Capital growth nudged up 2017 investment returns for the 43 portfolios participating in the REALPAC/IPD Canada Property Index. Annual results, released in Toronto late last week, show a 6.7 per cent total return across 2,455 directly held standing assets — an improvement from the 5.7 per cent total return the index posted in 2016 — even as income yields slipped to an all-time low.

Robust economies in Toronto and Vancouver, a continuing slump in Calgary, retailing challenges and sustained high demand for rental housing all play into index-wide capital growth of 1.8 per cent and income return of 4.8 per cent. Simon Fairchild, executive director with the index producer, MSCI, parsed out some of the components of the big picture.

“There are strong returns from residential and strong improvement from industrial. We’re left with retail being the worst performer last year,” he told the gathering on hand to hear the results. “The geographic picture is pretty much what we’ve been accustomed to in the past few years. The range of returns has narrowed somewhat and this, in part, is because Vancouver has slowed down. While it seems like the values in Calgary aren’t falling as fast as they were, they are still falling.”

Pointing to the index participants’ historic total return of 9.2 per cent since 1985, Fairchild qualified expectations for the future. “If 9.2 per cent is ultimately to be met going forward, we would have to see some truly exceptional rental growth over the next decade,” he advised.

Industry insiders enlisted to provide on-the-spot feedback likewise scrutinized underlying details of the 6.7 per cent total return — comparing markets and sectors, connecting performance to broader economic forces and grounding it in the context of institutional investors’ pursuit of stable, predictable returns over the long term.

“The averages are misleading at best, dangerous at worst,” cautioned Colin Johnston, president, research, valuation and advisory with Altus Group, one of three panellists polled in the discussion.

Retail slumps, Calgary slogs on

He tagged “headwinds for retail”, somewhat surprising gains for industrial, upbeat prospects for multi-residential and Montreal’s improving dynamics among distinct trends that bear watching. He also looked beyond the latest round of numbers to pronounce his confidence in Calgary’s future rebound — a sentiment the other panellists shared with some qualifications on timing.

“You have a disequilibrium in the market that is going to take some time to work off,” submitted Carl Gomez, senior vice president, research and strategy, with QuadReal Property Group.

“I think in the retail space, it is too early to go there,” concurred Laetitia Pacaud, former president of Strathallen Capital Corporation.

Alternatively, there’s plenty of retail repositioning potential in more lucrative markets. In 2015, retail was the index’s best performing property type with a total return of 8.8 per cent, and capital growth accounting for 4.4 per cent. Two years later, the total return was 5.3 per cent, with capital growth at 0.8 per cent.

Panellists were reluctant to label e-commerce as the culprit, particularly since it’s also seen as a contributor to the industrial sector’s recent gains, but suggested that many mall operators do need to get a strategy in place while e-commerce still accounts for a fairly modest fraction of retail activity.

“It’s up to the asset manager to value-add. There are going to be people who own assets out there who don’t have managers in place to survive the hit that’s coming,” Pacaud warned.

“There are some really good retail performers and there are a lot of bad ones,” Gomez agreed. “One of the things (asset managers must do) is unlocking the value. Many of the malls that are performing badly were built in the ’60s and ’70s. We have to figure out what to do with these properties. Some of them are in very strategic locations.”

Toronto and Vancouver watch Montreal ascend

Even if market divergence is less pronounced than in 2016 when Vancouver boasted chart-topping total returns of 12 per cent and Calgary bottomed out with a 2.8 per cent loss on investment, there is still a discernible split between the cities pulling up and lagging behind the index average. “If you took out Calgary and just looked at Toronto, Toronto would be stronger than the TSX,” Gomez observed.

Toronto registered total returns of 10.4 per cent; Vancouver followed with total returns of 9.3 per cent; and Ottawa was in harmony with the index at 6.7 per cent. Montreal’s 6.5 per cent total return fell just short of the national average, but the climb from the previous year’s 3.3 per cent total return was the greatest gain of any market.

Vancouver’s slip may factor into other markets’ improved results as the city’s high costs increasingly pose barriers to prospective investors. Meanwhile, some index participants cashed out. “There is a net disinvestment in Vancouver, but this isn’t the market. This is just a group of portfolios,” Fairchild affirmed.

“We have a very small market that is dominated by foreign capital. I call Vancouver the Monaco of Canada,” Gomez said. “If you can crack that nut or you have a position there, it yields you very good returns.”

In turn, Johnston speculated Montreal is capturing a share of investors shut out of Toronto and Vancouver, but he listed several other plausible reasons for their interest. These  include the city’s healthy job growth, renewed investment in infrastructure and growing confidence in Quebec’s political stability.

“The provincial (Quebec) government has done a bang-up job of cleaning up the financial turf,” Gomez added. Like Vancouver, he termed Montreal “a burgeoning tech capital”, but, in contrast to the “Monaco of Canada”, its metaphor might be the aging, iconic building with upside potential.

Investors are now tapping into repositioning opportunities in sync with a broader urban rejuvenation. “We are seeing a lot of interest from foreign capital and domestic capital,” Johnston said.

Geography overrides sector

On the downside of the index average, Calgary was alone in suffering a 0.3 per cent loss on investment. “Values are now down, cumulatively, 15 per cent over the past three years. For office, it’s 27 per cent,” Fairchild reported.

Winnipeg, Edmonton and Halifax achieved total returns of 4.9 per cent, 1.4 per cent and 0.6 per cent respectively, but joined Calgary in recording negative capital growth. Office properties in both in Calgary and Edmonton took a disproportionately harder hit.

Sector trends were relatively consistent in all markets, with multi-residential and industrial properties generally outperforming office and retail, but this translated into a varying range of returns. Industrial properties emerged particularly strongly in Vancouver and Toronto, recording capital growth of 10.5 per cent and 9.7 per cent respectively. On the flipside, Calgary’s industrial sector simply lost asset value to a lesser degree than other property types, recording 0.1 per cent negative capital growth.

“Geography is really the overriding factor,” Fairchild reflected. “It’s about where the assets are whether there’s a sector gain across the country.”

Nationally, residential surpassed its 2016 sector-topping performance, delivering a total return of 10.3 per cent driven by 5.8 per cent capital growth. Industrial was just one notch behind, with a total return of 10.2 per cent that represented a big step up from a 5.8 per cent total return in 2016. Office also recovered from the previous year’s loss of capital value to record an improved total return of 6.2 per cent.

A pause, not a serious downturn

In a comparison with other investment opportunities, the index fell short of the 9.2 per cent return on equities last year but significantly outperformed bonds. Looking to other property markets, it trailed the 7.8 per cent return for listed companies in the REALPAC/IPD Canada Fund Index and the returns on standing assets that MSCI monitors in the United States (7 per cent) and the United Kingdom (10.2 per cent).

Meanwhile, the drop in Ireland’s index, from a 12.4 per cent total return in 2016 to 6.4 per cent last year, seems to support Fairchild’s reading of Canadian properties’ performance. “The current slowdown looks like a pause, like 2001 to 2003, rather than a very serious downturn,” he said. “Each of the last years has now shown positive if relatively modest capital growth.”

From a three-year perspective, the index and equities are largely in step with returns of 6.8 per cent and 6.6 per cent respectively. Equities outperformed the index over the five-year horizon (8.9 per cent versus 7.7 per cent), but pushing out to 10 years, the index delivered a 8.1 per cent return versus 4.6 per cent for equities.

Hints of inflation, the narrowing yield spread between the index and 10-year Canada bonds, uncertainties over NAFTA and other potential economic upheavals are all wrapped into institutional investors’ contemplation of the future. “Is real estate still the best game in the country?” Michael Brooks, REALPAC’s chief executive officer, asked — garnering responses that leaned toward yes.

“There are still people with a lot of money to place,” Johnston observed. “Trophy assets will continue to retain their yields. Really good quality investments make up the majority of the index.” (Currently collectively valued at nearly CAD $149 billion.)

“If underlying NOI growth is there then it can withstand some of these market forces we’re seeing,” Gomez said.

When asked to peg the 2018 total return, Johnston came in at the high end at 7 per cent, Pacaud predicted 6.5 per cent and Gomez projected something in the range of 6 to 6.5 per cent. Closing out the results presentation, Nic Aaviku of HOOPP was revealed as the annual contest winner for most accurately foreseeing the 2017 total return.

His February 2017 prediction also sets him out as something of an optimist among last year’s contest participants, as 94 of the 104 submissions predicted a return in the range of 5 to 6 per cent. “It shows a consensus, but it’s true that these 94 people were wrong,” Fairchild quipped.

Barbara Carss is editor-in-chief of Canadian Property Management.