City Focus, Toronto: Cranes on the skyline

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Toronto, Canada

The city is undergoing a glut of new development, but do the cranes on Toronto’s skyline reflect an opportunity or portend the start of a bubble? Stephanie Schwartz-Driver and Chris O’Dea report.

Nobody knows quite how many construction cranes are rising over the city of Toronto – most estimates place it at around 180 – but they are a clear and very visible indication of the building boom that is transforming the city.

The city’s condominium boom is now well into another year, and major developers are readying more big projects even as the market prepares to digest a record-high supply of new condo units. “There are probably more cranes in Toronto than anywhere except shanghai,” says Sal Guatieri, senior economist at BMO Capital Markets.

To Nouriel Roubini, the economist who predicted the sub-prime crisis, that makes Toronto’s condo market one of a number of residential markets in the world that is looking frothy right now – if it has not already passed into bubble territory.

But a survey of Toronto’s condo market indicates that the asset class is more likely undergoing what equity investors would call multiple expansion, with strong fundamentals in the rental and secondary condo markets, rigor- ous operating discipline among developers and banks, and demographic and cultural factors that differentiate Toronto from other markets where residential real estate prices have been skyrocketing.

Some of Canada’s largest pension funds already have a toe in the water, and Toronto developers report interest in residential projects from US funds in New York, Illinois and California. At least one Canadian pension plan has been moving fast to tap the luxury spending that can follow upscale urban development, bringing a top-tier US retailer to Canada for the first time in a strategy to upgrade key shopping centres with tenants that can pay higher rents.

“In the past decade, developers, investors and city officials have completely revamped the central city, and it works,” says Barry Fenton, president and CEO of Lanterra Developments. Lanterra has built nearly 9,000 condo units since its founding 10 years ago, including properties in partnership with Cadillac Fairview, the wholly-owned real estate subsidiary of Ontario Teachers’ Pension Plan. Lanterra is currently completing ICE Condominiums at York Centre, a project with Cadillac Fairview of 1,343 condos in two distinctively scandinavian residential towers of 67 and 57 storeys adjacent to a 31-storey office tower. The complex, slated for occupancy later this year, will use Toronto’s covered pedestrian walkway system to connect to Maple Leaf square, a 2011 Lanterra-Cadillac Fairview project including residential and office towers, a hotel, and retail space.

The website for ICE shows a pair of condo towers emblazoned with words that are music to the ears of developers and pension fund investors: ‘sold out’. The ability of developers to sell most units during construction has supported Toronto’s condo market; but concerns are rising because many units started two to three years ago will be delivered in 2014 and 2015. Guatieri says nearly 60,000 condos are under construction, substantially more than the 10-year average of 37,000 in the pipeline. Developers expect about 20,000 units to be completed this year. That’s above the 10-year average of 18,300 units sold annually, says Guatieri, and well ahead of the 16,000 new condos sold in 2013.

While the new-condo market is showing some softening – Guatieri expects new condo prices could slip about 2% in 2014 – the market for rental apartments and secondary condo sales remained firm in 2013, which is bolstering the residential market. Rental vacancy rates have run between 1.2% in 2012 to 1.8% in late 2013, he says, while the median sale price of a condo in the secondary market actually hit a record of CAD302,000 (€200,000 ) in 2013, a 3.8% gain for the year. With the condo listing-to-sales ratio in line with its 10-year average, he adds, it’s clear that units are being held by owners or investors, not flipped for quick gains.

Some say the rising supply augurs tougher times. “We’re in the early phase of a prolonged correction in the condominium market,” says David Madani, Canadian economist at Capital economics in Toronto. After rising steadily from 2008 to 2011, new condo sales in Toronto have “slumped”, says Madani, and, “despite low interest rates, prospective condo investors remain wary of squeezed net-rental yields and fears of overbuilding.” Capital Economics predicts that a multi-year decline in housing starts across Canada will slow a national economy already sputtering from the collapse of the global commodity boom. US shale energy production has depressed oil prices, hitting results at Canadian producers and reducing demand for energy-related capital goods.

Toronto’s condo boom reflects a city scrambling to close a housing gap. no purpose-built rental housing was constructed in the Toronto region in the past 35 years, and government ‘greenbelt’ restrictions a decade ago dramatically slowed the construction of new single-family and townhouse units. That left Toronto short of housing just as it became a global city. For the past decade, between 80,000 and 100,000 people have moved to the Toronto area, the vast majority from outside of Canada, says Riz Dhanji, vice-president of sales and marketing for Canderel Residential. New residents from China, the Middle East, India and Russia have made Toronto a melting pot. Many are “buy- ing for the future,” he says. A downtown condo affords access to Toronto’s excellent schools and universities, as well as the city’s cosmopolitan cultural scene.

One big factor in Toronto’s rise, says Dhanji, is that it has become a world-class financial centre. The Toronto Financial Services Alliance, founded in 2001, co-ordinates government, industry and academic resources to build the financial sector. Toronto is home to pension funds that rank among the world’s most sophisticated investors, and Toronto’s banks have set up shop in the US or taken over US institutions. The alternatives industry is growing too. Numerous hedge funds have opened in the past few years, and new rules that some call ‘Canadian UCITs’ will enable managers to offer alternative strategies to retail mutual fund investors, a change that could double the country’s hedge fund asset base to CAD60bn.

“One in five Canadians works in the greater Toronto area, and city accounts for 20% of Canadian GDP – that is how significant it is,” says Paul Zemla, CIO of Bentall Kennedy’s Canadian operations.

The growth reflects the credentials of many new immigrants. “The high concentration of CFA charterholders – the highest per capita globally, with over 8,000 – makes Toronto a natural spot to locate a fund or service provider,” says James Burron, COO of the Alternative investment Management Association of Canada.

Immigration has changed the demographics and primary preference of residential buyers, says James Ritchie, senior vice-president of sales and marketing at Tridel, Canada’s leading condo developer. Many new residents are young, often single or recently married, and “they happen to like living in condos”, he says. Tridel began building condos in 1968, and has more than 20 new condo projects under way in the greater Toronto Area. Ritchie notes that, after 10 years of consistent growth, the Toronto condo market cannot be called a boom. Condo projects are being built across the entire metropolitan area, and while sales at lower prices in suburban areas can reduce reported average prices for new condos overall, that does not reveal weakness in the central city developments. “There are sub-markets, and they present different opportunities,” he says.

This construction is meeting a backlog in demand for rental accommodation, according to Ugo Bizzarri, founding managing director, portfolio management and investments at Timbercreek Asset Management, who points out that few apartments have been built over the past 40 years. At the same time, “we are adding almost a million people every 10 years, and among newcomers to Toronto around 80% have a preference for renting”.

For institutions that want to participate in the rental boom, says Bizzarri, “the opportunity is finding the local market that is getting gentrified and making an investment to create core. Our goal is to find opportunities to create value, not to buy core.” He gives an example of a multi-family property that Timbercreek acquired from an individual owner in a location that was being gentrified; his firm invested and rebranded the building.

“You need to be a local market player, and know the location,” Bizzarri says. “The boom is not that broad-based – it is not a rising tide that is lifting all boats.”

And he is not the only person to be concerned. “It seems like they might be building too much,” says Chris Langstaff, senior vice-president, research and strategy at Lasalle Investment Management. “There are concerns about pricing, because Canada never experienced a housing slump and prices are at an all-time high.”

The slowdown in Canada has pushed the Canadian dollar to a discount of about 10% to the US dollar, creating an attractive cushion and entry point for major Us institutional investors that are scouting residential construction opportunities, says Fenton. What is more, Canadian banks will not give developers conventional construction loan facilities unless they can demonstrate that a substantial portion of the units – typically 70% – has been sold under binding purchase agreements, says Ritchie. Barring that, developers would need to put more equity into projects.

Those features of Toronto’s condo market “put safety into the system”, says Fenton. “Building in Canada is substantially different than building in Miami or New York.” Financial safety margins are reinforced by local pension funds. At Cadillac Fairview, for example, “they have a lot of discipline in place,” he says. Fenton believes the inability of mid-tier builders to obtain construction funding means as many as one-third of the developers that were active several years ago will not be involved in the next phase of Toronto’s growth, reducing the total supply of new units in the next several years.

As for those condos – do not expect a slowdown. Fenton is buying sites and working on zoning for projects that will include construction of about 7,000 more new units within the next few years. While voices of concern will remain, “I’m of the firm belief that over the next three years, we’re going to have a 30% increase, not a 10% decrease.” Without a hint of doubt, he adds “i’m going to be right about it.”

Commercial sectors

One opportunity that typically appears when a city becomes a global destination is increased consumer spending at higher quality retail stores. Seeking to capitalise on the robust economics of Toronto’s condo-dwelling immigrants, Cadillac Fairview has partnered with Seattle-based Nordstrom to bring the top-tier US retailer into shopping centres the fund owns, including the landmark Eaton Centre in central Toronto. Nordstrom is replacing Sears, the iconic mass-market retailer that’s been struggling in the US and Canada. In 2013 Sears sold leases on four large sites in Canadian cities back to Cadillac Fairview, including the Eaton Centre site, where Toronto media reported that Sears was said to be paying an inherited long-term lease rate of just one Canadian dollar per square foot. Cadillac Fairview did not return calls requesting comment for this article. Cadillac Fairview in January doubled down on luxury retail, paying $650m to iconic Canadian retailer Hudson’s Bay for two properties in downtown Toronto; Hudson’s Bay owns US luxury retailer Saks Fifth Avenue, making Cadillac Fairview landlord to the two key players in the sector as they enter the Toronto market.

And while the condo boom is not directly creating opportunities for institutional investors, it is progressing hand-in-hand with a trend among office tenants to move back downtown.

Overall, office development is in the middle of a building boom. Nationally, about 4% of inventory was under construction in mid-2013, according to PwC’s ‘Emerging Trends in Real Estate 2014’ report; this is about four times the level in the US. in Toronto specifically, about 5.9m sqft of new office space is due to be delivered by the end of 2016.

“This is in part driven by companies looking to consolidate and centralise,” says Langstaff. “Toronto was traditionally a low-density city, but now it is intensifying around transit hubs.”

This is the second wave of office development, Zemla says. “Around 5m sqft came onstream in the mid-to-late-2000s, and it was all absorbed post-2008,” he says, in part because, bucking an international trend, the Canadian banking sector expanded post-2008. of the 5.9m sqft due to come on the market within the next few years, around 50% is pre-leased.

Blair McCreadie, head of Canadian real estate for Standard Life Investments, has some concerns about the amount of building in the downtown core. “There are headwinds in the office sector in Toronto. Roughly, it is a 35m sqft [market], and 5m sqft [of space is] being built. This will have some impact on rental rates and occupancy.”

One concern is how the city will handle its backfill capacity and how older buildings will reposition themselves in a context in which the class-A vacancy rate is only 4.6%, a signifi- cantly different vacancy rate compared to US cities. “We operate at a different level than the US,” says Zemla. “It is a much tighter market.”

We are not recommending core class-A office,” says Langstaff. “We think a new supply bubble is happening, with greater than usual new capacity coming into the market at a time when absorption over the last year has slowed to nothing.” Much of the new supply is LEED certified and designed with sustainability in mind, attractive to new office tenants.

Langstaff sees opportunity in repositioning backfill properties in neighbourhoods he classi- fies as “fringe CBD, on the edge of downtown”. These “brick-and-beam buildings, 100-year- old warehouses or low-rise office buildings of around seven storeys can be repositioned to offer the kind of funky, open-concept space that appeals to millennial workers,” he notes, to professional services firms, financial back- office operations, as well as to tech and media companies. He points to a recent value-added project in Toronto, a class-A office property on the fringe of the CBD that had languished for years. With repositioning after acquisition, it has done very well, he reports.

“For higher return investors, fringe CBD office benefits from higher vacancy rates and stronger demand,” he adds. Some parties are concerned about the rapid pace of development. “It sounds great to put development where transit is, but when does the city get to the point where it doesn’t function any more?” asks Zemla, noting that infrastructure is falling behind growth.

“Toronto has the worst traffic problem in north America,” Bizzarri adds.

The future in CBD development is logically in mixed use. “We believe that mixed use is the next evolution in development in Canada,” says Zemla. “it is probably the most complicated type of development. it will not be easy, but our expectation is that they will be some of the best performing assets.”

Gaining northern exposure

Toronto, like the rest of Canada, is a challenging market for institutional investors to find a toehold. Langstaff points out that less than 2% of foreign institutional investment in Canada is direct, and the city is no exception.

The large Canadian institutions have sold some of their holdings in Toronto, especially after the downturn, as part of a move to diversify globally, but they did so in a very tactical way. “The Canadian pension funds sold to diversify, but at the same time they moved up the quality curve, in addition to freeing up some capital,” says Langstaff. “And when the pension funds did start selling, the real estate investment trusts were very aggressive in buying that up. There’s enough demand and depth in the local market.”

Zemla adds: “Toronto is where most foreign investors start. Foreign investment is evident but has been limited. It is quite competitive to enter the market. Most of the foreign entrants that have been successful have worked with pension funds or local advisers buy buying from them or partnering with them.”

Debt is another way to participate in Toronto’s real estate boom, says Andrew Jones, managing director, debt investments at Timbercreek. “When real estate starts to get expensive, a good way to access the yield is through debt, without the equity risk,” he says. The company focuses on mid-size loans, CAD5-10m, or shorter durations, from one to five years. “We are not really mezzanine lenders—a lot of what we do looks like bank-style lending.”

Bizzarri adds: “The Canadian institutional pension fund investors are debt-averse, but there are still a lot of borrowers who require some debt financing.”

And the institutional buyer profile is changing in Toronto just as the market is booming. ‘The pension funds are buying more outside Canada, but they are developing in Canada,” says Jones.

Blair McCreadie points out that the REITs are also playing a different role. “Until Ben Bernanke mentioned quantitative easing in 2013, we had a balanced, consistent market. Since then the REITS, which represented 80% of buyers, have now stepped back, amounting for only around 50%.”

This is positive for Standard Life Investments’ strategy: it is active in the CAD25-125m range “where there is still a formidable amount of assets,” says McCreadie. He notes even more opportunity in the space now that the reiTs are no longer dominating.

This means that there is not a lot of triple-A core office in standard Life investments’ Toronto portfolio, an investment profile that is tightly held by the large pension funds and some reiTs. instead, the firm looks to suburban office for opportunities, as well as nondiscretionary retail in the Toronto suburbs.

McCreadie takes a positive outlook on the Toronto suburbs. “There are three suburban nodes that we would consider for office in this market,” he says.

He takes a broader view on retail. While prime retail in the Toronto area is very tightly controlled, moving down a tier, investors will find a mix of private and institutional own- ership. “Where there is significant private ownership in retail, that is a great place to find opportunities,” he says. “We have been buying shopping centres in secondary markets, and we find that we get 100bps extra in return, and we can buy the best centre in the market.”

Lasalle also takes a positive view of suburban markets, with Langstaff calling it “a bit of a contrarian play”. The firm focuses on areas that are seeing improvement in mass transit, such as the new light rail system under development. “New modern space has not been built in the suburbs for quite some time, but quality matters there and it is important to focus on class-A office,” Langstaff says. “There are some opportunities in value-add, but you have to be careful.”

Toronto suburban office tends to attract a different tenant profile than CBD office, says Zemla, appealing to head offices of regional or foreign firms. As a result, “we expect that the recent stronger economic performance in the Us and in europe will bring improvements to the suburbs.” Suburban office benefited from significant growth in the mid-1990s to the mid-2000s, but flatlined after 2008 as international firms retrenched.

Multi-family development is also possible in the suburbs. “There is not as much condo devel- opment in the suburbs; there is strong demand along the transit corridors, and low vacancy rates,” says Langstaff. “The key is finding the land to build on.”

The industrial sector is also focused in the Toronto environs. “This is the sector most closely tied to domestic demand, and it has recently recovered very nicely,” says Zemla. “Industrial has been some of the best performing assets for us.”

Langstaff sees industrial as an opportunistic play. “With the Us recovering and Canada so dependent on the Us for trade, a recovering Us housing market will help Canadian manufacturing,” he says.

Toronto was traditionally a manufacturing hub and the centre of the Canadian automotive industry. “Over the last three or four years, Toronto struggled a little outside office and retail because manufacturing slowed down,” says McCreadie. “But the infrastructure is here and the factories are modern.”

He adds: “Alberta recently has been very strong, benefiting from its strength in natural resources, but add in the weakening Canadian dollar and we might be seeing the economy shift to the east for manufacturing. We are looking at some industrial in the greater Toronto area. We like that asset class.”