Canada's prudent approach has helped it weather the downturn better than its southern neighbour and makes it a good fit for current investor sentiment. But it is not immune to surprises, as Stephanie Schwartz-Driver reports

In terms of fundamentals, Canada looks good, especially in contrast to more turbulent world markets. Although there is rising unemployment and a strong Canadian dollar, it seems likely that economic fundamentals may deteriorate somewhat for the next two years or so. Balancing that, however, is the strength and stability of the Canadian banking system, as well as the overall stability of the currency. In addition, as Canada is a commodities-based economy, it will benefit from growth in China and India.

Stability has been a defining characteristic of Canada's real estate market. To a large extent, it is defined by the stable ownership provided by the country's domestic investors - the pension funds. The large institutional investors control most of the trophy properties in Canada, both the prominent city-centre office buildings and the major regional malls. Their buy-and-hold strategies mean these properties rarely come to the market.

Although many of the pension funds have an overallocation to real estate now, especially to domestic real estate, this is unlikely to bring product to the market. "The pension funds are not going to sell into a down market," says Frank Magliocco, partner at PricewaterhouseCoopers (PwC). "Either they will go to the board and get temporary relief, or they will just reconfigure their allocations."

The Canadian banks have also added to this stable footing by controlling and limiting lending. By avoiding the excessive lending that prepared the ground for the US credit crisis, Canadian banks have remained well capitalised. In the wake of the economic crisis, however, they have also become more stringent in their lending policies. They tend to favour existing relationships but have strengthened covenants. In addition, they are holding back from lending to developers.

The banking system's pragmatic approach combines well with prevailing investor sentiment. "We do not have a high risk-taking culture, and even if we wanted one, the banking system would not let us," says Peter Doering, senior vice-president with Northam Realty Advisors, a firm focusing on real estate advisory and real estate private equity funds headquartered in Toronto.

The banks' stringent lending policies have kept a lid on the market. Loan-to-value ratios of 50-60% are normal in Canada. "There was not one commercial office project that received financing without being 50% pre-leased," says Doering. "Even on residential condominium developments, the construction lenders kept tabs. For example, lenders were looking for 55-60% presales, and towards the peak in 2007, lenders became wary and were looking for 85% pre-sold."

As a result, Canada does not have to work through overcapacity or overbuilding. Vacancy rates are around half of what is found in the US.

There is cash waiting in the wings in Canada - the REITs in particular are flush these days, having raised cash on the equity markets in anticipation of reaching the market bottom - but acquisitions are few and far between because stable owners are not bringing properties to the market. According to Magliocco, the REITs have raised more than C$2bn (€1.2bn), and much of this capital is sitting on the sidelines.

Throughout most of 2009, volume of activity has been way down in Canada, just as it has been in the US. Total transaction volume for 2009 amounted to just over US$42bn (€28bn) for the first three quarters of 2009, according to Real Capital Analytics. This is more than 80% down on the previous year.

However, there has been some surprising activity in the market towards the end of 2009. Confounding everyone's expectations, starting in September, there were three deals worth more than C$100m: a Vancouver apartment portfolio, and two in Toronto, one a downtown building and one residential land. These deals will serve as something of a barometer, setting pricing expectations in the new market environment.

"We have seen a bottoming across Canada between the first and second quarter of this year," says George Carras, president of RealNet Canada, a firm that tracks investment and development markets, "There was a noticeable recovery in the third quarter, and we will see a strong fourth quarter, due to a number of transactions that have closed or are in the pipeline.

Magliocco says: "There were hardly any transactions last year, and when there were, there were only one or two bidders. Now we're seeing seven or eight bidders in there." Magliocco is not sure what has inspired the change in market sentiment. "It was not anything magical - but it is a good sign."

Carras believes that investors are transacting again because they have more confidence in the market. "At the beginning of the year, there was an anticipation that there would be a lot of distress, but this has not materialised," he explains. "We track trades daily and distress makes up no more today than before - only around 4%." He added that none of the trades that have taken place in recent months were distress deals.

In Carras's view, investors were waiting to see what would happen, whether the forecasted distress would materialise in Canada. When it did not, and investors saw that the market was, relatively speaking, not that volatile, they began to spend the cash they had been sitting on.

This delay also gave investors a chance to get used to a new pricing equilibrium and new spreads: what once would have been 200 basis points is now more like 400 basis points. However, says Carras: "Pricing has not moved that much: Canadian investment is for those investors seeking security."

"We have always been a stable market," says Doreing. "If you want to make a big score and take more risk, you are better in the US." PwC's Magliocco agrees: "If you are looking for opportunistic, maximum valued-added deals, you have to look outside of Canada."

Foreign investors who look at Canada are attracted to core properties, for their stability - largely well-leased, good-quality office, retail, and residential in good locations. There was quite a bit of international activity in Canada leading up to 2007, and foreign investors are again testing the market.

Martin Pepin, a portfolio manager with Presima, a portfolio management company that specialises in real estate securities publicly traded on international exchanges, points out that US investors have been looking at Calgary recently, and there has been interest from Asia, particularly in Canada's west coast, in areas related to oil and gas.

German buyers are well acquainted with the Canadian market. For example, the DekaBank Group notably acquired the Bentall V, a high-profile class-A commercial and office building in Vancouver, this summer for around C$30m; the building was sold by SITQ, the real estate subsidiary of Caisse de Dépôt et Placement du Québec. "Over time, I do not think they will have any regrets after this acquisition," notes Doering.
"The best deal in Canada today is a newish building, with a 15-year federal lease," says Doering, who recommends looking at deals with minimal lease rollover in the next 48-60 months in the Toronto or Calgary markets.

Foreign interest in Canadian real estate will be good news to domestic institutional investors. Many of the largest Canadian pension funds have only been investing abroad for the past five to 10 years or so. "Most of the larger Canadian pension funds are almost over-invested in Canadian real estate," says Doering. "The top five are looking to lighten up on domestic in order to diversify. As vendors, it is possible that the pension funds would like to see more foreign investors take an interest in Canadian real estate."

Canadian investors traditionally keep a close eye on the US. The US real estate market tends to hit its bottoms and peaks first, although, noted Doering, this time the timing of the peak was closer than usual.

As recently as July, when the PwC/Urban Land Institute survey was conducted for the Emerging Trends 2010 report, Canadian respondents were not looking ahead to anything exciting. The report forecasts "a relatively stable transaction market, slightly better for buyers than for sellers". Average cap rates are expected to increase only modestly by the end of 2010. Downtown office and power centres are expected to see the highest increases: power centres are expected to rise by 50 basis points to 8.37% and downtown office by 44 basis points to 7.5%. Hotels are expected to top 9%.

Values are expected to increase by the end of 2010, according to the survey, but losses and gains are not evenly distributed. While hotels and secondary retail have fallen the most - by as much as 30% - Toronto office properties are down only 10% from the peak.
Values in many of Canada's geographical markets benefit from barriers to entry. In suburban markets, these take the form of bureaucratic obstacles - there are a few more rules and regulations in the way of development approvals. In some of the urban markets, Vancouver and Toronto, the barriers are geographic limitations, naturally occurring in Vancouver and as a result of greenbelt legislation in Toronto.

"Vancouver is like New York City: there is a completely different dynamic there," says Pepin. "People love to be in Vancouver, but I think there is not a lot of value to be made there." The market always trades high, with cap rates lower than in other major cities. The 2010 Winter Olympics is creating a major buzz but this may not result in lasting value as such events did in other major host cities.

Currently office space in Vancouver is tight - the vacancy rate stands at around only 4% in this geographically constrained city, and its downtown is only around half the size of Montreal's and less than a quarter the size of Toronto's. However, few large companies are based there.

With the exception of Vancouver, western Canada is experiencing a slowdown related to falling natural gas prices. This is despite the fact that having a commodities-based economy is an overall strength for Canada in this stage of the cycle. Calgary is the city to look at for distressed sales, but Pepin "is not sure that there are a lot of opportunities there that make sense on the value perspective". Over the next 30 months or so, 74mft2 of property is coming online, much of this speculative building, and office vacancy rates will rise in the city to more than 20%. Residential in Calgary is also experiencing overbuilding.

Toronto is the other city in which significant space is coming to the market: around 4mft2 of new class-A office space is coming on stream in the next 24 months, raising the vacancy rates to around 16%, from their normal 5%.

Along with the entire province of Ontario, Toronto is feeling the effects of the down economy, especially because of its exposure to the auto sector and the greater role that manufacturing plays in the local economy. However, the city is still a major centre, and institutional investor owners of older class-A property will be able to ride it out as their tenants move to newer developments.

Montreal is also a tight market. "Residential is doing well, and there are not a lot of office vacancies," says Pepin. Like Quebec city, Montreal has found its equilibrium, and its stability keeps it off the investment radar.

So while individual markets hold promise, and no market seems set to collapse, full recovery is still some way out. "I believe that some of the large owners and investors are cautiously optimistic," says Magliocco. "The verdict is still out on the general economy. Will more manufacturers go bankrupt? Will retailers south of the border survive? These concerns are holding back a full recovery."