The Disconnect Between Pricing and Fundamentals

By Amy Erixon, Toronto

The disconnect between fundamentals and pricing continues to be as much a topic of discussion as speculation when the US economic recovery will finally gain some traction. In Canada, where the recovery is firmly established, Q2 average earnings (from same properties), as measured by funds from operations (FFO) for Canadian REITs fell 0.3%, while pricing for the same companies and properties touched all time peak levels. Everywhere you look outside traditional equities, from gold to treasury bills, new pricing peaks and yield troughs are being established. This raises some important questions. Is this simply the weight of capital finding its way from equities to other sectors? Are we moving into an asset pricing bubble? And if so, what actions should be taken to get funds deployed in reasonable order?

Property, whose historic role in a multi-asset class portfolio is to provide steady income and stable value, is at present being buoyed by external factors such as record low interest rates and perception of relative price reasonableness (compared to investment alternatives of stocks, bonds, commodities, infrastructure, etc), driving yields to historic lows. In fact this week Goldman Sachs reported that the correlation of all “key assets” has reached the 96^th percentile over the past two months, a level reached only four times in the past decade, (but three times in the last two years). These are the characteristics of a market driven by emotion vs reason. It demands that we pay close attention to actual fundamentals, and understand how each asset class is being affected by these relative comparisons.

In my view, Real Estate’s role in a multi-asset class portfolio is increasing in importance, which has and will continue to mean investors accepting lower returns. Everyone is losing patience with the volatility in the stock market. These relatively high valuations might in fact make now a good time to harvest gains on non-strategic property while being patient and careful in the deployment of new resources.

Withdrawal of governmental support such as quantitative easing combined with the inevitable need for refinancing of the overhang of maturing CMBS, FNMA and private mortgages over the next few years will permit the anticipated liquidity crunch to unfold. Investment opportunities in both fixed income and real estate spaces will improve during the upcoming years. But in the short term the weight of capital shifting may cause yields to decline further. Properties offer distinct tangible features which still serve to lower overall portfolio volatility relative to other asset classes; such as high replacement value, market barriers to entry, distinctive claim on earnings (behind taxes, ahead of other creditors), and long duration predictable cash flow characteristics. This is even true for properties located in currently overbuilt markets.

REITs offer investors a highly liquid vehicle for accessing the sector and a variety of quality operators and sector strategies. REITs are enjoying renewed appeal with both retail and institutional investors. But historically, REIT valuations are on average are around 50% correlated with private property market and 50% correlated with the stock market. The problem with REIT stocks as a portfolio diversification tool is, of course, that the volatility of the stock market affects REIT volatility at precisely the time one would want it not to (over 90% currently). As global markets and all asset classes are becoming increasingly more synchronized this feature of publicly traded vehicles becomes more problematic. Additionally as the overall size of REITs as a percentage of overall property ownership grows, this volatile pricing effect spills into the private property market as well.

There is an under served market demand for a suite of private real estate vehicles that provide investors with the intrinsic benefits of property. To achieve this we need to rethink the trade-off between liquidity and pricing characteristics that are appropriate to the asset class.

Industrial Real Estate Review and Outlook – Mid-Year 2011

By Michael Fonda (Chicago)

On July 29^th, CoStar presented its Mid-Year 2011 Industrial Real Estate Market Review and Outlook for the United States. Jay Sivey, Hans Norby and Shaw Lupton, from CoStar, were the presenters. If you have access to CoStar, you should view this presentation. You can do so by going to CoStar’s home page and clicking on the tab on the far right – Knowledge Center. Then click on CRE Market Reviews. Select the particular “Session” that interests you. My specialty at Avison Young is Industrial Real Estate, so I went there.

My takeaways from the CoStar presentation are that: a) occupancy levels will continue to increase b) developers and their capital partners will continue their reluctance to create new supply and c) industrial real estate investors are willing to accept less of a return on their investments today than they were in 2008 and 2009.

Net Absorption: Net absorption has finally turned positive. CoStar is reporting approximately 94 million square feet (msf) of net absorption so far in 2011. Hamid Moghadam, CEO of Prologis (world’s largest industrial Real Estate Investment Trust with 600 msf of space worldwide), reported in Prologis’ latest earnings call that Prologis is projecting 150 msf of net absorption in 2011.

Supply: Total inventory of industrial real estate in the United States is a little over 20 billion square feet. Average annual deliveries of industrial real estate are 2.5% of inventory or approximately 500 msf. Since 2009, annual deliveries have been more like 30 to 40 msf or .02% of inventory. We lose, on average, 1% of industrial real estate inventory every year or 200 msf. We aren’t even close to replacing this inventory.

Distressed Sales: According to CoStar, distressed sales as a percentage of total sales increased sharply beginning in 2008. That trend has plateaued and is now starting to reverse itself.

Forecast: A good case can be made for increased absorption outstripping decreased supply, resulting in higher rents for industrial real estate by the end of 2012. Unfortunately for Chicago and the Midwest, there is a slight problem. That problem is articulated by Michael Barone in yesterday’s Wall Street Journal. To quote Barone, “The Midwestern (economic) model is unraveling before our eyes.” The good news is that the Midwest is voting the Old Guard out and replacing them with more forward looking leaders. Though it may take the Midwest a bit longer to share in the positive momentum beginning to develop in other regions of the U.S. industrial real estate market, we’ll get there.

Wide gulf remains between Canadian and U.S. office leasing fundamentals

By Mark Rose (Toronto)

In Canada, the propsects of a stable economy and improving leasing market fundamentals continues, as we look forward to the second half of 2011 – this, despite the lagging performance in the U.S., strange behaviour by the U.S. government, and a debt crisis that has consumed the Euro-zone, in particular Greece.

Two key metrics among others that influence the overall health of the market are business confidence and job growth. Business confidence remains positive, now close to 70% – up from around 58% one year ago and 35% at the height of the recession.

Canada's unemployment rate was unchanged in June at 7.4% as the number of people participating in the labour market increased. Employment rose for the third consecutive month, up 28,000 in June, surprising many analysts. Over the past year, employment has grown by 238,000 (+1.4%).

Despite the summer season, leasing markets remain active across the country. A recent survey of Avison Young’s markets across Canada revealed a national office vacancy rate of 7.8% – down 210 basis points from the same period one year ago. Conditions are especially tight in the country’s downtown markets – collectively showing a vacancy rate of 6.2% at the midway point of 2011.

Read the press release and full report here:

Avison Young releases Mid-Year 2011 Canada US Office Market Report: Decreasing vacancy and rising rental rates evident in many markets as business confidence grows; Canada continues to lead US in recovery

Avison Young Canada US Office Market Report (Mid-Year 2011)

On the development front, there is more than 8 million square feet of office space under construction in Canada – with more than 70% of the office space already preleased. And on the investment front, $8.5 billion worth of commercial real estate changed hands in the first half of 2011 – a marginal increase over the first six months in 2010. Toronto is the hottest market… and retail the most sought after investment, capturing more than 50% and 28% of the investment volume, respectively. Of course trophy assets are highly contested and confirmed by very low cap rates.

Year-to-date 2011 capital raisings (Canadian REITs and corporations) equate to $2.8 billion, in line with the 10-year historical average aggregate of $2.75 billion/year. In all, $5.6 billion was raised in 2010. And 2011 looks to at least match that. REITs remain the biggest buyers. The big news since our last update? Dundee REIT will soon close the largest office portfolio (24 assets in 2.7 msf) ever acquired by a Canadian REIT for $690 million from Blackstone Real Estate Advisors and Slate Properties.

The momentum established over the past 12 months, and particularly through the first six months of 2011, is expected to keep building for the remainder of the year.

And now we turn to the U.S…..

Two years into what has been an uneven recovery, a wide gulf remains between Canadian and U.S. office leasing fundamentals. Canada continues to lead the U.S. in this recovery, having weathered the storm of the recession more robustly. Employment, a leading indicator, has propelled Canada’s office markets forward, while in the U.S., employment gains have largely been lagging and inconsistent.

There are serious issues and risks facing the U.S. economy. As of June 2011, the Federal Reserve of the United States has pulled back on quantitative easing; employment growth and GDP are anemic or trending negatively; and the politically-embarrassing debate over the U.S. debt ceiling has potentially undermined the economic recovery.

This month, the Bureau of Labor Statistics reported a national unemployment rate of 9.1% for July -- essentially unchanged from June and May – and although it represents the highest level since year-end 2010, it remains lower than averages reported during most of 2010.

Sectors adding jobs included the professional and technical services sector, which added 24,000 in June and has added 245,000 jobs since its recent low in March 2010. Government jobs continued to trend down over the month, losing 39,000 jobs in June -- 14,000 of which were federal.

State and local employment has been falling since the second half of 2008. And as state and local governments struggle with operating deficits, these employment losses could serve to dampen the effect of any private-sector employment growth, and remain a threat to a broader economic recovery.

The U.S. office market saw its vacancy dip to 12.6% in the second quarter from 12.7% in the first quarter. The 10-billion-square-foot U.S. office market recorded positive net absorption of 12 million square feet in the second quarter – most of which was in class A space, as tenants continue to take advantage of oversupply and “trade-up”. As well, sublease space continues to decrease (it has fallen each quarter for the last four) and points to trending market improvement.

One area of optimism is the recovery of the sales market. Core assets, with stable cash flows, will remain the most desired investment class, especially in the biggest markets. There is a healthy sales and financing environment right now, albeit with minimal improvement in real estate market fundamentals.

According to Real Capital Analytics, June is on track to record the highest volume of sales thus far in 2011, and more than double the volume during the same month last year. The major markets of Manhattan, Washington, DC and San Francisco account for nearly half of the volume as of May.

Job growth is key to improved fundamentals, and those numbers have been bumping along. Watch what happens to the public sector employment numbers in the coming months as election campaigning season ramps up.

You can also listen to this Q3 2011 update on our Avison Young Audiocast tab: http://www.avisonyoung.com/Media_Room/Audiocasts/2011_Audiocasts/

Arm Yourselves Canadians

By Michael Fonda (Chicago)

In today's Chicago Tribune, John Kass gives his unique perspective on how the United States can right its economic ship. Click here to read his solution.

T. Boone Pickens can have the oil, Rand Paul the gold, Robert Kennedy, Jr. the wind (well, he'll have fight T.Boone for those rights), McDonald's the fish, Warren Buffett the railroads and Lady Gaga the minerals. Just leave me the Pillitteri Estates Winery and I'm happy. Their ice wine is superb!

We really love you Canada. It's just.....well, business.