Low interest rates have helped to fuel Canada’s red-hot housing markets. But Colin Lynch, Head of Global Real Estate Investments at TD Asset Management, tells Greg Bonnell the market is changing, and investors may have to be more discerning when looking for opportunities.
- telling the audience off the top that you say the easy money has been made. You've laid out the scenario that we're living through. Where do we go from here then as investors? It sounds like an environment in which to sharpen one's pencil.
- Exactly. There is still a lot of opportunity in the real estate space, and I think that's important to note. But I think if we step back and we look over the last 30 years, we have seen an environment where rates have come down. And as a result, some of those financing costs have become more attractive as rates have come down. And that's affected broadly all sectors, whether it's industrial, it's office buildings, whether it's shopping malls, whether it's multi-unit residential or apartment buildings.
Going forward, it's important to really sharpen one's pencil, to look at the fundamentals of the real estate, to look at things like location, to look at things like rents, and can rents increase over time? What will drive that growth of rents? And ultimately, that will produce growth in income. And in an inflationary environment, in an environment where interest rates are on the rise, it's really important to identify those assets that have great income growth potential. And that's where the differentiator will be between called the haves in the real estate world and the have-nots.
- Real estate is such a great discussion to have because there's so many different facets of real estate. You talk about doing your homework, looking at the fundamentals, trying to figure out profitability, cash flow. Are there certain sectors of real estate that start to look better in the rising rate environment?
- Yeah. So certainly, broadly put, as I just mentioned, any asset that has good potential to grow income will perform better in this environment. So let's look at first multi-unit residential. These are apartment buildings. Look across Canada, for instance, at Alberta, where we've had depressed rents and now with some optimism for the oil and gas sector, the energy sector, with some optimism around population growth. We're seeing growth in rents as a result of more people moving to Alberta, and that produces a positive dynamic.
Stateside, the US Sun Belt-- and so this is Atlanta, Raleigh, Durham, Austin, Dallas, all of those markets-- we've seen over the last 20 years significant growth in populations. And that produces a growth in rents. So in the multi-unit residential space, those would be attractive areas.
Looking retail, what we have seen in retail-- and retail is very broad, first off. So you have shopping centers, which a lot were shut down in the depths of COVID, most have reopened at this point. And we're seeing a lot of call it revenge shopping. So foot traffic's up, spend is up.
- I have found, you say, I wouldn't spend that much, but it's a long time since I spent a lot, so why not? Why not?
COLYN LYNCH: Exactly, exactly. And I was doing a bit of that shopping over the weekend as well. And so we're seeing that. And as a result, some retailers are beginning to be more optimistic in terms of expansion plans and the like. So there's some optimism there.
But you look in another part of retail-- grocery stores. And grocery stores boomed in 2020 and then 2021 as many of us went to grocery stores to procure those items because we weren't able to go to restaurants. And a lot of investors looked at grocery stores for the first time and said, look, at this asset where I can get a 6%, 7%, 8% net operating income yield. And I have stability, and this asset will be around likely for a long time because we all need grocery stores.
And so that sector has been quite attractive and we think will continue to be attractive in a rising rate environment because you're getting a 6% and 7% and 8% income yield. Those two sectors we think will perform well. Then we have industrial. So what's industrial? Industrial has everything from light factories all the way through big distribution hubs, where you get your Amazon warehouses, your Amazon boxes or Amazon warehouses and the like.
Well, there, it's really important to look at, what is the potential for growth in rents? If you have an industrial facility where you have leasing and the leases have another 10 years and the rents are going up by 1% per year and then inflation's at 5%, well, that's a little bit less attractive. Conversely, if you have a facility where the rents are going up by CPI, and it's great in terms of location, it's what we call where it's last mile or it's connected to a highway infrastructure, that's a little bit more attractive. So really, really depends within the industrial space.
And then lastly, we have offices. In offices, we have a whole--
- Which some of us have actually returned to.
COLYN LYNCH: Exactly.
- Despite the broader trends.
- That's right, right? And it's a fantastic to be in person, though we do recognize not everybody has returned in person. And I don't think we'll have full clarity on that for at least a few months until really the health dynamic is fully behind us. So there, you really have to sharpen your pencils, and you have to look at what type of office is future-proofed.
And is that type of office well-located, well-amenitized, high on ESG? That type of office that will perform better because it's that type of office that will draw employees, give employees a reason to come back into the office. So those will perform well. Conversely, if you have offices that are older, that are less attractive inside--
- Yeah, what's great about coming back to? Why would I leave the comfort of my spare office?
COLYN LYNCH: Precisely. And if you have a horrendous commute to get there, that's even a greater disincentive to come back to the office. And tenants know that. And so we think some of those offices in the real estate world-- we call them class B, class C-- will be challenged going forward.
- Wanted to ask you before you finish your opening conversation-- we're living in a rising rate environment. We've been talking about that. There is a fear-- clearly, it is reflected in the equity markets-- that aggressive central bank action could bring on a recession. Is there anywhere to hide in real estate if we end up in a recession six, 12, 18 months from now?
- It's a great question. Multifamily, multi-unit residential has traditionally been the place to go because at the end of the day, we need to live someplace. And I'd say even today, as rates rise, it becomes more expensive for somebody to afford a home. If you layer in potential volatility in home prices, we've had a spectacular run-up. I think some out there are calling for some moderation or some depreciation. That will increase demand for multi-unit residential, i.e. apartments even further.
So if there is a place historically that's been the place to go in a recession, it's apartments. And I think today is no different. Apartments are likely going to be that more resilient space, not to say that you could-- there won't be any depreciation in apartments. There might be. But that depreciation and that volatility will be less than in other sectors.