendor, you still believe your asset has intrinsically got a lot of good characteristics. So why you may think this is somewhat temporary, we all know that monetary policy goes a little bit too far and then it comes back, the pendulum swings back. So once we get to 4%, we'll start to see some easing. So there'd be some there if you're a vendor, unless you have to sell. And let's face it, in Canada and let's be clear, Canada is a far different environment in the US and the US. There are some loans that are underwater, there are some properties that are going to transact because they have to. In Canada we know the story more disciplined lending environment. We didn't have the big CMBS crisis that the US had and it's going to be a little bit similar this time. So you don't have a lot of necessarily vendors that are under distress, right? We have a lot of institutional capital and institutional ownership and in Canada. And so if you don't have to sell, why would you right now? And so I think you've got a little bit all that contributes to a little bit of a pause in the marketplace. But, you know, we always know traditionally when people come back from their summer vacations after Labor day, there tends to be a little bit of a ramp up investment activity. The Lenders, they've got to make their book. They've got some money to pull it out. You've got if you're a VP of acquisitions, you've got a slate of capital and you would like to deploy it if you can. So there typically is a little bit more activity that picks up towards the end of the year. But I think the question is, is that necessarily going to happen this year given this current and projected increasing interest rate environment? And of course, we keep talking about interest rates, but. There's inflation as well. Right I think inflation is difficult. You mentioned the price of labor or price of materials, et cetera. And so I think those are some concerns, particularly for anybody who's thinking of, you know, underwriting and development pro forma these days. Pretty tough because what's your bet on interest rates? What's your bet on rental growth? What's your bet on labor costs and raw materials costs? I think there's a lot more scrutiny when it comes to underwriting performance these days. So do you think it's more likely to impact the new projects then versus the acquisitions or they're both going to be impacted, existing and new? I think they're both going to be impacted, quite frankly. Marilyn, I think you'll have I think there are some people who are maybe slowing down their development plans, quite frankly, because of some uncertainty. And just like some people are, perhaps. Slowing down their acquisition plans. Now, if you've got cash and I do expect at this point in the market private capital has been coming in quite strongly. It's an opportunity to come in because some of the institutions are on the sidelines to a degree. And also, I would say this, the transaction activity we typically see in this environment is smaller deals, right? So cash and smaller deals, it's the big 300 and $400 million deals that are harder to do in this environment. Although that being said, you know, we have young corporate center which Cadillac Fairview is taken out in the market as strong acid suburban office. I think it'll be interesting to see that will provide an interesting benchmark that trade and that's on the market right now. And so we'll see we'll see what transpires there. Yeah it's interesting what you said about the industrial and we've seen skyrocketing industrial rents and whether or not they can actually keep up based on the increased cost of materials and of course, the increase in land costs. And a lot of discussions and conferences now are not so much continue opportunity growth on industrial but more of what are the possible headwinds. And labor is a little bit part of it, but there's that discussion of technology coming in. But the issue is if you're looking at rents in Toronto between 20 and $20 net, how much further can it go up to justify some of these projects? So yeah, it's interesting. And the one thing, again, we all know the rental growth has been phenomenal over the last two years. Right? astronomical, some might say. And I remember, we all remember industrial rents. In Toronto being $6 for two decades, and now all of a sudden we're closer to 15. So is that sustainable? Good question. One thing that I look at because I cover the retail market quite a bit is. E-commerce during the pandemic. It's sort of accelerated almost a decade's worth with regards to growth. But if you track this, you know, the percentage of e commerce, it it peaks and then it goes down once things open up again. And e-commerce has, since we've opened up in 2022, has really, really falling off is a percentage of sales. And you can see Amazon, you know, who was building a lot of five story centers, a lot in Ontario and around has paused a little bit. And I think you will see retail sort of wholesale distribution that space. I think the demand for that is going to wane a little bit, or at least slow from where it was at really, really high levels before. Right and I will just say the one thing the last thing I'll say about rental rates is. Where we see deals being repriced or potentially being dropped in industrial is when somebody can't get to near-term rental growth. In other words, if the rents are locked in and I can't get to lease expiry like for another four years, I'm not going to pay that low cap rate because I know my cost of capital is high. What was going to build me out before in my discounted cash flow was a spike in rents. I'm not going to be able to get that now. And so that's where you see a little bit of a we see a little bit of a pause or repricing even in industrial. So is this becoming like a perfect storm then, that interest rates are like the final nail in the coffin? Because we're talking about industrial starting to be slowed down. We know a multi-year as the yields are getting tight, people are getting nervous. Is interest rates like that final nail that causes a larger scale pause? Because I think fundamentals are there long term, but it's the short term pause that seems to be going on. Yeah, I think, you know, if we're in real estate, we're naturally somewhat optimistic. But I do think this causes that pause. And that's where I've heard the phrase you hear the phrase pins down. And I think we are going to have a little bit of that pause. I think, ray, we don't have our stats out yet for third quarter transaction activity, but I think it's going to certainly be muted. And I think Q4 is again, there are some deals that we are tracking and I think maybe some cities I was just talking to Sean Robertson, Tate in our auto market and he told me that there's some activity there. So we shall see. But certainly from the calls I've been taking from the brokers, you know, they continue to. Look for listings, but I would continue to run Argus models in the hope of approaching potential vendors saying this now might be a good time to put your asset on the market. But I think it's a lot harder to potentially get deals done these days. And there's a question as to whether you should bring things to market. And so I don't if we call it a perfect storm, but it's a perfect it's a perfect little mini storm for a pause and time to go indoors. How about that? The construction site, we call it show, that's our definition of the current market. So that's less vulgar than the alternate that I've been using. So we tone it down a little. Well, you know, you're working with the development community. I'm working with pension funds and like those and guys who still wear suits and ties. So I'll use more moderate language and say, we're going to talk. Yeah, I hang out with the construction guys. Every of the words is an expletive. So they're fun guys to hang out with. And we've been also seeing, especially on the retail side of the retail activity really hasn't really slowed last few years, especially when you compare it to the office market. And that's where we're seeing a little bit more redevelopment play or increasing the values based on increased densities or increased usage on those properties. And based on the recent activity that we've seen with transactions across Canada, we've seen properties sell with a little bit more hair on it, right. Do you think instead of going to the core assets and going for the top dollars, that they're hedging a little bit and perhaps positioning some of their assets to redevelopment and sort of bigger returns down the road and sort of banking some of those assets now. Yeah it's interesting you bring this point out because I'm moderating a panel tomorrow and I was talking to somebody from Greenock and my panel is the risk worth the reward when it comes to either development or investing? And a couple of my panelists were like, hey, there's more risk in core and core plus right now than there is in value add and opportunity funds, because you can at least be somewhat creative, as you said, whether you're getting more density, et cetera. If you think of a core, if you think of core assets right now, office or a regional mall or we talked about industrial multifamily. I think there are some we've talked about some headwinds. And so maybe you can if you're looking for something with a little bit more hair, you can you're going to competing against less people for that kind of asset traditionally. And you can probably get it at higher yield, right. Which and higher yields allow you to make more mistakes or wait it out a little bit. Right the only thing I remember talking to somebody and they said the only thing you can control really is what you buy something at after what happens. They are on, you know, if you're doing a redevelopment and your costs go out of whack or it takes long to get permit approvals or you don't get the density you want, etc., etc., those are some things you can't necessarily control, but you can control what you buy an asset at, right? So I think we're coming to an end to this podcast. Is there anything that I'm trying not to put you on the spot, but at the same time I'm trying to put you on the spot? Collin where do you think this is going to happen in, let's say, 2023 with cap rates? You think it's still going to go up based on the interest rates? Or do you think that we're going to see some flattening? So I'm going to steal a line from Rob Kumar, who was on from Kingston, who was on one of my panels. And he says, Cullen, let's not talk about cap rates. You should be talking about IRAs because a cap rate is really just an answer or an output. It all depends about what your rental growth assumptions are. Are your rents below market or are they above market or the market, etc.? So I think our survey showed that internal rates are a lot of pension fund. Life goes benchmark to 10 year Canada bonds. And so I think IRR are important. And I will say that and you know this we track and we show the spreads between IRR and cap rates and bonds and mortgage rates. And the one thing I can tell you is when the spreads narrow, when they get to a narrow point, they will expand. And we're at the narrowest point that we've been since the pre financial crisis in 2007 2008. So I think we will see an expansion in yields and that would probably be buyers and end cap rates. And then the question is, depending on your asset or your asset class, if your yields expand, OK, but do you have rental growth that's going to mitigate any value decline? Right and so that's the question, because if you're doing a DCF and if you've got contractual rental growth or you've got rollover, that allows you to do that. And I think what's interesting for me is the apartment conference got record attendance this year and apartments have always been bought on cap rate and gross income multiplier and price per suite. There was a lot of talk about IRAs and because it's become a more institutional asset class and really if you're going to look at on an apartment building, you know, you've got to put capital into it. And so the best way to do that is to if you're putting in balcony balconies, if you're putting in lobby refurbishment, is to do that over a period of time and to use a DCF. So I think we're going to get a little bit more sophisticated modeling in that regard. And I'll just add that in this whole question of sustainability and ESG, I think you'll see a lot more focus on discounted cash flow necessarily on a cap rate discussion because the sustainability of an asset only happens over the life of an asset. And taking a one year snapshot, which we traditionally done in this industry, is probably not the best way to look at assets. OK, great. Well, Thank you very much, Colin, for participating in our podcast. And I think it was very important with your points and again, I guess the next podcast. Thank you. All right. Thanks to both of you and Marlon. I'm sorry if I didn't swear quite enough. Maybe next time. That's OK. We'll get you a few drinks next time. Perfect All right, guys. Thanks