BMO Real Estate Forum: National Outlook
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The past year has been a rollercoaster ride like no other, but the commercial real estate industry staged a dramatic recovery beginning last summer. Nonetheless, pockets of concern remain. So where do we go from here? The recent BMO Real Estate Forum featured a series of presentations and discussions about the national outlook.
Douglas Porter, BMO Financial Group’s Chief Economist, discussed the economic factors that could impact the industry. Tony Reale, BMO Capital Markets’ Canadian Head of Real Estate, delivered an update on market trends, including how the pandemic has accelerated the industry’s evolution.
BMO’s Jim Eplett, Vice President Commercial Mortgages and Head of CMBS, and Karla McCarty, Head of Income Property Finance, joined the rest of the panelists in a roundtable discussion that covered key topics, including the outlook on financing.
Watch the video above for the full event.
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Male Speaker:
Welcome, and thank you for joining us for today's live webcast and discussion. We invite you to be a part of the conversation. You'll see a chat box located near the video window. Click Chat as a guest, and enter your name. Feel free to enter your questions, and our moderators will forward them to the panel. We'll repeat these instructions later in the show as a reminder. It is now time to begin and I will invite your host to take the stage.
Mike Beg:
Greetings everyone. I'm Mike Beg, head of BMO's Canadian commercial real estate finance business. Thank you all for joining us today. I think we can all agree this past year has been a time like we've never seen before. Banks centered COVID bracing for deeper impacts in the commercial real estate books. We were deferring mortgage payments to ease cashflow pressures. We were monitoring income property rent collections, and housing market trends, while continuing to support large development and financing demand by the industry.
I'll try not to steal our speaker's thunder, but to say the CRE segment or commercial real estate segment has done better than expected would be an understatement. The payment deferral program served their purpose and largely wound down several months ago for us, no more than about 20% of our income property book needed that kind of support. We have not had any losses or defaults in our commercial real estate book that can be attributed to COVID, which is really astounding compared to previous cycle corrections.
Availability of capital across the segment is strong. We have a veritable Z or nearly Z-shaped recovery because employment impacts were largely service sector, representing about 4% of GDP in terms of GDP impact. There's pain and ongoing adjustment in retail and office, but this is not our parents' or even our own prior commercial real estate recession experience, but a unique "pandemic one" as I'd put it, where low rates, and strong demand, and continuing under supply trends are driving borrowing and housing market activity. We expect that to continue through 2021 and 2022 and beyond.
We have a lot to cover over the next hour, so I'll walk you through the agenda quickly and then we'll get started. We'll start with Doug Porter who will kick us off with an economic update. Doug brings over 30 years of experience analyzing the global economies and financial markets. He's a well-respected commentator on economic and financial trends, and was named by Bloomberg as the top Canadian forecaster.
Following Doug, we'll be joined by Tony Reale, managing director, and Canadian head of commercial real estate for BMO Capital Markets. He is responsible for the execution of national property brokerage mandates across urban land development, office retail, and industrial asset classes. Tony has deep-rooted relationships and extensive experience with the most active public, private, and institutional real estate investors in Canada.
We'll then have a round table covering key topics and answer questions that were submitted. My Head of CMBS and Commercial Mortgages, Jim Eplett, will be joining for that round table portion. His boss, and Head of Income Property Finance on my team, Karla McCarthy, will then moderate that discussion. Karla brings over 20 years of experience in commercial banking, providing commercial solutions to mid-market and corporate clients, both public and private.
One last thing before we get started, if you were watching the event on desktop or laptop, you will see a chat box below the video screen. Please feel free to use it at any time during the presentation to submit questions to the panelists. Thank you all for your questions in advance we received during the registration as well. We will address as many as possible during the round table discussion. With that, I'll turn it over to you, Doug.
Doug Porter:
Okay. Thank you, Michael, and good afternoon or good morning to everyone depending on where you're joining us from. It's my pleasure to present our a broad macro look. What I plan on doing is over the next 20 minutes or so, is basically just walking through a few short slides here to basically set out the backdrop in this very complex environment that we're dealing with. I'll touch on the broad growth outlook, talk a bit about the inflation risks, and delve into what it might mean for a variety of financial markets. I'll end with a bit of a discussion on the housing market in this brief period.
I do have to start with everybody's least favorite topic, and that's COVID. There is some good news on that front. This chart looks at the number of new cases. It's a moving average. It looks at the US, the big five European economies, and Canada, and is roughly on a per capita basis. I think the key message here is after a very serious second wave, it does look like that second wave actually broke back in early to mid January, and we've seen the number of new cases come down, and come down quite aggressively, right around the world.
Now, we've had head fakes before. For instance, in Europe, late last year, looked like their second wave that crested, and then it picked right back up again around the turn of the year. Especially with these new variants, we can't completely let our guard down, but certainly the recent trends look good on that front. Of course, that's being reinforced by a more rapid rollout of the vaccines. For instance, to look at the US, there were a lot of criticisms and concerns that the vaccines were being rolled out in not too rapid a fashion and people were pointing out all the logistical errors. Well, now they're vaccinating more than two million people per day.
You can see they're a world leader, just a little bit behind Britain in terms of the pace at which the vaccine's getting rolled out. Canada's definitely been slow up to this point, but the supply is coming, and coming relatively quickly now. We think that this graph will change, and change quite markedly in the weeks ahead.
Now, before I go any further, what we had been assuming, and some of the numbers that I'm going to lay out in the moments ahead is we had been assuming that the vast majority of the US population, or the adult population would be vaccinated by June, and here in Canada by September, but in recent days it sounds like that timeline has actually been accelerated on both sides of the border. President Biden is now talking about having every American adult vaccinated by the end of May, and in Canada, some premiers are talking about having the job done by the end of June. If anything, some of the forecasts that I'm about to present are actually a little bit on the cautious side, and it may even turn out to be better than that.
Now, it's interesting, COVID may not be through with us, but I think it's fair to say that financial markets are through with COVID, and they're looking well beyond the pandemic, and it's not just the equity market. As we speak, the Toronto Stock Exchange and the Dow were both reaching all time highs today. This is a global phenomenon. In recent days, the Japanese equity market has actually reached its highest level since all the way back in 1990.
I think the key here is that that very short blast of a bear market that we had a year ago for five weeks has been completely reversed, and most markets are at or close to all-time highs. Even with the tech sector, who are suffering a correction in recent weeks, the bigger picture is the global equity market is pointing to a very strong recovery. It is not just equities though, and I think this is a very important message. It's not just equity investors getting carried away. Every financial market is pointing to a very solid global recovery in the year ahead.
One thing we always track, and I think it's a bit of a purer measure than the equity market is just corporate bond spreads. What we've seen there is after a spasm during the crisis last spring, corporate spreads have actually dropped below where they were before the pandemic began. Another market, which I don't have on here, is the commodity market more generally. I mean, oil prices have tended to hog the limelight, but the reality is beneath the oil price headlines, we've seen incredible strength in commodities right across the board, including in very economically sensitive commodities like lumber. Commodity lumber has been at an at or close to an all-time high in recent days.
Copper, as well, it's at a 10-year high or as close to a 10-year high, in which itself is getting within striking distance of record highs. If you look at a broad basket of commodity prices, say the Bank of Canada's commodity price index, it's up about 30% from year ago levels. Very impressive comeback by commodities right around the board. Again, I think the main message here is that almost every single major commodity market is pointing to robust global economy in the year ahead.
Let's just look at what we're calling for and we actually just heard from the OECD earlier today, and their forecast has been revised up quite a bit in the last three months. They're actually more or less aligned with us now. We're looking at almost 6% globally, a 6% growth globally this year. Just an incredible turnaround from the deep, deep drop that we saw in 2020.
Just to put some of these numbers into perspective. If you look at that table, and sort of the middle, at the bottom, on world GDP, a normal year for the global economy in this day and age, insofar as there is a normal year, would be something close to what we saw in 2019, something around 3% growth. Last year, we had about a 3.5% decline. That was the deepest single year decline for the global economy that we've seen in the post-war era, but much of that damage we think, will be reversed this year, with almost 6% growth and what doesn't get reversed this year, we think will be almost reversed by the end of 2022, when we think we'll have a full year of relatively strong growth as well.
No economy was spared last year. Every single economy in the world was hit by this one way or another. Everybody went through a recession. Some economies did manage to grind out a little bit of growth. China was one of the precious few, but even China, normal year for that economy would be growth of 5% to 6%, instead they only grew by 2%. Even they saw a recession. You can see Canada and the US were middle of the pack. Then you step down, and some of the Latin American economies, and European economies were hit even harder.
That was then. Looking ahead into 2021, we, the main message here is it will be a strong global economy, and we think every economy in the world will enjoy some sort of a robust recovery. There will be different shades of gray during this year, but overall, we think every economy will be looking at a relatively robust rebound. Depending on, partly the extent to which the vaccine gets gets rolled out in various economies and the extent to which an economy really relied on the tourism and the service sector more broadly. Some tourist sectors will be a little bit slower to revive. For some say, particularly the European economies, the recovery might be a little bit more lagged and be as much a 2022 story as a 2021 story.
Here in North America, we have actually just revised up in the last week or so. We have just revised up our Canadian forecast, and that follows an upward revision in the US forecast. There were three fundamental reasons for that big upward revision, in the Canadian forecast, looking for 6% growth in this economy. One is the US economy itself. Because Biden's proposal of a $1.9 trillion stimulus package looks as if it will largely survive Congress, that is just an enormous amount of spending power to be unleashing on the economy at this point.
We've been steadily grinding up our US forecast as well, and we may well be conservative based on that massive fiscal thrust that we're going to see from the US. 6% may be on the cautious end of the spectrum. Just to put that in perspective, if the US does indeed grow by 6%, that'll mark the best year for the US economy since the 1984 Reagan boom, when the economy grew by better than 7%. That's one big factor behind the upward revision to Canada.
Another one is that strength in commodity markets that we've seen. That's sustained its strength. It's definitely brightened the outlook in general in the resource sector. Commodity prices have hung in a lot better than we would have anticipated as recently as a few months ago. That gives a better upside bias to the economy as well. Thirdly, just the base effects, the numbers that have just come in recently, Statistics Canada just reported on the fourth quarter last week. It turned out the economy managed to grow at almost a 10% annual rate in the fourth quarter, even with renewed restrictions in a number of key jurisdictions.
Better yet, in the heart of the second wave in January, in the heart of restrictions in areas like Quebec and Ontario, Stats Canada now believes that the economy managed to grow modestly in January. That's much, much better than many forecasters were expecting. For instance, the Bank of Canada for one, was looking for an outright decline in the first quarter of the year. It does not look like that happened. Again, a lot of that is due to just the underlying strength in the housing sector, and construction more broadly, and in the resource sector. That's, what's really helped the economy grind through this very challenging episode for retailers and some service sectors in particular around the turn of the year.
Overall, we've upgraded our forecast to 6% for Canada. That would be the best year since 1974 for the economy. We may well prove to be conservative on that front. There is the possibility that it might even be stronger than that, depending on how quickly the vaccines get out there, and how quickly we can return return to something like normal in years ahead.
Now, of course, these wonderful performances that we're looking at for Canada and the US in 2021, of course I have to add that it follows the worst year for both both economies since the Second World War. Both are clearly playing catch up. When you look at the average growth rate, we don't think things will be quite back to normal until around late '22.
Now, just as every economy in the world went through the wringer last year, every economy in the world went through a recession, all 10 provinces went through a recession last year. No one was spared this downturn. However, there were clearly differences. The two big questions, the two big determinants in deciding how well or how poorly your province did was first and foremost, did you produce oil? If you did, you were probably hit harder than other provinces, and of course, how did your province fare with the virus?
Some provinces definitely fared better than or less negatively than others. That was especially the case in the maritime provinces, and in British Columbia, which suffered a much lighter hit than some of the Prairie provinces or Ontario and Quebec. Now, looking into 2021, it's not the mirror image of 2020, but it's pretty close. In other words, the provinces that were hardest hit last year, we think we'll see some of the bigger rebounds, and the provinces that fared relatively better or less negatively last year, we'll see a lighter rebounding in 2021.
If we average out the two years, probably a net winner would be BC, but frankly there isn't a whole lot to distinguish between the two provinces when we net out the two years. Now, of course, with that devastating hit that all economies, and especially North America, took during the spring, we saw a massive deterioration in labor markets last spring. The good news is the unemployment rates in both Canada and the US have come down, and come down very quickly in the US.
Because of our renewed restrictions and a lot of job losses in the hotel and restaurant industry in particular at the start of the year, Canada's jobless rate did back up in January. We're going to get the reading on February this Friday. We think the unemployment rate will start to come down. It's going to be a long process, though. Even with GDP and spending activity getting back to pre-pandemic levels, we think by around the middle part of this year, or a little bit later on this year, it's going to take longer for the job market to fully heal.
When you think about the sectors that were most directly affected by the restrictive measures or by the pandemic, the travel and tourism sector, hotels and restaurants, entertainment, these sectors, they may not be the highest wage sectors, arguably they're lower-wage sectors. They may not be the highest productivity sectors, but they're very jobs rich. They hire a lot of people, and shutting off an economy is very easy. It's painful, but it's very easy. Opening it back up is tougher. It's almost like shutting down a nuclear reactor.
You can do it relatively quickly, but getting it up and running again takes a long time.
We think on the job market, history will repeat on this front. It will take some time to get these jobs back. We see even by the end of next year, even with our relatively upbeat outlook, we still see the unemployment rate a little bit above pre-pandemic levels, even when we get out to the late '22 area. Now, despite that, despite that massive deterioration in the job market that we've seen, one very-- Michael talked about the unique features of this recovery. There's a lot of very odd or unique features of this recession and recovery, but perhaps one of the oddest is what happened to household incomes over the last year.
Normally in a downturn, in a recession, no surprise, household incomes decline as people are laid off, or they work fewer hours, or small businesses take home less money. This time, that did not happen. Personal incomes did not decline. They actually accelerated. The final numbers are now in, and household incomes in this country rose by 10% last year. That is an astonishing number. That's actually the biggest annual increase in household incomes that we've seen over 40 years. Just unbelievable.
Now, at the same time, these incomes were incredibly strong. By the way, there's no mystery there, what was going on. It was entirely due to heavy-duty government support. At the same time, as we were having this acceleration in incomes, consumers were restrained or constrained in what they could spend on. Yes, they could spend on goods, but they couldn't really spend on services. In many cases, you couldn't go to your corner restaurant or your local bar. You couldn't go on a tour or travel. You couldn't go to a Maple Leaf game even if you wanted to.
As a result of that, we saw an explosion in personal savings last year. Before the pandemic began, Canadian households were saving less than 2 cents of every dollar that they took home in after-tax income. Last year, households in Canada saved almost 15 cents of every dollar that they took home. Now, the savings rate is starting to come down a bit, but at the end of the day, households have been left with about $200 billion in savings that they had, that they wouldn't have had in, in normal circumstances.
That's almost 9% of our economy. Just to put it in perspective, that's comparable in size versus the economy to the huge stimulus package that's working its way through Congress in the US. This is just a massive potential amount of spending power that's sitting on the sidelines, and one of the reasons why we think the economy is poised for relatively strong growth over the next 18 months or so.
Now, another area that's very unusual, and it's related to that last slide, is typically in a recession, you get a big spike in business and consumer bankruptcies. That didn't happen this time. The opposite happened. We actually saw a collapse in business and consumer bankruptcies last year. Now, there's a number of reasons for this, but first and foremost, has been the unbelievable amount of government support that we've seen in the past year, as well, banks deferred mortgage payments where customer's asked for it. Also, of course, interest rates collapsed, reducing the interest burden as well.
For all these reasons, we've seen this remarkable situation where consumer bankruptcies fell and fell heavily. Now, they've creeped up a little bit in recent months, but they're still down 35% from year-ago levels. Now, we do expect business bankruptcies to beginning creeping up over the next year. A lot of businesses are hanging on, waiting to see what happens. I think this is only a partial picture of the strain, a very partial picture of the strain that that sector is seeing. We think this situation will change over the next year, but I think the main point is, is just how unusual this recession has been in many, many instances.
Now, of course the flip side of that, is we've also had this unbelievable deterioration in government deficits. Now, I will point out that every government in the world is faced with a much bigger budget deficit than they went into it, but I have to tell you, Canada's a world leader on this front. Almost no one can compete with us in terms of the amount that our budget deficit deteriorated as a share of our economy.
Before this all began, Ottawa thought its budget deficit for this current fiscal year that's going to end at the end of this month, was going to be about $30 billion. Instead, it's going to be well over $300 billion. Of course, the latest fiscal update late last year, estimated this year's budget deficit was going to ring in at $380 billion or almost 18% of GDP. The economy has actually turned out to be a bit better than they expected late last year. They're still rolling out a lot of support to this day, but I wouldn't be surprised if the final numbers are a little bit less dire than that $380 billion number.
Now, of course, famously, at the same time, Finance Minister Freeland indicated that they were willing to spend another $70 billion to $100 billion over the next three years to help support the economy. I believe that they are having a serious rethink on that front, given the much better than expected economic backdrop, the fact that we've got this massive stimulus coming at us from the US. I think this is one of the reasons why the budget has been so delayed, and now it seems like we're looking at late April before the budget has come out, because I think there is a serious discussion underway again in Ottawa, whether this degree of stimulus is actually going to be needed in the year ahead.
I think they're still trying to determine exactly what's the right way to calibrate the amount of support at this stage of the cycle. That's why we believe the budget has been delayed yet again. Now, of course it wasn't just fiscal policy that all hands were on deck. Monetary policy rushed out the door a year ago to basically deliver a massive support almost immediately. This is one critical lesson that central banks learned from the last cycle, is that when you know you're in an emergency, it makes no sense to hold back your ammunition. Basically, throw everything but the kitchen sink at the problem immediately. That's what happened last month.
Both the Fed and the Bank of Canada cut rates to the bone. Last year, the bank embarked on quantitative easing for the first time ever. Even as we speak, the Bank of Canada is still supporting the economy, still buying $4 billion worth of government bonds each and every week. They are almost single-handedly financing the budget deficit. Now, in recent days, we've had long-term interest rates begin to move higher, and move higher pretty aggressively. You can see they've carved out their own U-shaped recovery.
In recent days, we're basically back to where we were before the pandemic began for long-term bond yields. We think the market's almost priced in the recovery at this point. We don't see a whole lot further upside to bond yields. We do see them grinding higher over the next 18 months, but essentially, the market has all but priced in that very robust recovery that I mentioned. Those are the longer-term interest rates. The short-term interest rates, we think it's a different story.
Our view is that the Bank of Canada and the Federal Reserve, will remain extraordinarily patient, that they will not raise interest rates for an extended period of time. Our view is that they won't raise interest rates until 2023, even with this upward pressure that we're seeing on longer-term interest rates. I have to say that one of the concerns is, isn't this going to prompt inflation given this massive amount of stimulus that we're seeing, the quantitative easing, the upswing we've seen in oil prices?
Yes. In the next few months, we're going to get some pretty meaty readings on inflation, both Canada and the US. From a base of about 1% right now, we're going to see headline inflation get above 3%, we think, in both Canada and the US. We don't think that's going to be sustained. My main message here is that while there are more upside risks than we've seen in quite some time to inflation, we think ultimately inflation will settle back at closer to 2% when we get later into this year, and into 2022.
I still think it's reasonable to base your medium-term forecast on inflation of just a little bit more than 2%, but I will allow that the upside risks are a little bit more serious than we've seen in quite some time. I'll just bring the conversation home with a brief discussion on the housing market. One area where we clearly have seen a lot of inflation, and one area that I think a lot of forecasters just got dead wrong, they got a lot of things wrong in the last year, but one area where they were spectacularly wrong was in the housing market.
After being shut down last spring, the housing market was one of the first things to completely recover, and go beyond a V-shaped recovery, to the point where prices are at all-time highs. Sales are at all-time highs. Home building has moved above pre-pandemic levels. The chart on the right, that's my Canadian Football League chart. It's the nine cities in the CFL. It's the change in existing home prices over the last 12 months. The shape of that chart is the same as it was a year ago. The only thing that's changed is every city has taken a big step to the right.
In other words, the cities that were struggling a year ago are now starting to see price gains like Calgary and Edmonton. The cities that were hot a year ago in Central Canada, and Montreal, or Hamilton, or Ottawa, are now even hotter than they were before the pandemic. I've only listed the nine CFL cities. If you went to the next tier of cities below, you're getting even bigger gains. Cities like London, and Windsor, and Barrie, and Belleville, and into Halifax, are seeing gains of more than 20%, or, in some cases 30% or 40% home price increases.
Frankly, policymakers are starting to wring their hands in concern a bit at the strength, but I don't think they're going to step in. Frankly, I think they're welcoming growth where they can get it. Housing is probably the last area that they wanted to see come back this quickly, but I think they're going to grin and bear because realistically, certainly, the Bank of Canada can't be raising interest rates until the employment market is has improved quite a bit more.
Now, the outsized gains we've seen in recent months, we don't think that's sustainable. Certainly with immigration still likely to remain very, very low for a spell here, it basically fell off the table. This is the fourth quarter moving average, it masks the fact that immigration almost went to zero in the third quarter of the last year. Of course, the Liberals want to make up for lost ground, they've actually increased the medium-term immigration targets, but in the near term, it's still going to be a challenge, people arriving, getting here.
We think that will tend to blunt some of the strength in the housing market over the near term, but when we look out over the medium term, we remain relatively constructive on the housing market in general, simply because we do believe that these immigration flows will ultimately return to their very strong levels that they were at, if not even above pre-pandemic levels.
The last thing I'll touch on very, very briefly, just a quick comment on the Canadian dollar, which much like other financial markets, got absolutely walloped during the turmoil last spring. It reversed that in very short order. It's now actually higher than it was before the pandemic. As we speak, it's flirting with 80 cents, again.
Our core view is that while we're not especially bullish on the Canadian dollar, we think the external factors, a strong global recovery, a middling US dollar, and that comeback that we've seen in oil prices and commodity prices more broadly, are very supportive of the Canadian dollar. We remain relatively constructive on the Canadian dollar over the next year. We expect it to average a bit more than 80 cents in the year ahead. That's it for the formal part of the presentation. I look forward to the Q&A later on. I will now hand the ball back to Michael Beg. Thank you.
Mike:
Thanks a lot, Doug, for your insights and that great update. I'd now like to hand it over to Tony Reale, who will be giving an update on market trends and what's happening in the real estate industry.
Tony Reale:
Thanks, Mike. Thanks for inviting me to present today. Interesting that that budget deficit that Doug talked about is scary, but low-interest rates, really good for commercial real estate. I will cover commercial real estate, and the economy will bounce back, but the real question is, how will we change the way we use real estate? I'm sitting in my house in North Toronto. I haven't been back to the office in a very long time. I haven't been to a retail store in a very long time. I'm using Amazon a lot. My love affair with Amazon started 10 months ago.
I've been thinking about how all of this is going to impact commercial real estate going forward, and how it's going to impact investments in commercial real estate, and where those opportunities lie. I asked my team to prepare some slides. I looked at the data, tried to interpret it, and it all felt like this would be a short-term impact and difficult to extrapolate based on that data what the market will look like going forward. I stepped back and thought, "Well, I'm going to be presenting today, I'm not going to have a lot of data, the data doesn't really make a lot of sense to me, so I'm going to base it on being in the real estate industry for the last 30 years."
To give you a little bit of perspective, I started my career in 1990, in a recession, on the real estate infrastructure development side. Spent eight years at a major brokerage firm and ran the national advisory practice. In 2005, moved to BMO Capital Markets to help start the Real Estate Investment Banking Group. Seven years later, became the head of the Property Brokerage and Advisory Group. My team sells commercial real estate all across Canada, all the major four food groups, office, retail, industrial, multi-family, as well as land.
In 2017, something really interesting happened. We started a BMO Real Estate Development Fund and we're passively investing BMO's capital alongside our clients. In 2018, I became the Head of Real Estate Investment Banking. All of this to say, I've been around commercial real estate a long time, my team has sold a lot of commercial real estate, financed it, helped clients buy real estate, and helped BMO invest in real estate. This past year has been the most interesting year of my career.
To really understand where we are, and more importantly, where we're going, we need to step back in time and understand where we really came from. I started in 1990, major recession, highly-levered real estate investors go bankrupt, for sales, limited investor capital, real estate prices dramatically drop.
Emerging from all of this, we see the creation of the REITs. We see select pension funds start buying solid real estate platforms that have gone bankrupt for pennies on the dollar and they start investing directly into real estate. Today, Canada is one of the very few countries that has institutional pension fund life cos. directly investing in real estate, most investor [unintelligible 00:31:42].
Moving to the 2000s, interest rates continuously drop. Most of my team members, I think, have never seen a rising interest rate environment, which is interesting. Pension funds, life cos., institutional investors aggressively grow the real estate platforms and portfolios across Canada, demand starts to outweigh supply, commercial real estate values spike, and buyers start hunting for product outside of the major markets.
By the middle of the decade, for the first time, we see a very narrow gap and spread in cap rates between primary and secondary markets in Canada. Then 2008 happens. The financial crisis changes everything but not how we originally predicted it would change for Canada.
While most of the world's major real estate markets crushed, Canada held its ground. There wasn't any buyer sales, not like the 1990s. The owners of Canadian real estate had, and have very low leverage, long-term hold periods, and took a measured approach to not impact the Canadian economy. Very few real estate transactions took place and pricing held up, but over the last 12 years, these institutional investors have slowly started selling their assets outside of the major markets and focused only on gateway cities.
They've started also looking at gateway cities outside of Canada. For the Canadian cities, they first focused on Toronto, started investing more in Toronto through a narrow lens, then it moved to Vancouver very quickly, and most recently, to Montreal.
Their other major focus was development, so building what they couldn't buy. This led to the formation of some really interesting strategic partnerships between private developers and institutional investors. Because of the very narrow focus on only three markets in Canada, cap rates have dropped in these markets, and development yields have compressed significantly for new construction. Those development yields today almost sit right on top of cap rates. As a result, land prices for shovel-ready sites in the major three cities have skyrocketed. They've appreciated in other markets as well.
One asset class that has had limited liquidity is the enclosed shopping center unless there's redevelopment potential. The ownership of this asset class, the enclosed malls, has stayed with the pension funds and the REITs. Many have written down the value of these assets, but they're starting to try to sell for liquidity. Stay tuned for that.
Commercial real estate was chugging along, then the world gets hit by a global pandemic. The first thing I'd say is COVID-19 has changed how we use and think about commercial real estate. Of course, it has. We shut everything down and people are staying home. This should have an impact on real estate and has an impact on real estate longer-term, whether it's positive or negative.
There definitely needs to be a path for some normal going back to as much a normal as we have in the past. I don't think the pandemic has changed the course of commercial real estate. I believe it has effectively accelerated pre-existing trends. Changes to how we use retail and office through technology, how we get products to consumers, how we live at home and work from home, and whether that's an urban phenomenon or whether things shift to non-urban settings, part-time versus full-time.
Let’s talk about current trends. If you can move to slide one, please. I'd say there's four broad key themes and four specific to asset classes. The first broad key theme, and I spoke about this a little bit is, the Canadian real estate is in good hands. A large percentage of commercial real estate continues to be held by pension fund life cos. and REITs. That's a good thing because they have long-term views, unlike in 2008, they don’t need to sell.
The second key theme is increasing capital flows to real estate amid low-interest rates, so lots of dry powder across the investor spectrum including private equity and most recently, foreign capital with record low-interest rates, low cost of capital, limited acquisition opportunities. Overall, I don't see values declining. Of course, that depends on the market and the asset class. We will talk about asset class in a sec.
The third key theme is there's been a bifurcation in geographic preference. I spoke about this. Toronto, Montreal, and Vancouver continue to be the most highly sought-after markets in Canada. Montreal is gaining an awful lot of momentum as opportunities in Toronto and Vancouver are few and far between. The gap between these three markets and the rest of the Canadian commercial market continues to widen. 2006, 2007, we had a very narrow gap in cap rate between primary secondary markets. Today, that gap is huge. Liquidity is also very, very different.
The fourth key theme is investors selectively focused on core assets and quality underwriting. This is a direct result of COVID. Investors becoming highly selective and risk-averse focusing on the certainty of cash flow, focusing on tenant quality, and looking within submarkets and the physical quality of the asset.
They are leaving no stone unturned and bury risk-averse defending that cash flow as they think about where to invest and how to invest. In non-core markets, in weaker markets, we've seen prices decline. Again, not a lot of transactions to point to that. This is more investor sentiment and we've seen limited liquidity.
Next slide, please. In terms of the key themes by asset class and you've probably heard a lot of other real estate experts talk about this. Office landlords face challenges as tenants work from home. Office landlords are starting to get nervous, tenants continue to rationalize their office footprint needs during post-COVID. I think this is a little overblown, my personal view, and I definitely think it's too early to make the call. A lot of investors are sitting on the sidelines waiting to see which way it tips.
I'll talk a little later about the difference between core office and suburban office. Retail has been a clear loser in the pandemic, but grocery and convenience retail has remained resilient. It's scary to look at retail stats for over the last 12 months, but retail fundamentals continue to deteriorate. They were deteriorating prior to COVID, it just exacerbated it. Underwriting retail income is incredibly difficult. It's incredibly difficult to forecast tenant renewals, it's incredibly difficult to forecast where rents are going to go. A lot of investors are shying away from this asset class, but defensive retail assets in core markets are still very liquid.
The third key theme is strong fundamentals and tailwinds increasing industrial demand. Industrial, industrial, industrial. Canada is currently experiencing the healthiest industrial fundamentals on record. This is also a pre-COVID phenomenon, strong rental growth, low vacancy rates, lots of demand, logistics, last-mile distribution, all of the above.
What's interesting about this and with the emergence of e-commerce demand driving space absorption is the line between the industrial box and the line between the retail box is getting really, really blurry. Reimagining retail going forward, I think, is going to be a key theme.
Then the last is key new asset classes emerging, and so we're seeing data centers showing-- Data center investment is pretty big in the US. That’s a trend that started about five-six years ago. It's coming to Canada, highly sought-after asset class. Life sciences, research and development, labs, another asset class that's been emerging, and institutional investors wanting more of that.
Finally, triple net lease. Triple net lease can be across any asset class as long as it's a lease term, let's say, longer than 15 years. Triple net and investors are looking for this stable income stream to invest in, so that's an emerging asset class.
Next slide, please. Then in terms of demand by market and demand by asset class, I spoke about the big three: Toronto, Vancouver, Montreal. Montreal's elevated its status both in Canada but also on the global stage in terms of how foreign capital is thinking about that market. Stable markets, we see is Ottawa and Edmonton. We really like Edmonton's somewhat diversified economy. It's really helping. Sort of the lagging cities, Calgary continues to struggle especially in office and virtually every secondary market in Canada. Again, depending on the asset class, liquidity has really been hampered in some of these other markets.
In terms of demand by asset class, again industrial and that line between industrial and retail, and big-box retail starting to get blurry again. Multifamily, new construction is going to institutional investors and REITS, whereas older product being sold by private holders is actually being purchased by private groups and these private groups are putting high leverage on these assets. Those are the top three by far.
Urban mixed-use, and so urban mixed-use can include multifamily and retail and some office. We see that as stable, but it will bounce back. Core office versus suburban office, I think core office, there's been limited trade activity, again held by institutional investors, mostly in the major cities. Tough to peg value at this point, but we see cap rates-- Really, we don't believe they've moved, but again, tough to peg that.
Suburban office, what's interesting about suburban office when you compare to industrial and industrial development line, certainly in the GTA, it's almost getting to the point where you can-- I never thought I'd be saying this in my career, but it's almost gone to the point where you can demolish suburban office and replace it with brand new state-of-the-art warehouse industrial, which is pretty scary in terms of [unintelligible 00:44:38] and urban mixed-use has gone for that asset class.
Then secondary market retail, enclosed malls, very limited liquidity; grocery convenience retail, holding up really well. If you go and look at post-COVID medium to long term industrial, we think it's going to be medium-term, continue to do well. Longer-term stabilized; multifamily stabilized now, long-term increase; and triple net lease assets, I think, increase over time.
Then, finally, the last slide is really just the risk spectrum as a result of COVID. What we've done here is peg the asset classes along the continuum of high risk versus low risk and high demand versus low demand. One end of the spectrum: on the high risk, you have secondary market enclosed mall, limited liquidity; and on the other end of the spectrum, you have triple net lease which is emerging as one of the most sought-after asset classes, then everything between.
When it comes to retail, clear differentiation between grocery-anchored retail being more sought after, high street retail, which I really like and I think long-term will do extremely well, and then urban enclosed mall versus secondary mall, less liquidity.
Again, COVID-19 has not really changed commercial real estate but has accelerated pre-existing trends and forthcoming evolution of the industry. With that, I look forward to your questions at the end, but I'll turn it over to Karla McCarthy, head of income property finance [unintelligible 00:46:32].
Karla McCarthy:
Great. Thanks very much, Tony. Thanks so much, Tony and Doug for that great information. Now we're going to move into a round table segment to answer a few of your questions. As a reminder, if you've not had a chance to submit a question and would like to, you can use the chat or Q&A box down at the bottom of the screen.
Let's get started. Jim, [unintelligible 00:46:59] your way. Jim Eplett has now joined us as well. Welcome, Jim. Given the recent market volatility and uncertain outlook on commercial real estate values, what's your outlook on financing? Do you see tightening on real estate lending in the short term? Are there any particular factors you're watching that will influence your view?
Jim Eplett:
Great question, Karla, thank you very much. It's a pleasure to be on the panel today and speaking with you folks. Commercial real estate financing activity really ground to a near halt during the first half of last year as investment activity stalled and the major lenders turned their attention inward towards portfolio reviews and battening down the hatches, and probably as much as anything, adjusting to working remotely. The market snapped back sharply in the second half of last year and financing activity resumed along with it with some lenders actually being quite aggressive trying to catch up on lost ground.
I would say that our current financing market feels remarkably normal after my also 30 years in the business considering what we've been through. As for my outlook on the commercial mortgage financing space, the reality is that to all real estate questions like that, the answer is it depends. Commercial mortgages, just like the investment side that Tony spoke to, is really a tale of four markets across the four food groups of office, industrial, retail, and multi-family.
Industrial, again, emerging as the clearest winner out of COVID and lenders can't get enough of it. We're seeing spreads tightening, underwriting stretching, and with industrial on fire, I don't see that changing anytime soon. Retail, of course, another story. Lenders were already leery of retail heading into the pandemic, and as Tony said, COVID just really accelerated those existing trends.
There's still financing available for your necessities-based retail, the food and drug anchored properties. Properties with exposure to cinemas, health clubs, large restaurants, or tenants without an omnichannel bricks and clicks strategy are struggling to find lenders, and I think they will for a while yet.
Office, certainly the most hotly debated asset class, there's still financing available for office, but with vacancy heading up, rents are likely going to be under pressure. Lenders are being very careful and selective with office, but office is still a go-zone for all the major lenders. I was feeling really good about multifamily until CMHC came out with their latest numbers a few weeks ago that showed vacancies trending up across the country quite sharply in a few markets, actually. That's going to put pressure on rents, in the near term, anyway.
Lenders are being a bit more careful with multifamily, but the fundamentals of that space is just so very strong in Canada that it's still a favorite asset class amongst all the major lenders. I expect there'll continue to be plenty of liquidity for multifamily debt financing.
As for the particular factors that we're watching that will influence that view, I would say we're watching for potential overheating in the industrial space. No signs of it yet, but it's heading in that direction. The longer-term impact of social distancing on cinemas and fitness clubs and restaurants, office vacancy and rents, probably watching that, the most closely of any of the major drivers right now.
Multifamily vacancy and rents, particularly in Alberta where they can see spiked up the sharpest year over year. Of course, to the long-term rates that Doug mentioned earlier, watching long-term interest rates and cap rates is to ensure that loans can refinance at maturity in a potentially higher interest rate environment. I'll leave it there, Karla, and turn it back to you for more questions.
Karla:
Okay, great. Thanks so much, Jim. That was great insights into the financing. Tony, both you and Jim talked about industrial asset classes and how that market has been. Do you see any further differentiation in industrial assets between those that are more traditionally used and those that are potentially logistics, and do you see that as a potential opportunity going forward?
Tony:
About the US market, I would say the US market is primarily a big bomber warehouse distribution logistics. Canada, simply because of the way our population is dispersed, it's less of a factor. I think there are iterations of industrial in Canada that lead to the entire supply chain. You can invest in large logistics centers and major markets. That's by far the best. You still have to get that product to people.
I still like small bay. I like medium bay industrial. There are some really interesting iterations like self-storage. We're seeing trends in self-storage, which historically has been primarily used by people to store their grandmother's dining room set.
Today, we're seeing a transition to small bay industrial users that have been priced a little bit out of the market in terms of rental growth and are using this flex space within self-storage to grow and contract their businesses accordingly. The market-adjust gets creative. I think that power centers are an interesting opportunity when it comes to moving a product in industrial, maybe the reuse of enclosed malls in the future. So lots of different opportunities. I think the story is yet to be told and it continues to evolve.
Karla:
Okay, great. Thanks, Tony. Moving back to the economic outlook, we do have a question coming in, Doug, regarding whether you see recovery as being broad-based, or whether you see some sectors potentially lagging as we move through into our recovery.
Doug:
When people talk about a K-shaped recovery, I think it really applies to sectors better than anything. Some have come roaring back and actually are operating above and beyond where they were before the pandemic began, and others are absolutely struggling and bumping along the bottom and waiting for conditions to get back to normal before they can realistically expect recovery.
I would continue to look for that kind of extreme difference in sectors that we've seen until the pandemic is really in the rearview mirror. I think the sectors that we've discussed earlier like travel and entertainment will continue to struggle. In many ways this cycle, as I said, it's been very unique. It's as if it's been turned on its head, normally in a downturn, the sectors that are hit the hardest are construction, manufacturing, and resources. Those sectors have been some of those that have rebounded the fastest and seen some of the best gains because they're essentially in the good sector where things were able to more or less operate normally.
In a typical downturn, it's the service sector that acts as a bit of ballast for the economy as a whole and hangs in there well. Well, this time it was the service sector that absolutely got slammed. Things like cinemas, like your local barber, like gyms, like restaurants, usually, those sectors hold up well, and they're the ones that are absolutely struggling and won't be back to normal, we believe, until 2022.
Karla:
Thanks, Doug. For the final question, I'm going to ask Mike, based on your opening comments, you mentioned that the real estate market has performed a lot better than we expected, and also, the bank's portfolio is performing really well. Can you just touch on for us the banks of financing real estate in the current environment, and as we move forward into the next phase?
Mike:
Sure, cognizant of time, I'll try and make my points short. As a general comment, nearly all markets are under-supplied with the odd exception, and demand trends are strong. We are still seeing double-digit loan growth rates with strong stable drivers, as well recapped by Doug, Tony, and Jim. While retail and office are adjusting, we are more selective in those spaces. Residential and industrial segments are trending very strong. Our regional growth rates, if I was talking about a low end, it might be still double-digit in Alberta. At the high end, it might be closer to, believe it or not, 30% year over year-long growth in a place like Montreal, and probably averaging out into the middle teens in the middle.
BMO is not overweight in real estate. We're pretty stable and conservative players and we have room and capital to grow, so I'll point that out and I think that that's somewhat generally true of the major banks, so the industry has capital. The big banks like BMO are staying disciplined, maintaining project finance credit terms with stable equity recourse and pre-leasing and pre-sales.
Is there a housing market bubble risk emerging in Toronto, Vancouver, Montreal? Yes, that's something we're watching and monitoring and we're certainly looking for signs of speculation, but we're hoping and expecting that it will behave much like the 16, 17 corrections in Vancouver and Toronto that found soft landings. We don't have time to go into terrific detail, but there's policy leaders that exist that Doug has talked to a lot as have we, about monetary and mortgage qualification rules that can help ensure a soft landing. That's my comments.
Karla:
Great, thanks very much, Mike, and thanks so much to our presenters and our panel for joining us today. Thank you to everyone on the call for joining us. We hope that you enjoyed today's session and I want to thank you for taking time out of your busy schedule to join us on this call.
On behalf of BMO, we want you to know that we're thinking of you, your families, and your organizations. We're here to help. We've been through uncertain times over our more than 200 years of history. We have a strong capital position and we're well prepared to serve our clients. We hope our firm's commitment to the real estate industry and our commitment to you, our clients has been discernible here.
As a reminder, today's call was recorded and is available for playback. You will receive details on how to access that recording in an email later this week. Additionally, if you submitted a question that wasn't answered, we'll be in touch to provide additional information. This concludes our call for today. Thank you. Be safe and take care.
[music]
Mike Beg
Head, Real Estate Finance
Mike Beg as Head, Real Estate Finance, Canada is responsible for management of BMO’s Commercial Real Estate Finance group and its client relationships across …(..)
View Full Profile >The past year has been a rollercoaster ride like no other, but the commercial real estate industry staged a dramatic recovery beginning last summer. Nonetheless, pockets of concern remain. So where do we go from here? The recent BMO Real Estate Forum featured a series of presentations and discussions about the national outlook.
Douglas Porter, BMO Financial Group’s Chief Economist, discussed the economic factors that could impact the industry. Tony Reale, BMO Capital Markets’ Canadian Head of Real Estate, delivered an update on market trends, including how the pandemic has accelerated the industry’s evolution.
BMO’s Jim Eplett, Vice President Commercial Mortgages and Head of CMBS, and Karla McCarty, Head of Income Property Finance, joined the rest of the panelists in a roundtable discussion that covered key topics, including the outlook on financing.
Watch the video above for the full event.
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