David Tallman: Welcome to "Hard Hats and Quick Chats" where we unpack investment topics within private real assets. My name is David Tallman, Client Portfolio Manager at TD Asset Management, and today we wanted to discuss commercial real estate valuations. And for that very reason we have Luke Schmidt, Head of Global Real Estate Transactions at TD Asset Management with us today. Luke, welcome to "Hardhats and Quick Chats".
Luke Schmidt: Glad to be here Dave.
David Tallman: Alright Luke, let's jump right into it. Canadian commercial real estate has witnessed capitalization rates rise close to 20% over the last two years, really putting it on par with the global financial crisis. And essentially what that means is that the value of the income streams have dropped 20% and yet despite that, Canadian commercial real estate has had neutral performance. How would you explain that to our viewers?
Luke Schmidt: Rising interest rates have the effect of decreasing bond values. It's the exact same for real estate. Rising cap rates will lower real estate values. So bond yields, as they've gone up, cap rates have gone up with them. In fact, as you mentioned, cap rates have gone up about 20%, which would suggest that real estate values should be down about 20% as well. But this isn't the case. So why is this not the case? Because unlike bonds, which are fixed income instruments, by definition, real estate, the income can grow over time and with this income growth it has mostly offset this impact of rising cap rates. So we've seen actual real estate performance over this rising interest rate environment over the last year or two remain relatively flat because of this.
David Tallman: Okay Luke, that's great. I'm happy that you compared it to interest rates because everyone's talking about interest rates and we'll talk about a little bit more in "Hard Hats and Quick Chats" right away here. But I think you basically broke it down into two different points, that commercial real estate performance comes from these two primary indicators. One, how much income is the real estate making and two, what is the valuation of that income, i.e, what is the cap rate? Which brings me back to interest rates because most market observers would point out the fact that cap rates really started rising after we saw the really big rebound in interest rates. So my question to you is, are you comfortable or what is your view on cap rates today in relation to interest rates? And secondly, what's your view on income growth prospects for Canadian commercial real estate going forward?
Luke Schmidt: We look at where we are today, where the spread is, where bond yields are, and where cap rates are, we're pretty much right on from a long-term average of where that spread should be. So it gives ourselves in the market comfort that cap rates are appropriate, where they are, where current interest rates are. And the other good news is you're starting to see interest rates stabilize in this three to three point a half percent range. Obviously the Bank of Canada cut their short term rate, which ultimately influences long-term rates. It was for the most part expected, you know, built into the longer term rate. But it's nonetheless a good positive sign that we're seeing some stability in rates and that will translate into stability of cap rates where we are. The second component we discussed, it's not just cap rates, it's also where's income going. We have conviction that we'll continue to see income growth in real estate assets as we go out into the near and medium term future. Why is that? Well, growing income really means growing rent and rent is really a price on to occupy real estate. Like any price, it's influenced by demand and supply. First on the demand side, what's driving it? Ultimately, it's very high level economic indicators. One being population growth, which is driven by immigration. Even though we're likely to see immigration come down from the all time highs as we saw over the last year or two, the federal government targets for the next decade will mean we will see materially higher immigration over the next 10 years than we saw over the prior 10 to 20 years. So with this high increasing population growth, you have greater economic growth, greater labor force, greater demand for housing, greater demand for retail sales, increasing e-commerce. All this translates to more demand for real estate space and industrial buildings, retail centers, apartment buildings, and even office buildings. We're seeing increased demand. Now let's look at the supply side. It's actually much easier to forecast supply 'cause you really just have to look for the cranes whenever you go outside on construction sites. And what we're seeing is a dramatic decrease in construction activity. And why is this? It's a number of reasons, but the main reasons are one, higher construction costs as a result of the inflation we've seen both in materials and labor, higher interest rates, which is a cost of construction. And with these increase in cap rates, that means that there's a higher required return that developers need in order to kick off a project. We mix this all together. The current rental rate that you see for a project is not enough to economically kick off that new construction project given the current construction costs that we see in the environment. So with that you see new construction halting. This is good for new supply going forward. So we're currently real estate fundamentals, again, with the exception of office, which is going through a prolonged adjustment because of the COVID, it was hit the hardest. All other property types, whether it's retail, industrial, or multi-unit residential apartments are seeing vacancy rates below historical averages, which is good for real estate and our ability to drive rents given the demand and supply.
David Tallman: Great. Thank you Luke. I'd love to talk about it more, but I think we better close "Hard Hats and Quick Chats" down for the day. But we really appreciate it and we really appreciate our viewers. If you have any questions, please do not hesitate to reach out to your relationship manager and we will get back to you as soon as possible. Thanks a lot and have a great day.
Luke Schmidt: Thank you.
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Cap rates data collected by CBRE Canada as of March 31, 2024.
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