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TMX POV - Industrials & Apartments Still Turn the Heads of Investors

April 17, 2019

Amid weak returns in real estate, industrials and apartments still turn the heads of investors

By Ryan Thomas, Head of Business Development, Diversified Industries

With the Canadian economy virtually grinding to a halt in the fourth quarter of 2018, investors are understandably cautious when it comes to the real estate sector. After all, when any industry hits a rough patch – as many do when quarterly economic growth slows to just 0.1% – its problems can reverberate across the other parts of the economy that support it, and that includes real estate.

Retail is a great example of this phenomenon.

As retailers prepare for a rough year in 2019, with worries about high consumer debt, slowing sales growth and more store closures and layoffs, retail real estate is also feeling the pain. TSX-listed retail real estate equities posted a negative 5% return in 2018, which more than erased the 3% return of 2017. Office properties fared even worse in 2018, turning in a negative 4% return after rising 22% in 2017, doubtless impacted by the ongoing energy crisis in Alberta, as well as tenant companies' more general need to clamp down on expenses by reducing their office footprints.

However, there are two bright spots in Canadian real estate that have attracted investor interest, delivering double-digit returns despite fears of a protracted economic slowdown: industrial real estate and multi-family residential properties.

Indeed, industrials and apartment equities were the only two components of the real estate sector that delivered positive equity returns in 2018, gaining 18% and 11% respectively. Industrials matched their 2017 performance almost exactly, while apartment returns slowed from 17%.

So what's driving investor appetite in these segments? I spoke with Jameson Bouffard, BDO Canada's national real estate and construction leader, to get a front-line point of view.

"Classic retail that we know and love is completely changing, in a big way due to the Amazon effect," Bouffard says. "Industrial will get increasingly attractive."

He says that the very megatrend that has disrupted retail – the rise of online shopping, led by Amazon – is proving to be a key support of industrial real estate. That's because even though online merchants don't need large-scale storefronts with expensive leases, they do require massive warehouses to fulfil shoppers' online orders. And legacy retailers trying to catch up online still need large, sophisticated and efficient distribution centres to hold their own with their digitally native competitors, he notes.

But that's just one piece of the puzzle. The other is the still-nascent and rapidly growing cannabis sector, which captivated investors throughout 2018.

"Every producer is going to need industrial space in order to grow their products, which generally require a large footprint," Bouffard said.

A number of cannabis companies have opted to buy existing manufacturing plants and convert them into production and storage facilities, he said. While obtaining financing for such projects can also still be a challenge – at least for now, while the sector matures – Bouffard expects this trend to provide a support to industrial real estate.

As for the multi-family residential segment, Bouffard says that while these properties tend to have more interest-rate sensitivity due to high valuations, there also isn't very many of them on the market, which creates a scarcity premium and can drive prices even higher. Rates have also ticked higher very gradually, and further hikes could be put on hold altogether if the economy deteriorates further, which likely means investors aren't too worried about the rate overhang.

And while price appreciation in Canadian housing in general appears to be moderating, prices overall still remain near historical highs. Lack of affordability has fueled demand for apartments, which in turn has supported the double-digit equity returns that the segment has delivered over the past 24 months.

The bleak economic picture will figure prominently in any discussion of Canadian real estate over the course of 2019. But as companies look for ways to navigate what could be a difficult year, the sector – or at least some of its components – appears likely to continue to attract significant investor attention.

This article is provided for information purposes only, is not intended to provide any type of advice. This article is not an endorsement or recommendation of any securities or industry referenced herein. Views, comments or opinions expressed in this article are those of their respective contributors only, and are not necessarily endorsed by TMX Group Limited, any of its affiliates or their respective management or employees.