A year ago, the U.S. Federal Reserve delivered a shock to the system with its announcement regarding tapering of economic stimulus. Short-term rates spiked and investors’ lengthy love affair with REITs cooled.
That “wait-and-see” sentiment is on full display in the Real Property Association of Canada (REALpac) /FPL Advisory Group’s second quarter 2014 REALpac / FPL Canadian Real Estate Sentiment Survey. The April survey of more than 40 industry participants found the sentiment was stable compared with the prior survey, which it describes as the “hallmark” of the Canadian market these days.
In particular, those executives noted that asset prices remain high thanks to the persistent low interest rate setting (the U.S. Fed may have roared last year but it never pounced), the economy is still not firing on all cylinders and the industry isn’t expecting much action on rates until sometime next year.
“On the one hand, you have the U.S. perspective which is that surely rates have to go up given the tapering announcement of 2013 and the U.S. government is the owner of so much debt that they have to discontinue buying, continue tapering,” said REALpac CEO Michael Brooks.
Not north of the border
That relatively bullish sentiment is not shared north of the border. Benjamin Tal, deputy chief economist at CIBC World Markets, told attendees at this week’s Land & Development Conference in Toronto that he does not expect rates to rise in Canada until mid-2015 and even then will edge up very gradually.
The U.S.-Canada disconnect was borne out in the survey. U.S. real estate professionals are much more bullish about market conditions and future prospects than their Canadian counterparts. That is also displayed in overall sentiment. While it is stuck at 54 in Canada, it is at 67 among U.S. survey participants.
You would think that another year or two of ultra-low rates would be embraced by real estate market participants, but the risk of eventual interest rate increases has created nervousness and uncertainty in general in the commercial real estate market and has put some REITs in a tough spot in particular.
“If you are a CEO of one of the 69 Canadian REITs, what do you do in the face of potentially rising interest rates?” said Brooks. “I think for them, you just have to drive on. Ladder your mortgage maturities and push maturities and renewal dates out. Find accretive buys, enhance what you already have, optimize your own operations and keep growing your portfolio as best you can in this market.”
Challenge for youngest Canadian REITs
The REALpac chief added that the challenge may be greatest for some of the youngest Canadian REITs, about 15 of which went public in the year prior to the May 2013 U.S. Fed tapering announcement.
“So for a number of those smaller REITs which IPO’d before May of 2013, they are a bit stuck at a unit price below issue price and trying to figure out how to get back,” he added. “For the REIT market as a whole, if you weren’t worried about interest rates going up, many of the existing REIT units look like bargains based on them trading at or below current NAV and the relatively high current yields.”
Brooks said the rising interest rate concern may be resulting in reduced investor appetite for new share offerings on the part of existing REITs to fund new acquisitions. This is borne out by broker comments REITs are either out of the market entirely or are being very picky about what they are buying.
“They have this now higher accretive return hurdle to hit that maybe some other buyers don’t.”