Canadian investment returns for 2023 show retail improvement, industrial deceleration and continuing office value decline. Analysts and industry insiders on-hand to digest last week’s release of annual results from the MSCI/REALPAC Canada Property Index also highlighted the steadier outlook for commercial real estate in Canada than in the United States or many other global markets, and shared their views on promising opportunities.

“If you’re going to invest, this is the country that you want to invest in because the others have a bunch of issues,” Mark Rose, chief executive officer of Avison Young, told a gathering in Toronto. “In the U.S., they’re overbuilding; there’s far less discipline; there’s probably still a question around regional banks. That’s not what we’re dealing with up here. It’s just a very different structure.”

“I’m quite positive with Canada and what we’re seeing in the country with the growth in population and everything that entails,” added Marie-Josee Turmel, general manager, real estate investments, with Canada Post Corporation Registered Pension Plan. “It’s going to help continue growth. We’ll have new development, new construction and it should help the overall sector.”

Flat total return as capital loss and income gains balance out

Last year saw a flat average total return on standing assets in the Canadian index — comprising 2,264 assets held in 52 portfolios collectively valued at CAD $165.7 billion — as a 4.7 per cent drop in capital value cancelled out the 4.6 per cent income return. Retail emerged as the best performing asset type (for the first time since 2014) with a total return of 3.2 per cent, while industrial posted a total return of 0.3 per cent and slipped down after six years on top.

All asset types lost capital value, but the slippage was most muted for multifamily, with just a 0.5 per cent negative trajectory. It recorded a 3 per cent total return, retaining standing as the second-best performer for the seventh consecutive year. Office bottomed out the field with a -5 per cent total return and a nearly 10 per cent drop in capital value.

That rippled through to regional markets, where MSCI executive director Ken O’Brien linked negative total returns in Ottawa, Toronto and Montreal to their higher proportion of office assets. In contrast, he attributed Calgary’s revived showing — ranking as the second-best market with a total return of 4.6 per cent — to a “strong component” of retail in the asset mix and the removal of some office inventory for conversion to multifamily housing.

Office is also fingered for flagging returns in other countries where MSCI has recently unveiled 2023 investment results. After a flat total return in 2022, Ireland charted a -8.5 per cent total return in 2023, which O’Brien deems “an office story” given that it accounts for 60 to 65 per cent the country’s index. The slide was even steeper in the United States, falling from a 4.5 per cent total return in 2022 to -8.4 per cent in 2023. There, office represents about 21 per cent of the index, but suffered a 20 per cent decline in capital value (versus a 12 per cent loss in Ireland).

“I think the numbers did come as a bit of a surprise to the constituents that are in our fund index,” O’Brien observed. “There were significant writedowns on the office sector in our U.S. portfolios.”

“Most office buildings other than Class A and AAA buildings are probably at 40 to 50 per cent, and some are selling at 60 to 90 per cent less than their value from a couple years ago,” Rose noted.

Outbound investment falls off, foreign interest picks up

Yet, there’s little evidence Canadian investors are bargain shopping. Jim Costello, chief economist with MSCI Real Assets, tracked the pullback on foreign investment. Typically, about 50 per cent of Canadian investment in commercial real estate is for acquisitions outside the country, but that contracted to about a third last year.

Investors were more active buyers at home across most asset types, with the exception of apartments and hotels. While office investment within Canada shrank by 52 per cent relative to the pre-pandemic period, it practically evaporated in the U.S.

“Looking at Canadian capital flowing into the United States, in 2023 what’s missing from there is the office sector. People are still afraid of jumping into offices until we see where the bottom is,” Costello said. “Where they’re doing more globally than at home is apartments. In the United States the apartment market is just so large; it’s so liquid. If you want that exposure, it just provides that opportunity. So that’s the one thing that has been a constant for the Canadian investor.”

On the flipside, Phil Stone, managing director and head of Canadian research with BentallGreenOak, tallied foreign investment at 23 per cent of transactions in Canada last year — a large shift from a historical average around 4 per cent. “There were some pretty big names across multiple sectors, even in office,” he recounted.

“I think we’re going to see pension funds of non-domestic investors coming to Canada,” Turmel reflected. “We have some very nice trends and the growth in population is one of them.”

Despite a 28 per cent year-over-year drop in investment transaction value within Canada, 2023 activity was largely on par with the five years preceding 2020. “The sharp declines are really about the falls from the excess highs we had in 2021 and 2022 when interest rates were at record lows and investors were hungry for yield,” Costello advised.

What’s different from last decade is a shift in preferences. Excluding land purchases, about half of last year’s investment was in industrial assets — up from about 18 per cent in the 2015-19 period.

“Industrial had been a $5-billion a year market and it’s up to now, on average, a $15-billion a year market,” Costello reported. “The office sector had been almost a $9-billion a year market, down to $4-billion.”

As in the U.S., Canada’s Class B and C office stock is hardest hit. In contrast, downtown office is again outperforming suburban, albeit as both sub-markets registered negative total returns last year.

Post-pandemic adjustments for retail and industrial

Super regional malls show more marked improvement, boasting a total return of 4.7 per cent in 2023 and surpassing community/neighbourhood shopping centres for the first time since 2017. Retail was also the sole asset type to deliver positive total returns in all eight major regional markets represented in the index, ranging from 0.5 per cent in Ottawa to 6 per cent in Calgary.

“Admittedly, it’s a function of where retail has been,” O’Brien acknowledged. “This is a story everybody knows, how retail literally fell off a cliff.”

Drilling down to property categories, population growth, redevelopment and intensification potential and lack of new supply are all considered positive factors for enclosed shopping centres. Meanwhile, grocery-anchored plazas have consistently been tapped as a preferred asset in recent years and are expected to remain so.

“It is a little crowded in grocery-anchored retail, but we think it’s resilient from an income perspective,” Stone affirmed. “We just haven’t built enough of it to support the tremendous population growth that we’ve seen.”

Costello similarly projects prospects should be sound for the many investors who have moved into industrial since 2020, given that e-commerce was already on course to steadily gain market share before the pandemic intervened to spike up demand. Activity has slipped from those heights, but is still about where it was plotted to be in the absence of the pandemic.

“It’s tapering down into what was the previous trend, but that previous trend was favourable for industrial. If you’re doing a little bit more activity every year in e-commerce sales, that generates a little bit more demand for logistics space. So it’s not like the fact that industrial is so crowded takes away from demand for it in the future,” Costello maintained. “It’s still on that nice steady growth path.”

Industrial assets delivered a total return of 0.3 per cent to Canadian investors in the index last year, further breaking down to 3.8 per cent income return and -3.3 capital growth. That follows outsized total returns of 17.5 per cent in 2022, 31.6 per cent in 2021 and 12.7 per cent in 2020.

“For the last couple years, industrial rents and industrial values were going up 70, 80, 90, 100 per cent. You’ve got to give that time to catch up. Then we started to build and build and build and build,” Rose remarked. Still, he picks new industrial as a likely strong performer, along with multifamily, data centres, cold storage, outdoor storage and student housing.

Familiar and emerging favoured assets

Turmel foresees more value loss for various assets within the index, but with expectations of a turnaround relatively soon. Among best investment bets, she picks demographics-driven categories such as multifamily and logistics, stating a preference for “new generation” assets, but conceding those are difficult to find in multifamily.

“There’s more writedowns to come, yes, because the numbers are still light in a few sectors. It should be done in ‘24 some time,” she said.

Stone similarly picked multifamily and small-bay industrial as favoured assets and agreed with Turmel’s outlook on values. “I don’t know if anything looks cheap at this point. There still has to be some repricing,” he mused.

Prospective investors also await a catalyst to unlock the conundrum of purpose-built rental housing. Demand looks assured into the future, but current economic conditions are undermining the momentum that was brewing a few years ago.

“That’s a place where we should all be putting money, but it just doesn’t pencil out,” Rose said. With a boost to clear the upfront hurdles to new construction, he suggests both public backers and private investors could be big winners — providing stability for key players in Canada’s labour force and tapping into a stable, lucrative tenant base that is increasingly being priced out of homeownership.

“Today, around the world, teachers, nurses, firefighters, police officers can’t afford their homes. Workforce housing is under siege right now,” Rose asserted. “The public sector needs to bring money to the private sector and we can get rolling. It is something that is really available to invest in and make a lot of money.”