The main reason for this is that long-term vacancy rates have remained historically low (1%–3%) compared to other commercial real estate asset classes, which are subject to much wider swings over market cycles. Further, strong demand and limited supply have resulted in healthy market rent growth.
In fact, over the past 20 years, national multi-family rental rates have grown consistently at an annual rate of anywhere from 1% to 5%, or 3% on average annually. By contrast, over the same period, rent growth for other property types has been more volatile, sometimes even declining into periods of negative growth.¹ The data is clear: multi-family assets generate more stable operating income over the long term, while delivering a much higher total return per unit of risk¹ than other property types.
A number of factors involving supply and demand imbalance are responsible for the historical performance of this asset class. Lifestyle preferences, strong household formation, increased immigration and a more pressing need for affordable housing are all currently driving demand. Which in turn is impacted negatively by a challenging regulatory environment, and increasing land values and construction costs. We believe these key market dynamics will support continued robust performance for this asset class over the medium term.
Undersupplied housing market
The current supply and demand imbalance affecting multi-family real estate is in large part due to housing supply shortages in recent years. As we see in the graph below, from 2012 to 2018, Canadian households increased in number by about 250,000 per year, outpacing housing starts of, on average, 200,000 per year. While factors affecting supply shortages differ from region to region, the planning approval process is seen as a major hindrance to supply expansion across all regions. The regulatory hurdles Canadian developers must overcome are well known, with the World Bank ranking Canada 63rd in the world for ease of obtaining building permits. Lengthy approval timelines are the main reason for this ranking, with the most straightforward projects taking an estimated 249 days for approval compared to 81 days in the United States.³ This is supported by the Fraser Institute, which has determined that costly and challenging landuse regulations in Canada are the main culprit responsible for housing supply shortages and rising prices.⁴ We expect local governments will continue to grapple with and rectify these housing issues, but the nature of the problem does not lend itself to short-term solutions and we expect the imbalance to persist for the medium term.
Despite these challenges on the regulatory front, purpose-built multi-family starts have been increasing in recent years, with the number of units under construction in 2018 topping off at 59,000 – almost three times 2011 levels.⁵ Tight vacancies of 1% to 2% in most major markets, healthy rental rate growth and strong interest from institutional investors are key factors driving purpose-built rental construction growth. Although developers have been reluctant to launch purpose-built rental projects in the past given valuation differences between rental and condominium developments, rising rents and lower capitalization rates are closing the valuation gap in many markets. As a result, we expect to see continued growth in purpose-built rental construction, although we’re not expecting a surge in supply over current levels as the sector still faces zoning constraints, lengthy development approval timelines and increasing development levies. In addition, developers have to contend with rapidly appreciating land values as well as higher construction costs, making it more expensive to bring new product to market. Construction costs for apartment buildings have continued to rise above the rate of inflation, with Toronto, Vancouver and Ottawa all experiencing the greatest increase at 7%, according to Statistics Canada’s Building Construction Price Index (BCPI).⁶ Further, various rent control measures across provinces add another risk factor to rental housing pro-forma models. All of these factors suggest that developers will continue to be challenged in bringing new purpose-built rental product to market in the medium term.
Demographics and lifestyle preferences—driving demand
With the fastest-growing population among G7 countries,⁷ it looks like Canada will not be putting the brakes on its healthy population growth rate of close to 1.0% for at least the next five years.⁸ This momentum is in large part due to immigration.⁷ Generally, the immigrant population is a strong demand driver for rental housing, with immigrants highly concentrated in major Canadian cities such as Toronto, Montreal and Vancouver, which together account for 56% of all recent immigrants.⁹ Accordingly, it’s no surprise that rental housing in most large cities has benefited from immigration.
An increase in one-person households is another trend that is driving the demand for rental housing. Over the last 65 years, the percentage of one-person households has climbed dramatically from 7% to over 28%,¹⁰ and is now the most common type of household. Factors primarily responsible for this single-occupancy trend are an aging population, delayed couple formation, the growing participation of women in the labor force and a higher rate of separation.⁹ The economic situation and lifestyle of the one-person household are more conducive to renting than owning, so the vigorous growth in this demographic can only bode well for multi-family rental demand.
The business intelligence firm Informa recently conducted a survey of renters, and the results indicated that lifestyle preferences are key to rental demand. A hassle-free lifestyle, moving flexibility and location are all cited in the survey as the top motivators for renting. Further, 34% of respondents cited a preference for purpose-built rentals because they offer more services and more secure tenure.
Home ownership affordability—shifting demand to rentals
Renting and buying are competing housing options. As home ownership affordability deteriorates, rental housing becomes the natural alternative. RBC recently reported that home ownership affordability is now at its worst level since 1990.¹¹ RBC’s housing affordability index measures the share of median income required to buy a home and reveals the national average is at 43% for condominiums as at Q2 2018. Home ownership is particularly challenging in Vancouver and Toronto, with the affordability index at 52% and 46%, respectively, for these two cities. The potential for interest rates to go up and tighter mortgage lending guidelines will only contribute to the affordability decline going forward.
The demographic trends noted above, combined with affordability constraints, have seen home ownership rates drop by 1.2% between 2011 and 2016 (according to the two most recent census surveys). This is the first time they have dropped in 45 years. Younger age individuals, that are generally more financially constrained, are especially impacted with home ownership rates falling for 20 to 34 year-olds and 35 to 54 year-olds by 3.7% and 2.2%, respectively.
Multi-family real estate has proven to be an attractive asset class given its ability to improve portfolio risk- adjusted returns. We view this sector positively as supply and demand fundamentals continue to indicate an imbalance going forward. In summary, we believe that increasing immigration and household formation combined with a shift in lifestyle preferences and the growing need for affordable housing, pitted against a burdensome regulatory environment, land shortages and increasing construction costs, will curtail market equilibrium over the medium term. This bodes well for multi-family investors as these factors support strong market fundamentals and performance stability moving forward. Accordingly, we expect multi-family real estate will continue to be an important contributor to a diversified commercial real estate investment portfolio.
Healthy growth in 2018, but 2019 headwinds are getting stronger
Despite a slowdown in the fourth quarter, the Canadian economy finished the year showing healthy economic growth, with the increase in 2018 GDP expected to be in the range of 2.0% to 2.1%. However, decelerating household spending, persistently low oil prices, weak global trade and ongoing geopolitical uncertainties are weighing down the Canadian economic outlook, with 2019 growth forecast to be in the range of 1.7% to 1.9%.¹³
Household spending to come under pressure – While household spending has played an outsized role in economic growth over the past few years, a combination of weak wage growth, rising interest rates, high household debt and slower home price appreciation are all expected to temper growth in 2019. The Canadian economy added 163,300 jobs in 2018, a significant decline from the employment gains of 427,300 made a year earlier. The reduced employment gains are largely due to narrower workforce availability, with unemployment at a record low rate of 5.6%.¹⁴ Yet despite tight labour markets, wage growth has not increased and remains below the rate of inflation. Also, increasing interest rates will likely put a dent in household income and household discretionary spending. The wealth effect of a softer housing market and declines in the equity markets will be a further drag on household spending.
Non-energy investment and trade, the bright spot in the economy – Canadian business investment and trade in the non-energy sector is well positioned for stronger growth. Completion of the United States-Mexico-Canada Agreement (USMCA) has considerably reduced uncertainty for most businesses. Continuing US economic strength, particularly in industrial production, is fully supportive of stronger non-energy exports, which are also expected to benefit from a low Canadian dollar. This low-dollar environment will most likely prevail in the near term given interest rate differences and depressed oil prices.¹⁵ Even though recent data on business investment has been somewhat disappointing, the current environment is still supportive of increased activity. The Bank of Canada’s fourth quarter Business Outlook Survey shows a balance of increased investment, with 46% of firms expected to invest more compared to 21% expected to invest less in 2019.¹⁶
External risks becoming more pronounced – While rising interest rates and softer housing markets remain the primary downside risk factors for the Canadian economy, a global economic slowdown on the horizon is raising red flags. Ongoing trade tensions between the US and China, slower global growth, geopolitical uncertainties (e.g., Brexit), tighter financial markets, declining business confidence and the potential for a fiscal cliff in 2020 derailing US growth are all critical risk factors to monitor going forward.
Real estate market Q4 review and outlook¹⁷
Canada is almost certain to set a third consecutive quarterly record for investment volume in 2018: after a record-setting first half, investment in Canadian commercial real estate continued its pace in the third quarter with acquisition volumes totaling $11.9 billion. Total acquisitions for the first three quarters stood at $38.7 billion and, at that rate, full-year Canadian commercial real estate investment volume should approach the $50 billion mark for the first time. Major deals closing in the fourth quarter included: Queen’s Quay Terminal (office) in Toronto, which sold for $261 million; 1340-1360 Danforth Road (multi-family) in Toronto, which sold for $155 million; and Sun Life Plaza (office) in Calgary, which sold for $225 million. Investor appetite for industrial and multi-family assets has driven up investment volumes in 2018, with each of the assets benefiting from solid fundamentals and favorable overarching market dynamics. Overall, strong demand, healthy fundamentals and a fairly stable economic and political landscape all suggest a bright investment outlook for the sector going forward in 2019.
The office market concluded the year on a high note as the overall vacancy rate compressed for the third consecutive quarter by 50 basis points (bps) to 11.9%, the lowest national vacancy rate in 13 quarters. Occupier demand continues to be fueled by maturing and new tech tenants, who comprise 22.7% of all tenants in the office market. There has been a significant concentration of tech firms targeting Toronto and Vancouver recently, with both cities recognized internationally for their tech capabilities. They are also able to offer well-established community support as well as easy access to high-quality tech talent. Favorable immigration policies and business incentives will help Canada retain its competitive position globally, which will further strengthen market fundamentals. Rising investor confidence, bolstered by robust tenant demand, with 7.1 million square feet (SF) of net absorption in 2018, has pushed the development pipeline to expand by 27.1% year-over-year to 14.2 million SF. As workplace requirements continue to evolve, new supply coming to the market will focus on creating unique experiences to attract and retain world-class tenants.
Industrial market fundamentals in Canada remained strong in 2018 as the country ended the year with a record low availability rate of 3.2% and a record high national average net rental rate of $7.72 per SF. Overall, year-end absorption totaled 31.6 million SF, far surpassing the new supply of 15.4 million SF. This marked the third consecutive year in which new construction has lagged demand at the national level. Historically, demand for industrial space highly correlates with the overall macroeconomic performance of the country – as the greater economy went, so too went the industrial sector. Over the past few years, however, this relationship has begun to shift, with industrial demand appearing to outstrip the greater economy. This relationship is complex and significant factors driving this recent disconnect have been the rise of ecommerce and the evolution of supply chains. While ecommerce penetration has made significant advances as of late, there remains significant room for additional industrial sector growth since the ecommerce adoption rate in Canada still lags other large markets such as the US and the UK. As consumer preferences shift and retailers and distributors increase their omnichannel operations across the country, the industrial sector will be increasingly driven by growth in demand for logistics, warehousing, and transportation space. These uses in fact accounted for 76.7% of the national industrial demand and this trend shows no sign of reverting to historical norms in the foreseeable future.
Following the shuttering of the remaining Sears Canada locations in early January, retail turnover remained at the forefront of discussion in 2018 with seven retailers announcing their exit from the Canadian marketplace. These brands are from across all retail categories and totaled an estimated 880,900 SF of retail space, predominantly located within regional shopping malls. The list includes Town Shoes and Fluid Brands, parent company to home furnishing stores Bowring and Bombay & Co. Miniso also made news in December when its parent company filed for bankruptcy; however, they have since reached an interim agreement with the Canadian franchise to remain open. The Asian discount retailer first opened in 2 017 with plans to operate 500 stores across Canada, but is now anticipated to be significantly scaled back. A similar litany of closures followed the sudden departure of Target in 2015, with over 2.5 million SF of turnover, excluding Target. Overall, the retail sector showed weaker performance in 2018, with consumer confidence dropping seven times in 12 months and softer year-to-date core retail sales growth of 2.5% as of October 2018 – down from 5.1% for the same period last year. On a positive note, Canada welcomed 43 international brands to the market in 2018, on par with the five-year average.
The Canadian multi-family market remained tight in 2018 as demand continued to outpace supply, precipitating a national vacancy rate drop of 50 basis points to 2.4%. Key to the tightening of the national market vacancy rate were the compressions noted in Calgary and Edmonton, with these cities beginning to trend back down towards pre-energy recession levels. Vancouver and Toronto remain the tightest purpose-built rental markets in Canada despite recent slight upticks in vacancy to 1.0% in Vancouver and 1.1% in Toronto. Turnover has also slowed across the country, further highlighting the highly competitive market conditions. Ontario in particular has seen a dramatic reduction in turnover, likely due to recently expanded rent control regulations. All of these factors contributed to average rents increasing across the country, driving the national average monthly rent up by 1.8% in 2018 to $1,125. As affordability becomes more and more a pressing issue, additional purpose-built development is needed to alleviate the pressure on current demand. However, rising land prices have forced purpose-built developers out of the downtown core in most major cities. Purpose-built developers have thus begun to turn toward intensification opportunities on existing holdings as this allows them to add supply without the upfront cost of new land.
1 Based on net rent series, starting in 2000. Source: CBRE, as of Q3 2018. 2 Return per unit of risk calculated as average annual return divided by standard deviation of annual returns. Source: Manulife Real Estate. 3 The World Bank, Ease of doing business index, as of December 2018. 4 The Impact of Land-Use Regulation on Housing Supply in Canada, Fraser Institute, July 2016. 5 CMHC, as of Q3 2018. 6 Statistics Canada, as of Q3 2018. 7 Statistics Canada, Average annual population growth rate among G20 and G7 countries, 2011 to 2016. 8 Conference Board of Canada, Winter 2019. 9 Statistics Canada, Census of Population, 2016. 10 Statistics Canada, Census of Population, 1951 to 2016, and National Household Survey. 11 RBC Economics, “Canadian housing affordability at worst level in nearly 30 years”, as of September 2018. 12 The RBC Housing Affordability Index Measures show the proportion of median pre-tax household income that would be required to service the cost of mortgage payments (principal and interest), property taxes, and utilities based on the median market price. 13 Range of GDP forecast based on published data by RBC, CIBC, BMO, TD Bank, Scotiabank, and the Conference Board of Canada, as of December 2018. 14 Source: Statistics Canada, as of January 4, 2019. 15 RBC Economics, as of Q4 2018. 16 Bank of Canada Business Outlook Survey, Winter 2018. 17 CBRE Research, Q4 2018.
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