A great year for Canadian real estate

Author: Thomas von Hahn and Jim Hilton, Blake Cassels & Graydon, Toronto

2006 was a banner year for Canadian portfolio transactions. It seems that for large deals institutional investors were prepared to pay a premium. Fortress Investment Group paid $2.8 billion for Intrawest, Colony Capital and Saudi Prince Al-waleed bin Talal purchased Fairmont in a deal worth $3.3 billion. Summit Reit's industrial portfolio attracted a $2.1 billion buy-out deal by ING's Australian real estate arm and its Dutch parent company with the result that Summit Reit was taken private.

The market clearly favoured large transactions with assembled pools of assets being priced at a premium. Commentators state that such mergers predominate because portfolio combinations produce efficiencies and savings. Furthermore, regulations similar to the Sarbanes-Oxley laws have substantially increased the expense and the management time and exposure involved in accounting and regulatory filings for smaller Reits. The Reit privatization trend may be caused by the concern over the costs of compliance for public entities edging out the perceived tax benefits that Reits were said to represent.

If the American example is any indicator, it seems that investors will buy smaller Reits, take those Reits private, and where certain segments of the portfolio are mispriced, they will realize value by repackaging and marketing those segments. The public entity is broken up into smaller segments and those where the mispriced value is perceived can sometimes realize significant spreads over what had been paid.

Some experts suggest that the biggest reason Reits are being privatized is that there is so much capital available to purchase real estate today. Canada continues to benefit from more sources of capital flowing into real estate from around the world. It is fair to say that Reits and other established platforms are of particular interest to large capital funds as they provide a quick entry and an immediate critical mass when entering the Canadian market.

The Canadian housing market was strong in the first three-quarters of 2006. Calgary witnessed a dramatic increase in both housing prices and office rental rates. Construction activity was very strong in both sectors and Calgary's office, condominium, industrial and retail markets were all supported by high oil and gas prices. It is fair to say that elsewhere across the country the increase in house prices that had been witnessed in the last few years has slowed and slight declines in new home prices are being reported.

Perhaps the biggest change in the Toronto marketplace has been the commencement of the construction of three major office buildings in or around the downtown core. These buildings share a green building standard with innovative, flexible and user-friendly technologies to the highest environmental standards, including LEED certification. With new products coming online, existing Toronto Class-A office buildings may need to retool to continue to attract tenants with forward-looking employees who demand state of the art facilities.

The high demand for all traditional asset classes such as office, industrial, retail and multi-family residential has resulted in institutional capital being increasingly invested in less traditional asset classes such as seniors' housing, public storage, and hotel and hospitality ventures. While institutional investors are actively investing in more diverse asset classes, developers are taking advantage of the opportunity to realize value in their assembled portfolios and pipelines of the products they can offer. Canadian-based developers of industrial products, condominiums and mixed-use projects are finding international sources of funds which are willing to share development risk for some of the upside. The developers off-load some of the risk and financial exposure and focus on the fee revenue generated by managing the development and lease up process.

Interestingly, Canadian institutional investors are starting to become much more active in markets outside of Canada. Canadian pension funds and their advisors have been actively buying up property in Europe and South America and are pursuing opportunities in China.

An important continuing trend in the Canadian real estate marketplace has been the overwhelming acceptance of the public-private partnerships structure as a method for governments to finance new infrastructure (for example, for the 2010 Olympics taking place in Vancouver and Whistler) and to replace aging infrastructure across Canada. Ontario, Québec, British Columbia and Alberta provincial governments are active in this area, and are building bridges, roads, hospitals and other public facilities. It is notable that perceived Canadian strengths of political stability, transparency, easy-exit strategies, low currency risk and the availability of debt and local partners continue to attract both equity investors and debt financers from around the world. The infrastructure developments in Canada will be a lasting legacy for the country, and have involved some key players from Australia, the United States, the UK and the rest of Europe.

As in other major markets, capitalization rates have been further compressed with the result that the spread between interest rates and capitalization rates is being reduced on an ongoing basis. Due to the overwhelming abundance of capital in the Canadian marketplace, the seller's advantage is more pronounced than ever. Auction sales are the norm, with multiple bidders stretching to find value or value-add opportunities in all asset classes.