KBWY - With A Potential End To The Hiking Cycle In Sight Will Stability Return To Real Estate?

2023-04-30 05:11:00 ET

Summary

• What an end to rate hikes could mean for real estate.
• Why office is space in North America is facing uncertainty.
• Canada's growing need for apartment blocks.

After a year of aggressive rate hikes, many central banks are believed to be close to ending their hiking cycles. Colin Lynch, Head of Global Real Estate Investing at TD Asset Management, speaks with Greg Bonnell about the potential impact on various real estate sectors.

Transcript

Greg Bonnell: After a year of aggressive rate moves, the markets are anticipating the central banks are nearing the end of their hiking cycles. So what could that mean for real estate? Joining us now to discuss, Colin Lynch, Head of Global Real Estate Investing with TD Asset Management. Colin, great to have you back on the show.

Colin Lynch: Great to be here again.

Greg Bonnell: Let's get into where we are right now. We are anticipating-- we're on a conditional pause in Canada. We're anticipating the Fed is near the end. Others may be near the end. How do we read that through for real estate?

Colin Lynch: Well, we read it through a bit as stability. So as you mentioned, we've had changes in the interest rates in response to inflation. What's the impact on real estate? Ultimately, if you have leverage, if you're a developer, your debt tends to be variable rate.

There are also owners of real estate that do have variable rate debt, and as those interest rates went up, the cost of debt increased. So certainly, now, when we have a view from the markets that we are nearing the end of the hiking cycle, that does provide some stability, whether you're a developer in terms of your modeling, whether you're an owner of real estate as well. In addition to that, we have also seen some changes in the yield curve, and when you look out five or 10 years, certainly, the pricing has come down. And that's important because some of the fixed-rate debt is actually priced based off of bond yields.

So as those yields have come down, the cost of debt has also come down. Now, we're significantly above where we were last year and the year before. So certainly, still more challenging from a leverage perspective, but certainly benefiting as the cost of debt has come down. So that is providing a bit of floor stability right across the commercial real estate space. There are still pockets of challenge and still pockets of opportunity, but broadly positive now that we are reaching a stabilizing environment for rates.

Greg Bonnell: Commercial can mean a lot. Let's talk about office only in the sense that we know there's been some concerns recently. My own life might not be much of a test case, but I couldn't get a seat on the train for two days in a row now. So people are coming back to the office, but office is still challenged.

Colin Lynch: Yeah, that's right. So it is important to recognize that we are seeing a pickup in physical office use. We are certainly not where we were in 2019, but to your point, certainly midweek, Tuesdays, Wednesdays, and Thursdays across much of North America, we are seeing an increased return to the office, conversely, not so much Fridays and modestly on Mondays. That's a North American phenomenon.

London and Europe is a bit similar, but certainly, when you get to the continent, European continent plus several Asia-Pacific cities, we are seeing a much more robust return to the office, four to five days a week. And that's important, because sentiment in terms of owners and occupiers of office is a bit different around the world, a much more positive sentiment in the Asia-Pacific, and parts of Australia, and parts of continental Europe than we see here. Here in North America, we have two things. One is what we just talked about, the physical return increasing, but not at 2019 levels.

We also have questions about the economy, and where are we, and ultimately, real estate does serve the economy. So if the economy is slowing, that will impact the degree to which tenants are expanding or using more space or contracting or using less space. The other thing that happens in an environment, where there is questions on pace of growth in the economy, is tenants use that opportunity to upgrade space. So space that was in a higher quality, better-located building that was not available that does become available, tenants might use that opportunity to move from what we would call a B class or C class office building to an A class or double-A or triple-A. So we've seen that pretty much universally in previous periods of economic slowdown, and we are seeing it now. So when you look across leasing, we've seen those better quality, newer, well-amenitized buildings have higher leasing than those older buildings right across North America.

Greg Bonnell: Well, let's talk residential, because we have some interesting dynamics setting up. As you said earlier, you're seeing some stability now when it comes to the rate environment. We're also seeing record immigration into this country. How does that play into the rental market? Before the pandemic, purpose build. People keep saying, oh, we need more apartments, we need more apartments. Where are we at?

Colin Lynch: We certainly do need more apartments. So to your point, immigration of 2021 was nearly 850,000 in Canada. Last year, in 2022, over 1,050,000. My understanding is that we are on a similar pace this year. So a lot of demand, and that's comprised of economic immigration.

You also have refugees. You have international students, and international students has been quite significant, both last year and this year and is expected to continue. So we have significant demand. What is the pace of supply? And when you look across the apartment stock, the condominium stock, and new housing, in general, the pace of supply is not keeping up with demand. And we're seeing that in terms of pricing.

Certainly, when you look at rental pricing, so how much are you paying to rent a space, that is up significantly. So today, we're seeing asking rents much above in-place rents, and we anticipate that to continue. Because ultimately, vacancy across the country is declining significantly, and in major metropolitan markets, like Toronto, in Vancouver, in Montreal, we're seeing vacancy come down to where we were pre-pandemic, and in some cases, lower. So ultimately, that does drive rents higher, and that's a fundamental supply demand equilibrium, lots of demand, limited supply. So as a result, the pricing and the rental prices have increased.

Greg Bonnell: Those higher rents would seem like an incentive for the industry to build more. Are we seeing that reaction not only in real time, but in a timely fashion that actually gets us more supply to house everyone in this country?

Colin Lynch: That's a really good question. So certainly, the industry would like to build more. There are some hurdles to overcome in order to build more. So on the one hand, one has to work through a planning process in order to get the permitting, the zoning approval in order to build.

It depends on which municipality you're working with across the country. That can take some time or a lot of time, and increasingly, it's taking more and more time to get approvals through the system. The other thing that's happened is we have had, as we've seen throughout society, inflation, and that has impacted the cost of building.

So whether you're looking at the cost of materials or you're looking at the cost of labor, both have increased quite materially during the pandemic. So as a result, if the cost of building and the length of time required for approval means that it takes a lot more time or it is more expensive to build, then that actually de-incentivizes builders for building a lot more inventory. So therefore, when we come back to that demand and supply question, that's actually restricting supply at a time when we have a lot more demand.

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