BMO Real Estate Forum: Quebec Outlook 2023
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BMO’s Commercial Real Estate team offers an insightful virtual discussion on the Quebec housing market, regional market trends and economic outlook. Featured panel speakers include:
- Robert Kavcic, Director & Senior Economist, BMO
- James Burrow, Director, Sustainable Finance, BMO Capital Markets
- Mike Beg, Senior Vice President and Head, Real Estate Finance, BMO Commercial Bank, Canada
- Kate Low, Regional Vice President, Real Estate Finance, BMO Commercial Bank, Canada
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Mike Beg:
On behalf of the Commercial Real Estate finance team. Thank you all for joining us today. Before we begin as we gather here today, I acknowledge that our teams across North America are on the traditional territories of many indigenous nations. We honor and recognize the first Peoples of our territories and the ongoing contribution of First Nations, Inuit and Maiti peoples to the vibrancy of our communities today.
For this event, we are excited to be joined by industry leaders who are actively involved in the Canadian housing markets and have perspective on market trends industry outlook and sustainable finance in the real estate sector we have a lot to cover over the next hour, so I'll walk through the agenda quickly and then we'll get started.
We'll start with Robert Kavcic who will kick us off with an economic update. Robert has been with BMO since 2006 and plays a key role in analyzing Canadian regional, Economic, Fiscal, and real Estate Trends Following Robert we will then have a roundtable covering key topics and answer questions that were submitted.
For that, we'll be joined by James Burrough asDirector of Sustainable Finance for BMO Capital Markets. James works to identify and address opportunities to grow sustainable finance products across BEMO, moderating that discussion is be most Kate Lowe, head of my Quebec team in my in Real Estate Finance Canada she brings over 10 years experience in the real estate finance industry.
One last thing before we get started next to the video screen you will see a chat box please feel free to use it at any time to submit questions to the panelists. Thank you for all the questions we received during the registration as well we will address as many of these as possible during the roundtable discussion. And with that, I'll turn it over to you, Robert.
Robert Kavcic:
Great. Thanks a lot, Mike, and thanks everyone for joining today. So I'll try and set the stage here from a macro perspective and give an overview of some of the key economic questions were getting on the economics team right now like the outlook for a recession, what's happening with inflation where interest rates are going. And then I'll close out by kind of an overview of what we're seeing in the housing market because we have seen some pretty significant changes over over just the last you know 6 to 12 months as the Bank of Canada has been raising rates and then we'll hand it off from there.
So on the 1st slide you can see just a quick snapshot of our economic outlook here. I'll keep this story pretty short effectively what we've seen is an economy that has shown quite a bit of resilience so far to what has been a generational increase in interest rates in both Canada and the US.
So through the fourth quarter last year, fourth first quarter of this year the economy is held up very well and we do expect though that because of that increase in interest rates because inflation is squeezing household budgets and spending.
And credit conditions are starting to tighten up a little bit across North America that as we go into the second half of this year and maybe into the early stages of 2024 the economy is at risk of at least a moderate downturn
So you can see on the chart there, but we've penciled in a very modest one by historical standards, but we do have to be respectful of the risk here that's posed by all of these macroeconomic factors. Why does this look relatively modest? I I'd say two big takeaways. One is that the Household sector has come into this period with a tremendous amount of liquidity on the balance sheet, so there's a big buffer in place in terms of savings that have been built up through the downturn through the pandemic and the job market as well is coming off just a period of exceptional excess demand.
So the hope is that we can chip away some of this excess demand, not so not go so far as to create a lot of unemployment. So a lot of these factors kind of pushing and pulling, but all of them leading towards an outlook that looks for a very modest downturn through the latter stages of this year on the next slide.
We can see a couple quick takeaways here at the regional level. So when you zoom into Quebec, QC underperformed last year we suspect they're probably gonna underperform a little bit this year but then run effectively in line with the national average in 2024 and beyond. And I will say that even though Quebec is kind of at the bottom of this list, I think we have to look at this as as a positive story first of all because the economy has been exceptionally stable over the over the COVID period and through the last year or two in the face of rate hikes.
And remember, longer term, Quebec just has a slower growth potential than a province like say Alberta, Saskatchewan where the populations a lot younger. So this is a this is a pretty positive story and I think from our perspective we were extremely bullish on the province pre Covid for various reasons and now that we kind of scrubbed out this Covid shot and we're getting back to you know more normal longer term growth picture, I think Quebec does still stand out to us as a province that should perform at or slightly above the national average with the number of positive factors in the economy there.
So the next slide we can zoom into the job market. Here I mentioned that there's just a tremendous amount of excess demand. You can see it an unemployment rates on both sides of the border just know, just above 5% in Canada, just below 4% in the United States. These are 30 or 40 year lows for the unemployment rate in North America just speaks to how exceptionally tight and how strong the job market is right now and then similar when you zoom into Quebec either at the provincial level or into the two major cities, you're seeing the same thing you're seeing.
Their logo? Unemployment rates going back to at least the early 1970s in Quebec. So similar, similar story where you have exceptional job market tightness that's obviously supporting the household sector and spending in the face of these rate hikes, but it is putting some upward pressure on wages, So on the next slide you zoom into the inflation story.
And what we have seen here is very clearly that inflation did peak last summer that was pretty much on Q and as expected and we've seen highlight inflation gradually kind of come down this mountain to where we are now, which is 4/4 and 1/2 percent or so in North America. It's not far enough yet though, so when we look at some of the factors that have driven inflation and some of the factors that are going to dictate how much further we have to go with say, interest rate hikes to get inflation back down to a level that's sustainable for policymakers, we have this checklist here that's on the screen that we've been watching as we've kind of gone through this episode and you can see where most of the way down the list here where on the good side of the economy, for example, we've seen price pressure really back off consumer spendingn physical goods is backed off.
Remember early in the pandemic, everyone was out there buying exercise bikes, renovating their backyards That was a tremendous amount of spending on physical goods that created a lot of the inflation, a lot of the supply chain issues that the economy had. That's pretty much still gone now, and inflation in that area of the economy has more or less subsided.
House prices are off the highs. Resource and agriculture prices have backed off, so you can check all of those boxes where we're still struggling here is on the service side of the economy. Services are still very much in demand and they're very wage driven as compared to goods. So those two factors are very tight job market and strong demand for services are still putting up or pressure on inflation. And the last piece is the psychology side where everyone's talking about inflation.
Everybody's asking us about inflation and the more and more that households in the general population, the business community, expect to see inflation, the more kind of reinforces itself into more inflation.
So that's what policymakers are leaning on, those last few, those last few points and where we are right now if you look over the last one month or the last three months and you strip out some of the volatile items the from the from the CPI, the run rate right now is about 3 1/2 to 4% in Canada and so that's a little too hot for the Bank of Canada that wants to see 2 inflation in the long run.
Yes, it's a long way down from where we were 6 to 8% a year and a half or so ago, but it's still. It's still a good one to two percentage points above the Bank of Canadas target, so hence why they're leaning on this pretty hard. Still, on the next slide you can see what that means for the interest rate backdrop.
We've seen 500 basis points of interest rate increases in the US We've seen about four hundred 450 basis points in Canada, assuming that we're going to get another rate hike next month, which we do.
So this is as I said earlier, this is a generationally abrupt and aggressive tightening cycle that the North American economy is going to have to absorb and so far it's absorbed that very well, but from the Bank of Canada's perspective because of that inflation backdrop and because the labor market is still showing signs of tightness and because we're even starting to see signs now that the housing market the most arguably the most interest rate sensitive sector of the economy, is actually gaining some momentum, we do think the Bank of Canada is going to have to raise rates again.
So they did you kind of come out and promise to Canada, they were done raising rates early this year.
Turns out that wasn't the case. We saw a rate hike at the last meeting and we'll probably see one more in July, so at that point we think that real inflation adjusted interest rates should be high enough to damp down demand and tip the economy over into a into a much softer period through the later stages of this year and that should be enough for them to actually pause and back off raising rates.
One thing we've said for a long time here and if you follow financial markets closely that the bond market is kind of.
Come in and out of pricing interest rate cuts in the second half of this year and a lot of optimism has kind of come into the idea that we might get rate cuts in the second half, our argument all along has been, no, that's going to be much too premature And so even though we do suspect we'll probably get another rate hike from the bank and they're going to pause there, we think that we're probably not going to be in a situation where we have enough evidence that inflation is really, really cracked to support rate cuts until into 2024.
So that's one takeaway from this well. Two takeaways. One is that we probably have another rate hike coming, second being that rate cuts are not a story until 2024 and then the third takeaway I would say here is that when we look out beyond this cycle, specifically where do we settle when we come out of this cycle in 20/24/2020 and beyond, are we going to see rates slashed back to zero like we saw over the last decade?
I'm going to argue that no, we're not going to see that. I think the past decade was the exception, not the norm historically where you had a big credit event in the US that really suppressed interest rates across the yield curve in North America for a good decade now we've kind of shifted out of this disinflation or deflationary environment into one where inflation is a lot stickier, a lot of big global macro forces are incrementally adding to inflation.
I would say, I would suspect that neutral interest rates now look quite a bit higher than they did over the past decade and we probably see Bank of Canada policy rates settle into somewhere around, let's say three 3 1/2 percent.
So if you're thinking of this in the real world, what does this mean? Are we going to go back to 1 1/2% variable rate mortgages? No, probably not. You're probably going to have to get used to the idea that yes, 5 to 6% is probably high and restrictive, but maybe 3 to 4% is something that's a lot more normal over the long term, can't be sitting there crossing our fingers and waiting to go back to those 1 1/2 percent mortgage rates because you might be disappointed.
So that's kind of how we see the interest rate cycle playing out.
On the next slide I'll look at very quickly what's going on in the housing market here and we could spend an hour on this. So I'll try and burn through some of this pretty quickly and save time for some discussion after, but effectively our position on this has been that we've been very bullish on Canadian housing for going back 10 or 15 years, a lot of price increases have been dictated by just supply and demand demographic fundamentals.
During the pandemic, the Bank of Canada cut rates to 0, promised they're going to keep them there for a long period of time. And then Canadians, Kind of got a little bit too aggressive and went a little bit too wild in the housing market. We saw a little bit of froth build up quite a bit of froth in some markets the minute the Bank of Canada came out and started to raise rates.
Housing activity went quiet overnight and we went through this correction. So that's the context where we are. We've blown a lot of the froth out of the market that we really needed to see and now we're starting to see some signs of stability.
So on the next slide you can see just very quickly here a snapshot of our base case housing forecast on the sales side. We have seen volumes come back. We've expected that they were going to come back pretty sharply in the spring and through the rest of this year. Prices we think have most likely bottomed out across most markets.
Are we gonna smooth sailing from here. Maybe not. We are suspecting that we're going to see prices stagnate a little bit through the rest of this year as we kind of still absorb some of those higher interest rates and some of the economic fallout from all of that tightening
And then probably most controversially, we suspect that new construction activity is actually going to be down this year, not up and certainly not doubling like policymakers are pushing for.
So the next slide, very quickly on the resale market here, some of the big trends we're seeing, one is that the market is balanced out very quickly, so I kind of showed you a chart there of unit volumes coming back that is help.
But the big story I would say across most markets is that just people are not selling homes and there's no forced selling out there and that's really helped tighten the markets up.
So the green line here is just the sales, the new listings ratio that's without complicating things here. That's just a measure of market balance. So higher on that chart is a much tighter, much, much stronger market and then you can see how prices more or less follow this market balance over time. All right now if you look at the Quebec market, the market balance here is actually very very normal and it kind of points to mid to high single digit price growth going forward and a lot of reasons out there are people who just don't have to sell homes right now or are not selling homes.
Reality is we just haven't seen enough. Economic stress on households or homeowners, either through job loss or through the mortgage market in this bit of an aside here, even though the vast majority of Canadian homebuyers piled into variable rate mortgages during the peak of the boom in 2021, reality is that those payments aren't necessarily rising in real time.
Amortizations are getting stretched out which is something we're going to have to swallow over the next two ¾ years, but it's not creating a lot of stress on the ground.
Right now, today and it's certainly not creating or certainly preventing any kind of force selling that you otherwise might see. So all these factors combined just have really held in the market balance and held prices find a floor.
On the next slide. Quick way to look at valuations here and there are a number of ways that we look at valuations. I just chose one for the interest of time here and this is inflation adjusted house prices across some of the different markets in Canada.
So on the left side of the screen, that blue line is 3% inflation adjusted home price growth. That's the long run run rate that we've seen in Canada.
The middle section there is the difference between what we're actually seeing on the ground and that long run run rate. So you can see housing bubble in the late 1980s, you can see a period of exceptional affordability or undervaluation of housing early in the 2000s and then you can see where we got there during that pandemic boom where prices clearly got too frothy. But what's interesting is when you break that excess pandemic froth down by region, what you find is the vast majority of the excess was concentrated in Ontario, the GTA and Southwestern Ontario markets like one or two hours outside the core of the big cities.
Western Canada wasn't frothy at all for various reasons, but you zoom in to go back to his kind of stuck right in the middle of the pack here where it wasn't showing a lot of excess relative to some of the markets that are really under pressure right now like in Southwestern Ontario. But yeah, it was a little bit frothier than somewhere like a like a Calgar at or in Edmonton so as a result of that, I mean we have seen prices back off 5 or 10% obviously, depending on the location or the market
But again, it's kind of one of the arguments for Quebec to holding relatively steady here is we just didn't see the same amount of froth build up as we did in some of the other markets in Canada. And then the last slide or the last couple slides just very quickly on the demographics.
So I mentioned that we've been very bullish on housing because of the demographic story. Take a quick look here at what the population in the 25 to 34 age group has done.
Over the last 10 or 15 years, it's been exceptionally strong in terms of growth. We all know about international immigration
Everybody talks about that. We're seeing 500,000 people per year coming on a permanent basis, another 5 or 600,000 per year on in terms of non permanent residents that's dropping a tremendous amount of demand on the housing market.
Provincial migration flows are another story and I'll highlight Quebec here because historically if you go back, Quebec has been a perennial.
A province where you've seen Perennial outflows to other areas of Canada, but what has actually changed now is because of the economic strength in the province, people are actually staying on net. So we're not seeing big inflows, but people aren't leaving anymore on net and not incrementally has been a big positive.
And then the millennial age group as well as aging. So that's all put tremendous amount of growth in that 25 to 34 cohort. So the low growth scenario here these are Statscan projections that's a scenario where we assume that immigration is really not a factor and what actually happens over the next 5 or 10 years.
Growth in this cohort actually peaks and starts to roll over, so that would already for some weakness in housing demand, but the high growth scenario there takes federal immigration targets and drops those on top of the population as well. And you can see under this scenario where immigration is running at the rate it is today, we continue to see this very strong growth in housing demand going forward so from that perspective it does look like we're going to continue to see a very, very solid support for housing in this country and on the next slide.
We can just kind of wrap it up here and I'm not going to read through this. These are just some key takeaways if you want to screenshot that and save it for later, those are some of the kind of, you know, key points that made here.
I think if there are some takeaways, I would say that yes, we are at risk of at least a moderate downturn in the economy we have to be respectful of the fact that we haven't seen a tightening cycle this aggressive in probably 30 years, 30 or 40 years from a housing perspective, I think we have seen most markets find a floor in terms of prices and activity, probably will remain a little bit choppier sluggish going forward as we digest all of this tightening and the economic impact of it, but from a long term perspective we just still have a tremendous amount of demographic strength and on the supply side of the market, I think my position on this for you know for all along has been that at we just physically cannot possibly double the rate of housing construction in this country.
So coming out the back end of this cycle we're going to remain probably pretty supply constrained.
In terms of housing and that should ultimately remain supportive for prices once once we adjust this adjust to this change in interest rates. And so I will leave it at that and I believe I'll turn it back to Mike.
Mike Beg:
Thanks Robert for your insights and update I'd now like to hand it over to James Burrough who will be giving an update on sustainable finance in the Real Estate sector. Over you, James.
James Burrough:
Thank you, Mike and thank you, Robert so
So if we can go to the first slide, please I think what I will aim to do today is really set the market for construction and the market for buildings in the wider context of how much that constitutes of Canada's overall emissions, I will have a look at some of the some of the regulation that's gonna come down as a response to this.
I'll have a look at some of the incentives that can help building owners and construction. Operators decarbonize and then just I guess, hope to make it somewhat tangible for the people on the corn and give some practical advice about how to respond to the kind of trends and sustainability in the construction and building operator industries.
The thing I will say is that talk about sustainability here. Sustainability encompasses various different kind of components, but the one I want to focus on at the moment is climate and the response.
To the imperative to decarbonize because I think that is going to be the most tangible thing and that is going to be the thing that requires the most kind of actionable responses from building owners and operators. So really wanted to focus there.
So starting by looking at how much of Canada's total emissions buildings constitute just to set things in context, so from buildings themselves I think that's about 20% of Canada's total emissions. But when you add in construction activity, as in building those buildings, you can add another 5 to 10% on top of that, so for Canada, all emissions attributed to buildings and building activity is around 20 percent, 25% of total emissions
For Quebec, this is slightly lower, it's around 20%. Due to the kind of cleanliness of Quebec's electricity grid, almost all of Quebec's electricity is sourced from hydro, which is an entirely clean source. So that's why the emissions are slightly lower there.
But I think the key thing to note here is that construction and operation of buildings is a very material part of Canada's emissions footprint as a country and that's in common with most kind of Westernized developed nations. So because it is a material constituent part of our emissions profile, there's obviously.
Significant government, focus on it, and meaningful targets at the federal levels at the provincial levels and at the municipal levels. So as we look at the overall federal level.
We have a green building strategy in Canada, the ultimate goal of which is to hit net 0 emissions by 2050 and in doing so make our buildings more climate resilient. So a lot of folks will remember the heat dome in BC or even extreme weather events like the Direct Show last year that affected Ontario and Quebec.
So aside from having low or 0 emissions buildings, we would also seek to have buildings that are more resilient to those extreme weather events that we can see.
Becoming more frequent as global temperatures rise the interim target for Canada is a 27 emissions reduction versus a 2025 baseline by 2030 candidly. Unfortunately, we are not tracking well to that at all. We are 9% up versus 2025 versus down.
So what does that mean? I think that means that you know, federal, federal focus on this area will continue and will intensify and that you can expect that to flow down through to the provincial and Municipal levels.
What does that look like in Quebec at the moment? Quebec target is to reduce building heating emissions by 50% from 1990 levels and also have a focus on government buildings by reducing their emissions by 60% below 1990 levels. So suffice to say, buildings are a major part of our emissions footprint and there will be significant focus on reducing them that we can just expect that to intensify.
So if we can go to the next slide please, it would be great to talk about some of the specific policies. And what building owners and operators and builder developers can expect to see in terms of changes in regulation and I would say this is certainly not going to be an exhaustive survey, but it is pulling out a few key points that people might want to delve into in a little bit more detail as it applies to them.
So I think you know 2 components to emissions as that highlighted before. One is the construction of new buildings and one is existing buildings. So there are ways to reduce emissions associated with construction and there are ways to reduce emissions associated with these existing buildings. But I'll start with construction.
So at a federal level, expect to see Canada's A progression in Canada's building codes to incorporate sustainability to a greater and greater extent. So in 2020, what we saw was the national model building code introducing A5 tier performance model with kind of for each tier.
Driving a 10% improvement in the buildings efficiency as you go go up through those tiers. Now that building code was relatively vague and how it was expected that those that tiered kind of model would be implemented at the provincial level, but expect the federal building code in 2025 to add some more detail onto that and I think what we're looking at there is the introduction of more technical requirements for existing buildings and the inclusion of GHG emissions reporting on buildings in that 2025 code and pushing towards 2020 thirty you can expect to have standards around embodied carbon and embodied carbon is effectively the carbon that goes into making the concrete and steel that goes into the construction of buildings.
So suffice to say Canada's national building code will provide an overarching framework for increasing the sustainability of buildings that we are constructing in Quebec expect them to kind of expect the province of Quebec to follow suit there with a particular focus on eliminating fuel oil in favor of electricity which is a major theme in Quebec.
So that kind of covers the construction side as we look at existing buildings, regulation for these is typically covered at the municipal level. So looking at the city of Montreal, Montreal has committed that all municipal or new buildings by 20-30 should be net zero and all buildings should be net 0 by 2050 practically speaking as I've mentioned, Montreal's climate plan covering this decade includes eliminating the use of heating oil and adapting bylaws to support.
Energy efficiency and resilience the key one to focus on here is that the bylaw around emissions disclosures and ratings of large buildings, the idea being that you can't reduce what you can't measure.
So starting last year there have been requirements on large building owners to report on emissions and this, you know, we can expect that beyond emissions reporting actual emissions regulation over the amount of carbon that are given building can emit, we can expect that to follow. So all the charts on the right hand side.
Saying is that for the very largest building owners?
Emissions reporting has been mandatory as of 2022. This will progressively move through tiers from buildings.
You know of a 50,000 square square meters of floor space down to 5000 square meters of floor space down to 2000 meters per square square meters of floor space by 2024 UM and as I mentioned, expect these emissions reporting requirements to be followed by actual carbon intensity requirements. So if we can move on to the next slide.
So here's where I'd like to focus just a little bit on what can actually be achieved in terms of reducing the emissions profile of new buildings, so I suppose what I've hoped to land in the previous two slides is that regulation and changes coming in the industry around how carbon intensive new buildings are and how carbon intensive existing buildings are.
What I want to do here is highlight just a few of the techniques that may be worth looking into as you're constructing new buildings that would make them sustainable. So three things to focus on.
Here Mass timber, green steel carbon concrete being three of the kind of key ingredients, obviously, that go into any construction
So mass timber is very beneficial from a sustainability perspective because it can be used to replace steel, which is obviously producing steeling steel is a very carbon intensive process and if you use timber instead of steel it avoids the emissions associated with carbon and timber in many circumstances particularly mass timber.
Cross laminated timber can have many of the same structural properties as steel and additionally you know some aesthetic benefits as well, so using mass timber is in replacement of steel not only avoids the emissions.
Associated with steel production, but is actually in some sense it's a carbon negative technology so what trees do is they grow as they absorb CO2 from the atmosphere and they lock that inside the wood of the tree, so if you were then storing that word as part of the building the carbon that has been sequestered from the atmosphere is then locked indefinitely you know in as part of the building structure so by using mass timber you are actually in a sense taking carbon out of the atmosphere and storing it so it whilst steel contributes to carbon in the atmosphere.
Ask Timber can actually be a carbon negative technology. I don't wanna sound too down on steel and I'm obviously aware that using timber is not necessarily applicable in every single building. Steel still obviously needs to be used in many circumstances, but there's increasing innovation in terms of how steel is made to make that lower and lower carbon.
I won't get into the kind of chemistry of how that happens, partly because we don't have time but partly because my understanding of the chemistry is limited and I don't want to expose myself.
There, but suffice to say that if you look at companies like Boston Metal and H2 Green Steel, they are producing steel using renewable energy as a source rather than by.
Burning fossil fuels and using electric arc furnaces rather than blast furnaces to produce steel in a way that is a lot more carbon intensive on the environment, what I would say is that green steel still trades at somewhat of a premium. I think this is around 5:00 10% in contrast to mass timber, which I don't think trades at a premium to steal at all.
So the certainly would be, you know, a relative.
A cost implication on a new construction that was using this, but that has to be weighed against the kind of potential premiums associated with building a very low carbon or net zero building.
Concrete is another raw material going into buildings that is pretty carbon intensive. But there are methods of adding inputting additives to concrete or changing the manufacturing process that can turn concrete into a low carbon or even carbon negative technology.
Where CO2 is actually sequestered in the concrete as it goes into the building. Two companies to look up here are happily to Canadian companies. One is Carbi Crete, which. Which sequesters carbon and precast concrete slabs And actually as a carbon negative technology, so sucks carbon out of the atmosphere carburetor Quebec based company I believe so additional benefits there another company's profile would be carbon cure out of Nova Scotia and they have technology that can be fitted to any kind of commercial concrete manufacturing process to lower the carbon emissions associated with that.
Just wanted on the right hand side to flag a building that has employed some of these techniques in Quebec, so the point Olevera Ecodistrict in Quebec City, there's a 13 story 90 unit condo tower there, which at its time was the tallest wood building in North America. I think that dates back to 2014
So you know buildings of substantial size are being made principally out of timber and I think this proves it, an example dating back.
Almost 10 years, so maybe if I can skip on to the next slide to cover some of the some the measures that can be retroactively applied to existing buildings to reduce their carbon footprint. In other words, retrofits.
So. There's a suite of measures associated with retrofits These can span lighting
You know, LED lighting and wireless motion sensors are something that I expect most people have already employed, but there are more material retrofit measures that can both generate cost savings and also reductions in emissions. The most principled one, honestly for the from the emissions perspective is switching, Switching source from natural gas fired heating to electric fuel pumps.
What I would say there is that. For all but the most extreme climates, fuel pumps really are a technology that is ready to be in the market right now in some of the colder parts of Quebec and I know most of Quebec is pretty cold, but in even the more extreme parts of the province it may be a requirement that gas backup is used in addition to heat pumps for the very coldest days.
But that I would say that technology is now commercially mature and deployable in most pretty cold climates there. Also look at other measures like the building envelopes or improving the cladding and the insulation properties of the building looking at on site renewable power generation and using digital building controls that help optimize how all the building kind of sensors and fixtures and fittings kind of operate together to be as efficient as they can in concert.
And again retrofits are happening now in buildings of all sizes just to quickly put out put out a few examples of Quebec Montreal. Montreal Trudeau and Montreal Mirabel airports have both gone through very, very extensive, you know, deep retrofits which have significantly reduced the carbon emissions by more than 35%. Concordia University is looking at decarbonizing its entire campus. The same has been done to Montreal Olympic Park and the World Trade Center in Montreal.
So, you know, lots of high profile examples of major building retrofits going on in Quebec with admittedly A bias towards Montreal in the examples there. So apologies for the folks that are in the other jurisdictions.
But I assure you they are also happening outside Montreal as well so just moving on quickly here.
For the next slide, so I'd mentioned some of the regulations around building, improving the greenhouse gas footprint of buildings. I won't go into detail on this slide, feel free to take a screen shot, but suffice to say there are significant numbers of federal level incentives provincial level incentives and municipal level incentives to help building owners who are, you know, keen on doing retrofits and I would also say probably the biggest one here is CAD infrastructure banks.
Building retrofits initiative, which is deeply concessionary capital to help finance building retrofits typically between 2 and 4% and I have to get a bit of a plugin for BMO here. BMO is the only bank currently that has the ability to offer BMO clients lending at Canada infrastructure bank rates for retrofits, so between those kind of two and 4% interest rates in contrast to BMO Prime which is sitting at about 6.95 right now.
So just skipping on to the next slide, wanted to kind of finish off with really hopefully some relatively practical advice about what I would do if I was particularly building owner right now about thinking about sustainability. So I guess the first step is understanding the carrots and sticks, so building awareness of the regulation incentives as I hopefully pointed out earlier, you know regulation is beginning to come down the pipe and move, you know move on to the horizon here. Building codes are changing emissions reporting will become mandatory for most buildings.
And emissions intensity targets will be set, so you ending on where you are in the province and what municipality you missed municipality you sit in, I think it would be time well spent investigating some gating some of those emissions reporting regulations that will be coming down, but also some of the incentives that will help you decarbonize your business model and make it ready for the future.
I think the next step that I would look at is triaging your portfolio. So assuming you are building owner and operator and you have multiple buildings, there are gonna be some that are higher risk from a climate perspective so greater potential of becoming a stranded asset because the mechanical systems and the buildings for example are much more carbon intensive and there are gonna be some that are more modern.
So you strategically look across your portfolio, focus on the assets that have the greatest risk of becoming stranded or becoming outdated and exposed to devaluation. Risk and then turn those into opportunities as we was as we run our retrofits financing product a lot of the deals that we're doing, a lot of the what we're seeing in the market is building owners and constructors taking old partially vacant or fully vacant buildings converting them, you know doing adaptive reuse for example taking an office and turning it into a multi unit residential building and in doing so making it as energy efficient as it possibly can by taking it, taking taking advantage of some of the fairly generous incentives that are out there in the market.
Last two quick pieces, relatively quickly here is, I would say, when it comes to energy efficiency and sustainable new construction, it's not enough to kind of take a simple payback view of the investment opportunity you need to be finally kind of factoring more.
More elements into your model to adopt what's called a life cycle cost analysis approach. So kind of key things to model for here are you know, potential redundancy of building mechanical systems, so in practical terms you don't want to fit a new natural gas fired furnace next year when that may make you know on the wrong side of emissions regulations in 10 years time meaning that you have to strip that out.
Looking at incorporating the lower operation and maintenance costs of some of the new kind of electric systems like heat pumps that are coming onto the market now, looking at the salvage value of equipment modeling for the impacts of the carbon tax which is currently about $65 a ton, but we'll go up to 170 a ton in 2070 and also looking at the incentives available to make any sustainability or decarbonization projects more attractive.
Final point is in anticipation of the compliance you know the emissions reporting requirements that I mentioned earlier in the call have a look at solutions to begin thinking about and then footprinting your carbon emissions now for most building owners this will be a requirement through the mid to latter part of this decade. So beginning to get a handle on how you would do that and some of the challenges and opportunities associated with that right now I think it's time well spent. So I think.
Final note, BMO does have solutions covering the retrofit space there that are differentiated covering recycling of construction materials through a habitat for Humanity program and covering emissions footprinting. You know, BMO can help you with all these measures, you know there are a few slides after this to cover those that we can potentially share after this call, but I think the first port of call, if you're interested would be to speak to your relationship manager there and I think that's it from me. So I will. I'll now pass it over to Kate to begin the Q&A.
Kate:
Thanks very much, James. Greatly appreciate you deconstructing what is a relatively complicated topic that I know draws a lot of interest from our market. So thank you again for that Now just as a reminder to our audience, if you have not yet had the chance to submit a question and you'd like to do so please do so using the chat box found right next to our video screen,
All right, so we can get started. Now the first question is off to Mike will the steady increase in office Vacancy reverse or are we seeing a permanent change?
Mike:
I'd say yes and no, IE we and Roberts team originally estimated back in 2020 and we have seen what we still expect to be a 20% estimated all in national office demand drop versus pre pandemic levels. So I always said it's more of a permanent reset to a new hybrid work location paradigm more than a market correction that will return to pre correction levels but both resets and corrections have they take time.
At the bottom and then stabilize and that will happen here too back in 2020, I personally thought we'd have seen that stabilization by now, but it's taking longer, longer people like working from home, employers like lower lease expenses. The trick is finding the best balance for your business or your personal career development if you're an employee once office has reset and we get to more stable hybrid models and supply adjusts to reduce demand say within the next year or so.
Then you'll see a return to a more stable declining office vacancy with demand trends back more in sync with employment and GDP People will always work in offices, just less so than before 20, and I think we're within a year or two of that stabilization point.
Kate:
Thank you, Mike. That taught. That echoes what I've been hearing as well, which goes along the lines of survive till 25. So we'll see what happens after that.
Robert, the next question is for you, where are cap rates heading in the next 12 months?
Robert:
Not a simple answer to that. I think the short story is higher partly because we have not yet adjusted to the fact that we've, as we talked about earlier, moved to this not only through this tightening cycle, but what is probably going to be a higher neutral or a new normal level of long term bond yields going forward then we saw during the past decade or so and And there's a lot of nuance this obviously multifamily given what's happening with demographic flows and rental.
Demand is proving to be a lot more resilient than the office sector as Mike just talked about and you would expect that and it typically is a more stable sector anyway, but even in multifamily, I mean depending on the market we see cap rates around that three and a half, 4% mark in some areas and maybe be that made sense when you had extremely low bond yields now you have 10 year GOC yields are risk free money three and 4% GC's pushing up higher than that as well, so.
That the relationship doesn't make a whole lot of sense right now and historically when you look back over the last 20 or 30 years, you do tend to see a pretty stable spread between what you can get from risk free asset out in the bond market or from the government of Canada relative to the, you know, the market risk and the liquidity risk, the tenant risk that you're taking in something like a multi unit property so.
All that said, I mean, like, fundamentally, there's a lot of strength there, but I think the just the mechanics of what the cost of borrowing and what the alternatives out there suggest that we do have to see cap rates still drift higher and again there is obviously very variation based on location and based on the specific sector.
Kate:
Wonderful. Thank you, James Over to you now can real estate development expect some sort of discount rate if they're development is more aligned with the SG?
James:
I think is this is a shorter answer to this and there's a longer answer to this now if we're speaking about it construction right now, I would say at the moment for most banks they won't necessarily in the next two years expect to see any sort of discount what I would say speaking for BMO because that's who I can competently speak for, but I imagine that it would be the same for the other banks, is that all banks are looking to incorporate climate risk into their risk modeling as a fundamental pillar of risk modeling, the idea being that if you're Business model, if you're building is not fit for the climate related regulation that is coming, it is not desirable from a sustainability perspective, then there is risk of that effectively devaluing or even becoming a stranded asset so that the climate risk is effectively credit risk
It feeds into that, so in the longer run it's not gonna be something that happens overnight and it's not necessarily gonna be something that's very visible but in the 3:00 to 4:00 year time frame banks will absolutely be incorporating.
More sustainable your business model is or your construction is when they think about what rate they will lend you at.
Kate:
Thank you, James. Mike.
How is the current macro environment changing the bank's appetite to lend in real estate and do you believe the strong industrial market will hold for the long run?
Mike:
I'll talk about economic environment and regulatory environment first. The economy, Things seem to be going well in terms of monetary tightening, limiting inflation without any major hiccups on the commercial borrowers we have having defaults or losses just haven't seen books have stayed clean for example a year ago before the rate hikes we estimated our income property, commercial mortgage book on average would achieve well more than you know one.
Times debt service coverage ratio income to principal and interest payment ratio in a high rate. Deeper recession stress scenario, we also modeled our book a year ago to go from then averaging about 1.4 ish times debt service coverage and I've talked to some other banks and very similar sort of numbers I'm reading out here, so I wouldn't call them be most specific but we thought we'd average 1.4 back then going down to about 1:3 or 1.25 to 1.3 kind of in that range after refinancing at the higher rates that were coming and we modeled it based on our own economic forecasted rates out of Roberts Group plus about 50 basis points, which was smart because it has been at least that much more
Anyway, a year later that forecast is holding up quite well and we have no defaults or losses and only modest shift in risk profile of a largely investment grade book of commercial mortgages. The truth.
Because the average term in that book was two years going into the right correction and we're maybe 40% of the way through that book refinance. So the proper answers talk to me maybe early 2024 when we modeled this tall bottom
But so far the forecast is holding up perfectly well fairly well, stable.
After talking about the housing market. After many forecasts, kind of a 25 to even 30% price correction bought or bottoming out late this year as Robert mentioned things seem to have bottomed earlier and less severely than originally modeled. We we've seen the housing market bottom in the last few months at a national home price index correction of I think around 16%.
And there was talk of that correction actually taking to the endof the year and obviously we feel we're roughly a few months into it. So I said things were going well but then a US bank failed and then we're looking at more bank failures. They're small banks They won't shift the world, I think, but they're not doing anything for confidence in the short run And then return to office. Kind of stalled too from some of my earlier comments on office and you know risk rates rising.
Rights, pardon me, hit the office sector then not one, but two regulatory capital increases impacted all of Canadian banks, said one banks, both Basil 3 are, some call it Basil 4:00 and also we also had a separate regulatory capital increase and those things you know they may sound technical but they impact the amount of capital that banks can supply in the marketplace and the pricing they can can supply it at and there's a lot of caution about real estate.
As a result of all those things sort of happening at the same time until the bank books have fully digested the refinancing risks, I told you we're maybe 40% of the way through in terms of our own commercial mortgage book. So I'd say 2023 remains a correction year while we wait for our, I won't say mild recession or Robert, you used the downturn phrase I think earlier, but it it's either a technical recession that's not too severe.
Or downturn, however you wanna put it, and we're gonna wait for that to come and go really in the span of I think more or less this year in 2024. We hope and expect and forecast to be a recovery year, but with a slower trajectory of growth I think in the outlook beyond that first and for some sectors within real estate like industrial, you know industrial's been hot with really strong demand driven by ecommerce fulfillment during the pandemic where people were more online.
But that trend was strong before the pandemic and it will remain pretty solid after the pandemic, but it is reaching A leveling point. So.
All I'd say is with a million new Canadians last year and normalized rate of maybe 525,000 or more is the number I think I heard from your team, Robert that I agree with on a go forward basis that's 50% even that lower 525 versus 1,000,000 the past year is still 50% higher than before the pandemic more than that and you combine that with record employment that Robert mentioned earlier.
So whether it's residential building of A house, condo or rental, that's probably from a segment point of view where it's really at and an industrial will probably remain a close second to that, I mean retail is doing relatively well, but some pockets will be weaker doing due to slower GDP growth during and beyond, you know this year's anticipated recession anyway back to you Kate.
Kate:
Thank you, Mike. Robert, we have another question for you. We'd like to know with all that's going on in the market today, how can people keep affording the higher prices of rentals?
Robert:
It's extremely tough and it doesn't seem like in a lot of cases they can, so we have a we have what is pretty much evolving into almost a social crisis in a number of cities in Canada. Let's be honest, OK, maybe it's not as acute and some of the smaller markets, but in markets like a Toronto or Vancouver, it very much is.
And.
I like there. There's a big policy debate out there about this we need more supply, absolutely. But the reality is we just, we just can't bring supply to market faster than we already are. We see it in the numbers where we're building more than we ever have. In per capita terms, we're building more than we ever have before.
When I when I speak to home builders across the country, tell me the same thing, yeah, but we just, we just physically don't have the capacity to build anything more. So we keep adding demand to a market that we just physically can't supply and obviously.
When you have those two factors pushing against each other, what's the relief valve? It's prices, it's higher resale prices, and it's higher rents. So under the current settings that we have with this amount of demand growth, there's just unfortunately not really a way out of this affordability problem and so households are making other changes here.
In a lot of cases, they're just leaving the big cities and we look at the migration numbers you you see record migration flows out of a province like Ontario for example, into other markets that are more affordable like say in Alberta and you see migration out of the biggest.
Cities in Canada into some of the suburban and further out areas and one of the one one of the benefits of this move to hybrid work or work from home is that we've actually opened up a lot more affordability because people can now live in markets where historically they couldn't because they were tied to that kind of 1 hour commuting line to the core of A big city, right. So that's been one area that's helped.
But this, and I'll say because, I mean, we're talking Quebec here, this isn't nearly as acute a problem in Quebec.
Obviously you still feel it in the rents and home prices, but it's not quite as acute in some other areas and you can kind of see it evidenced in the migration flows where on net as I mentioned earlier, people aren't leaving Quebec anymore like they have historically. There's enough economic strength, enough job market strengthen, enough relative affordability still versus some of the other big cities even though it may not feel like it versus 5 or 10 years ago, but relative to the other cities are still as affordability in Quebec.
As well. So that's all helping in that specific situation I guess.
Kate:
Thank you, Robert. I think we have time for maybe two or three more quick questions. So now we'll
hand it over to James. James our real estate developers and owners in Quebec ahead of or behind the curve compared to what you're seeing across Canada and what could we be doing better?
I would say that based on my limited sample size, the I think real estate developers are probably marginally ahead of the rest of Canada on average in terms of some of the clients that we're speaking to certainly seeing very high levels of enthusiasm not just to kind of comply but to almost exceed compliance and to get towards very close to net zero in terms of building standards.
Some of the examples I highlighted earlier know what's happening at Montreal airport, what's happening. With Concordia University is really I think, emblematic of that ambition and Quebec is in the enviable position of once it electrifies because of that hydro generated grid in Quebec, it means as soon as you switch off fuel oil or natural gas, you're gonna get to a very, very high level of carbon reduction.
So I think Quebec definitely is definitely up there with the leaders of the pack should continue continue on that trajectory.
Kate:
Wonderful. Thank you, Mike. We're going back to you. What's your view on retail financing within the next 12 months?
Mike:
I'd have to say weaker for discretionary and non needs based retail given we are entering a mild downturn again as Robert said and weaker consumer spending associated with that, but as I've said 2024 is a recovery outlook year to this year's correction overall Canada has lower retail per capita per capita than say the United States and relatively good overall vacancy growth trends because of that and the strong population growth and employment
Robert might have a more granular view than me on that question, too.
Robert, did you want to comment on that?
Robert:
No, I think like from a macro perspective, I think that's pretty fair answer.
Kate:
Excellent. Thank you.
So for our last question today, we'll hopefully not end on a doom and gloom, but we were hoping for a stable 2024 with the rates starting to drop. Robert, what possible events do you see on the horizon that could disrupt this?
Robert:
So.
I would say a couple of things that always comes back to inflation here, right. So if we continue to see evidence that inflation is just not breaking from where we are now, that's going to be bad news obviously and you see how the market reacts to every incremental decimal point on inflation, right? So I mean our thesis on this all along has been pretty consistent.
It's been getting from 8% to 4% was going to be pretty fast and pretty easy and we did that right where we're there we we got there. But getting from 4 back to two is going to be a lot harder and it's. It's gonna take a lot more.
Leaning against the economy by the Bank of Canada and the Fed. And unfortunately, that's exactly how it seems to be playing out because if you look back over the last three months, the last six months, we're kind of stuck around this 4% mark and it's not breaking so. That at the end of the day, I mean there's a lot of geopolitical risk and all these other factors out there that at the end of the day is probably the single biggest factor because it's gonna dictate how long we have to sit here with these.
These restrictive interest rates or move incrementally higher or how quickly if we start to see inflation break that we can back off from these rates and the longer we sit here at these interest rates, the more likely we're going to run into issues with some of the refinancing risk Mike talked about or even in the household sector as these three operate mortgages come to renewal that are amortizing out over really long periods of time and have to kind of reset to those schedules while if we're resetting to those original schedules in A5 or 6% mortgage rate environment, it's going to hurt a lot more.
And if we're back down to somewhere around like the 3% mark or the three mark, right, so and where we are on that front is going to be dictated by inflation. So I think that's the big swing factor. The good news is we've done a lot of, we've seen a lot of the work we've needed to be done on inflation, but.
Still proving to be a little bit sticky and that's why Mike and I are both kind of pointing to the later stages of this year as an area of economic risk.
Kate:
Thanks very much, Robert to the audience, thank you again for joining us. We hope that you enjoyed today's session and I want to thank you again for taking the time out of your very busy days to spend the time with us here as a reminder today's call was recorded and is available for playback, so you'll receive an email with details on how to access that later on this week. This concludes our call today. Thank you again, Mike, Robert and James and thank you to the audience. Take care.
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 …(..)
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Robert Kavcic
Director and Senior Economist
Robert has been with the Bank of Montreal since 2006. He plays a key role in analyzing economic, fiscal and real estate trends in Canada. Robert regularly contribut…(..)
View Full Profile >BMO’s Commercial Real Estate team offers an insightful virtual discussion on the Quebec housing market, regional market trends and economic outlook. Featured panel speakers include:
- Robert Kavcic, Director & Senior Economist, BMO
- James Burrow, Director, Sustainable Finance, BMO Capital Markets
- Mike Beg, Senior Vice President and Head, Real Estate Finance, BMO Commercial Bank, Canada
- Kate Low, Regional Vice President, Real Estate Finance, BMO Commercial Bank, Canada
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