Without Cap Rate Compression, These CRE Fundamentals Must Drive Returns, Say Global Investors

Peter Ballon, global head of real estate at CPP Investments, kicked off the global capital markets session at ULI’s Spring Meeting in Toronto by characterizing the current CRE climate as one marked by persistent inflation, rising interest rates, rising capitalization rates, bank failures and a potential recession.

Despite these intense headwinds, the five panelists were sober and pragmatic about current conditions. There was a general tone of acceptance that interest rate hikes have caused real estate prices to fall and that owners/investors must come to terms with the fact that they need to navigate the transition toward higher capitalization rates. They discussed a variety of additional topics, including the changing office sector, the appeal of gateway cities and risks associated with buildings that are not adapting to climate change.

Dennis Lopez, CEO of QuadReal Property Group, summed up the transition in the context of industrial assets. During the pandemic, cap rates got pushed down to levels that were not realistic. “We've had a cost of capital adjustment, so if you were in the mid- to high-threes, and now you're in the mid- to high-fours or a little bit higher, an additional hundred basis points on a basis of three-and-a-half or four is a lot of money to lose. So that's really the transition owners are in right now,” he said.

In the U.K., Lopez said that cap rate increases last year “really whacked everybody on industrial valuations,” adding that the effects were a bit less severe in the U.S., and even less so in Canada.

“The best part about [industrial assets] though, is that the fundamentals are pretty good; in fact, they're very good,” Lopez said. He added that projected rental growth rates are expected to be between 3% and 5% over the next three to five years, “so [there is] pain right now, but the fundamentals look really good.”

“People do compare the office today with retail a few years ago, and it's a good analogy in some ways, in particular as it relates to the reaction of the capital markets,” noted Lars Huber, CEO for Hines’ European Region. There will be winners and losers in office “and the capital markets will sort that out. But I do think office has been painted with a broad brush over the last few years.”

In Europe, Huber noted that after the global financial crisis, there was more planning, moderate leverage and a bit more caution than there was in North America, so the supply of office is much more limited. “The demand for office is actually strong as it relates to Grade A. Grade B is suffering and net absorption is down, but for Grade A it is absolutely up.”

Huber echoed what others at the ULI meeting had said about office assets, namely that desirable office projects were no longer about just the right location; the building itself needs to be just right. Huber cited energy efficiency as a big differentiator that he views as very important. In Europe, he said Hines is putting more focus on that today, and they are also concentrating on operations, human centricity, services, amenities and technology.

Huber emphasized that focusing on fundamentals at this point in the cycle is critical. “It's so important to focus on income growth because you can no longer rely on cap rate compression and have leverage drive your returns. Therefore, all the operator-lead models that focus on what tenants really need and want are what’s going to make the difference. And those who are better positioned there will be able to have higher value growth. With all of that, I do think there's a future for office.”

Talking about investor sentiment, Nathalie Palladitcheff, president and CEO at Ivanhoé Cambridge said, “it's a lot about emotion here in North America. Office is the word you can't pronounce, like Voldemort with Harry Potter.” Palladitcheff added that it's not the same in Europe and Asia. Everybody there talks about offices as a major asset class and there is acceptance that there are cyclical changes, “and probably structural changes as well, especially with ESG.”

In North America, Palladitcheff continued, “we should let go of this emotion and really deal with what is beyond that,” which in her view means redefining what location means. “A good location today is far different from what it used to be,” she said, and determining what “quality” means is also a challenge.

Rather than saying office is oversupplied, “I'd say office is under demanded and it kind of gets you to a similar place, which is that we have more inventory than we have demand for,” said Amy Price, president of BentallGreenOak (BGO). Key questions for investors relate to how long this will last and what should be done about it. “A top asset will do well if it is modern, well located and on a path to decarbonization,” Price added.

Price said that while there is clarity in the retail sector about what top assets are, it’s trickier with office. “It's really not quality as much as newness, which is what people want right now. So as an investor, it's new now, but will it still be new in five or seven years?”

Session moderator Ballon noted that in the past, investments in gateways cities were considered low risk and the belief was to never bet against big cities. “Is that still the case?” he asked the panelists.

“You don't want to count these cities out, particularly places like New York and San Francisco,” Lopez said, adding that they are great cities, but problems there will persist for a while. “They're in jurisdictions with higher taxes and the departure of people from these jurisdictions to lower tax places is not just a headline. It's been happening big time and it's had huge impact,” on the cities people are leaving as well as the ones they are going to.

His company is looking beyond cities and focusing on micro locations within cities. “Some of the data capabilities now allow you to go through vast amounts of data and pick out spots. It could be a moderate-growth city that is a great investment, or it could be in a high-growth city that's not a good investment.” But he added that at the moment, QuadReal is generally staying away from gateway cities.

“The movement away from the gateway city, particularly in the U.S. context of the Sunbelt, is about people moving from Chicago, Los Angeles or New York in search of more affordable costs of living,” said Gary Berman, president and CEO at Tricon Residential. As an investor, “it’s all about that marginal dollar. Where’s the trend? If you have that marginal household per person moving to the Sunbelt, that’s where the liquidity is.”

Regarding office, Berman said that in Sunbelt cities, “you can work remotely, and you can have a better standard of living.” He cautioned however that “we have to be careful with that because if you can do that, then one day I think you could also” offshore those jobs and then one day AI can do them.

Berman added, “I think Toronto is very lucky that there aren't alternatives in Canada to the same extent, because in the U.S. there are 50 [metro areas], let's say, with more than a million people. In Canada, there's only a handful, so many of the jobs are in cities like Toronto.”

As a European, Huber said that what’s happening in large U.S. cities “sounds pretty alarming to me,” and that “in Europe, we don't see that shift away from the gateway cities at all.” He believes this has to do with “the fact that there has always been a broad range of cities that have been attractive beyond just Paris and London.”

Speaking of Copenhagen or Amsterdam, Huber said that while those cities were already very attractive, they have transformed over the last 10 years so more people want to live and work there. “They are where talent can be found, where educational offerings are and where opportunities are, frankly.”

Huber added, “I think the European cities, in particular the inner cities, have done more to make these places attractive over the last decade or two than stateside.”

Centralized decision-making, much of it relating to transportation funding, also plays a role according to Palladitcheff and Berman. Europe's transportation infrastructure is the big difference, compared to North America, Berman said. He also mentioned cities — like Copenhagen — with a well-established bike network. “They've tried to do that in Toronto,” Berman said, “but it doesn't work as well.”

Those European cities are “commutable and they're easy to get to. The problem in the U.S. — and Toronto to a certain extent — is you don't have that transportation infrastructure,” Berman said. And this has added to the deficit in office usage. If a person can walk to their office in 20 minutes, they will likely work there, he added, “but what happens if I have an hour-and-a-half commute?”

Ballon asked the panelists “through the lens of an investor, what are you seeing in Europe, Asia, India or wherever you invest, that are trends coming [to North America], not going the other way?”

“In Europe, it's hard to have a conference where after five minutes you're not talking about ESG or climate changes,” Lopez said, “but that is not the case in the U.S.” He noted that Miami is booming with buildings under construction right on the water. “But if you Google FEMA to see what southern Florida will look like in 2050, all those buildings are underwater. So, you kind of wonder, what's going on? Who's putting that money up?”

Lopez added that for his company, it's not just flood concerns — it's also the risk of fire to buildings in some areas. Climate impacts “don’t seem to have registered as much here in North America,” or more specifically in the U.S. He said his firm’s investment memos require a sign off on environmental impacts so “we think about it all the time.”

“ESG, for me, is major,” especially as it relates to mispricing, Palladitcheff said. “I'm afraid that the wakeup call is going to be very brutal in the U.S. when we realize that so much is obsolete.” He further noted that Europe has already begun to upgrade its inventory and “the U.S. is going to have to catch up.”

“In the U.S., I look at the whole trend toward decarbonization as an opportunity,” Price said. Right now, she said building owners in the U.S. are being forced to think about this because regulation is coming and they hear what’s being done in Europe. “But it's not yet integrated into the being of groups like investors, owners and city planners,” she added.

“Tenants care more than they used to,” and they generate the revenue in buildings, Price said. “There's just no question, directionally, that tenants are going to care more, not less; certainly, the large tenants that we all want to occupy our buildings.”

“And number two, capital cares,” Price said, distinguishing that global capital cares about sustainability more than U.S. capital right now. “So, I think the opportunity is to figure out how to engage your tenants, figure out what they want and also partner with your capital to figure out what's important to them."