JRE - How Real Estate Is Reacting To Continued Rate Hikes

2023-07-11 14:57:00 ET

Summary

• Rising rates show resilience in the economy, which is benefiting real estate.
• Office real estate still facing challenges.
• Retail and industrial are bright spots.

With central banks expected to hike rates further, how are the various classes of real estate handling the current environment? MoneyTalk's Greg Bonnell discusses with Colin Lynch, Head of Global Real Estate Investing at TD Asset Management.

Transcript

Greg Bonnell: Markets are pricing in more rate hikes from both the Fed and the BOC this month. So what does it all mean for the various classes of real estate? Joining us now to discuss, Colin Lynch, head of global real estate investments at TD Asset Management. Colin, always great to have you here. Great to have you back.

Colin Lynch: Well, great to be here. Great to be here.

Greg Bonnell: It's an interesting time because the last time we spoke, we thought perhaps the central banks would be done by now. And the markets thought perhaps they'd be cutting before the end of the year. The environment has changed. What does it mean for real estate to be at this point in the year and still talking about rate hikes?

Colin Lynch: Well, it's a really interesting question. I think we have to look at two parts of that question. First is, again, what's the reason why we're looking at potentially incremental additional hikes from the central banks?

Well, fundamentally, the economy is looking a little bit stronger than people anticipated. So we have more jobs than folks perhaps would have forecasted at the beginning of the year. We have more buoyancy in the economy. And ultimately, because real estate serves the economy, it is benefiting from those improved economic conditions.

So think, in the retail segment, folks are shopping still more. They're buying more. Yes, we have higher prices for many goods and services. But ultimately, that also feeds through in terms of tenancy strength, and that helps the underlying real estate.

So that side of the equation is relatively positive. Clearly, the side that's challenging is for particularly real estate owners that have leverage. And so you can think about developers that tend to use variable-rate financing. You can think about owners of property that may have some variable-rate financing or even owners that have fixed-rate financing coming into renewal. That higher interest rate environment, which is a derivative of underlying rates from the central banks, can present a bit of challenge.

And so ultimately you've got those two sides that are playing against each other. On the one side, you have income that is growing quite markedly well across all the different types of real estate, with the caveat of office in certain parts of the world. And then you have the capital side, meaning, what's the cost of financing? But also, at the end of the day, real estate gets measured against other investment classes.

And so if you have bonds that yield a higher rate, if you have equities where the dividend yield's gone up, real estate also has to compete against those other asset classes. And when you have underlying central bank rates that continue to increase, that competition gets a bit more challenging. So you get pros and cons. And really depends on the sector within real estate whether the pros outweigh the cons or vice versa.

Greg Bonnell: Colin, I recall last fall -- you've been on since then. But last fall, you were one of the first people to tell me that as you were taking a look at research about people re-engaging with the broader economy coming out of COVID, now that we've got that behind us, they were filling sports stadiums. They were filling restaurants. They were getting on planes, but they weren't necessarily filling up offices.

So it's been quite some time now. How is the situation looking in terms of people going back into the office? What does it mean for commercial real estate on that end?

Colin Lynch: Yeah, it's a great question. In a nutshell, the same, and just to slightly different degrees. And of course, the geographic overlay is very important. People are filling up the sports stadiums. They are traveling a lot. They are going increasingly to shop in person. And so talking about the retail for a sec, we see a lot more individual shopping, and they're buying more.

But to your question about the office, we've seen a gradual return. And that's really ticked up incrementally, particularly in Canada, the US, and also, to a degree, the United Kingdom. So in these three markets, plus a couple of cities in Australia, namely Melbourne, we are around the two to three days per week mark.

You have some tenants or companies that are at pushing four. There are some that are around the one. But virtually, the broad consensus is we're working in a hybrid environment. Very few companies are fully remote. And very few companies are five days a week in the office from an office worker perspective.

So that's part of the story. The other part, as I mentioned geographically, is continental Europe, the Asia-Pacific, Latin America, where folks are very much towards the four and five day a week model. And so it's really interesting stepping back, where you have a very gradual re-entry that might have started this year at two days a week, ticking towards three in places like Canada and the US. And then you have other parts of the world, like a Singapore, like a Japan, like South Korea, like France, where you have a much more pronounced return to the office in the four to five days a week.

So in the US and Canada, CBDs, Central Business Districts, are certainly that but also central social districts. And we've seen a lot more return to the downtowns, particularly on the weekends and in the evenings. And during the daytimes, we're seeing a phased and incremental return increasingly to the office.

Greg Bonnell: You talked about bright spots. You mentioned retail earlier. Obviously, the reason why they're hiking rates is because the economy continues to do well. We continue to spend money. So retail can be a beneficiary on one end of that equation. What about industrial warehouse spaces? What about residential? Much is said about the dearth of supply in this country.

Colin Lynch: Yeah, that's right. Canada has a very significant dearth of supply across all forms of residential. So whether it's market-rate housing, whether it's affordable housing, whether it's deep affordable housing or social housing, we are at a significant deficiency across all types of housing.

There is a couple of reasons for that. One, a lot of demand. So we've had significant immigration. Whether that's economic immigration, whether that's also refugees, whether that's international students, all three sources have been quite pronounced. And that has driven demand for housing of all types.

But in this environment, where costs have increased materially, and so whether that is construction costs in terms of labor, supplies, whether that is also financing costs, all of those costs have increased. Plus, it takes a long time to get projects approved. What's the net result? We aren't building enough. And actually, year-over-year, we're building less because it costs a lot more to build.

And so we have a problem in Canada. We have a lot of demand and not a lot of supply. From an investment perspective into real estate and residential real estate, that has meant that market rent relative to -- and which is different than in-place rent. But market rent continues to increase materially, i.e., if you're moving out of some place, and you're looking for a new place to rent, you're paying a lot more this year than you were last year or the year before. And so that increase has been quite profound.

In the warehouse space, we also saw material increases last year. That's begun to level off a little bit. Rents still continue to increase. But ultimately, as folks have returned more to in-person shopping, if you look at e-commerce penetration, we've broadly flattened last year relative to this year at high levels, but flattened.

And so there has been a little bit of, call it, the heat moved off of the industrial warehouse market in Canada, certainly in the US, and also in Europe. So that's interesting because that's a direct correlation to the retail space. Still overall positive -- important to know for industrial real estate -- but not as positive as it was last year.

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