The potential opportunity in real estate amid lower interest rates

[AUDIO LOGO] * The prospect of lower borrowing costs has been putting the spotlight on some sectors which may have been out of favor, including real estate. Joining us now to discuss the potential opportunity there is Colin Lynch, managing director and head of alternative investments at TD Asset Management. Colin, great to have you back. Always wonderful to have a conversation with you. * Thanks for having me here. Glad to be here. * Interesting times, indeed. Before some of the market volatility we saw last week and the week before, we were talking about market rotations because of this anticipation that, as major central banks, including the Fed, either already cut or get ready to start cutting, we're going to see some other sectors, perhaps, get some of the spotlight on them. Let's talk real estate. If we're talking interest rates, we've got to talk real estate. * Yeah, absolutely. And certainly, the prospect of potential cuts in the States, cuts here in Canada, and in other geographies around the world eases the pressure off of real estate just a bit. We haven't seen it fully filter through because, generally put, these things take time to filter through. But a couple of big things to look at. * Number one, if you are an investor and you've got the opportunity to invest in many different things, what is the bar for competition for real estate? That bar for competition is the dividend yield off of equities and the potential for upside. It's the yield off of fixed income. So those yields off fixed income have been elevated because you can effectively invest in what was perceived to be lower-risk assets but to get a pretty attractive yield. * Now, as those yields come down, the equivalent, which is in real estate cap rates, which is effectively your net operating income divided by your value, those have been going up as income has gone up and as values have come down. And so what's happened today? As those costs, as those bond yields come down, as cap rates go up, real estate becomes incrementally more attractive. So that's big point one. * Big point two is debt is used a lot in the real estate world. So not just income-producing assets, where people may choose to own debt, in addition to an equity position, but you also have things like development and what we call value add, where you're doing retrofitting, renovations, et cetera. That is used, sometimes extensively, in those activities. So if the cost of debt is coming down-- and frequently that debt is variable-rate debt-- as that cost comes down, the attractiveness of doing some of those activities increases. * So we're at the start of this journey. Because, for instance, in Canada, we've had two rate cuts. And relative to historic highs, we're pretty much near those historic highs still. So I'm not going to say the whole world's changed. But what I would say is there's a dose of greater optimism today than there was just a quarter ago. * So there's the macro conditions on what we're seeing out there in terms of the bigger landscape. We know we can break down real estate in so many different ways. I think the first way we're going to break it down is geography, the US versus Europe, versus here at home, in Canada. * Yeah, absolutely. So in Europe we saw certain countries move ahead of the rest of the world. So two years ago, if we go back a couple prime ministers in the UK to Liz Truss-- * We don't have to go back that far, do we? [LAUGHS] * It's true. It was quite interesting. A lot was going on. And one of those things had to do with the budget and the impact of the budget. And what that did was impact the pound, but it also impacted borrowing costs in the UK. * So that, plus a proclivity of appraisers in the UK to adjust to real estate values, meant that the real estate market declined faster than the rest of the world. That was a very interesting test case for the rest of the world, not just in terms of what the rest of the world see declines, but what is the magnitude of those declines? * So we've seen about 20% to 25% in terms of income-producing properties in terms of the decline in values in the UK. That's happened. The market, I would say, has effectively reached a bottom, and we're seeing a bit of optimism on the other end. * Why? Because we see more buyers in the market from around the world looking at properties that are attractively valued. Go back to the cap rate perspective, from a cap rate point of view. * So UK, the Nordics, very interesting, moving through that bottom and inflecting. Other areas, such as German offices, not so much. Come to the US, we've also seen significant value adjustments in the last years. It followed what we saw in the UK and Nordics. We now believe that we are reaching a point of potential attractiveness, as well, in the US. * So we've seen a decline around that 20% range, weighted average across all the property types. Canada has followed the US. So we've been a little bit slower than the US. But again, here, we are beginning to approach some of those values that we're seeing in the US. * But in Canada, the fundamentals are a little bit more attractive. We have less retail per capita than the US. We have less industrial per capita than the US. And we have, clearly, a housing shortage here. So the fundamentals are a bit stronger, I'd say, in Canada than US. * Now, last place of interest is in the Asia-Pacific, because there the dynamics are a little bit different. In Japan, you saw a rate hike. And so there still is-- we look at bond yields relative to cap rates. And if cap rates are above bond yields, that's positive. There still is a positive spread in Japan, but that's narrowed because of the Bank of Japan moves. So we're watching that. * And then, lastly, in Australia, Australia has followed Canada. So again, if we look at the order-- UK, Nordics first, and then other parts of Europe, such as German, in particular, offices, the US, Canada, then Australia. * Now, in the geographic breakdown-- you started mentioning the other way we can start thinking about real estate as investors, whether it's office properties, retail properties, industrial, residential-- when we start looking at this big macro environment in the opening innings of lower borrowing costs starts to have an effect, how do you start seeing those different sectors? * Yeah. So very good question. Different impacts across those sectors. So in areas where there is the most supply-demand pressure, meaning limited supply and a lot of demand-- i.e. housing-- we have seen movement up in cap rates. But that movement has not been as pronounced as other areas. * So conversely, if the borrowing costs go down, then debt tends to be used relatively extensively in the residential space-- so think new construction, developers tend to use a lot of leverage, or even income-producing properties, people tend to use a lot of leverage. So therefore, if the cost of debt is coming down, there's a more material impact on the residential space relative to other spaces, plus significant demand. * And yes, there has been supply incrementally in certain places. But overall, still, and not just in Canada but in the US and the UK and Australia, et cetera, relatively insufficient supply relative to demand. So pretty big positive in the residential rental condominium development space. * In the industrial space, relatively positive in Canada. In the US, you see a lot of supply. And that is of some concern in certain parts of the US. In the UK, relatively positive because the supply is constrained. And ditto for parts of the Nordic. So in the UK, the Nordics, parts of Europe, like in France and Germany, in Canada, in parts of Australia, generally, quite positive. * OK, retail. Essential retail, very positive. Why? Demand's very high. We all know we've been paying a lot for our essential goods-- think grocery, pharmacy. Those prices have been high. Those retailers have done well. And so therefore, they've taken lots of space. So therefore, if the cost of debt has come down, that means that the ability for buyers to buy into those spaces increases. Demand for those spaces increases. Prices increase over time. And so that's a relatively positive space. * Then you have shopping malls, which have been stressed-- so think enclosed shopping centers-- in the last 10 years. If they have survived the last 10 years, generally put, their business models are generally strong. I say generally. There's some exceptions. And the key point is, what is the potential for those shopping centers to develop residential? And if there is potential, go back to what I said about residential. * Lastly, office. Lower rates is not the cure-all for the office challenges. The cure-all for the office challenges are the propensity of people to actually physically be located-- * Go back to the office. * Exactly. That's the cure-all. And if that office is well-located, high quality, close to transit, and attractive, then people will be more likely to actually want to be in those offices. And the tenants, therefore, the companies that are in those spaces, will be more likely to want to pay good rents. And if it's not that, then guess what? The lower rates is not, in my view, going to be a cure-all for a challenged office. [AUDIO LOGO]

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