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Counsel Views – Episode 10: Michael Kitt

From skyscrapers to groundscrapers: A top-to-bottom look at today’s commercial real estate market, and key trends shaping its future

Counsel Views, hosted by Stu Morrow, Vice President and Head of Investments, RBC PH&N Investment Counsel, is an audio series aimed at bringing insights to clients from thought leaders and experts across Canada’s leading wealth management firm.

Episode guest: Michael Kitt, Head, Private Markets and Real Estate Equity Investments, RBC Global Asset Management

In this episode of Counsel Views, we welcome back our first-ever guest on Counsel Views, Michael Kitt, Head of Private Markets and Real Estate Equity Investments for RBC Global Asset Management (RBC GAM). With his uniquely broad and deep industry experience, Michael brings tremendous insights into today’s commercial real estate market, from retail to industrial, and from Canada to across the globe. Tune in to listen to this industry thought leader’s views on critically important developments affecting the outlook for this asset class, including the COVID-19 pandemic, the work-from-home trend, and the impact that rising inflation may have on various segments of the real estate market.

Michael leads RBC GAM’s initiative to develop, launch and manage a suite of real estate funds that are designed to meet the investment needs of both institutional and affluent investors. He brings more than 25 years of direct real estate investment experience to his role. Prior to joining RBC, Michael was CFO and Executive Vice President of Finance and Strategy for Oxford Properties. He also held senior positions at Cadillac Fairview Corporation and Ontario Teacher's Pension Plan Board, all related to commercial real estate investing in Canada, the United States and Europe. Michael has also served as trustee board member for two public REITs, Invest REIT and Choice REIT, and was a member of the audit committee and governance committee throughout both of his terms in both entities.

View transcript

Stu Morrow (Host):

Hello out there, and glad to be back in this side of the seat on Counsel Views. And I'm also happy to welcome back Michael Kitt, who is the Head of Private Markets and Real Estate Equity Investments at RBC Global Asset Management. He leads the firm's initiative to develop, launch and manage a suite of real estate funds that are designed to meet the investment needs of both institutional and affluent investors. He brings more than 25 years of direct real estate investment experience to his role. Prior to joining RBC, he was CFO and executive vice president of finance and strategy for Oxford Properties. He also held senior positions at Cadillac Fairview Corporation and Ontario Teacher's Pension Plan Board, all related to commercial real estate investing in Canada, the United States and Europe. Michael has also served as trustee board member for two public REITs, Invest REIT and Choice REIT, and was a member of the audit committee and governance committee throughout both of his terms in both entities.

Michael, thank you for joining us again on Counsel Views. How are you today?

Michael Kitt (Guest):

Yeah, fine Stu. Nice to speak to you again. Wish we were in person, but this will have to do for the time being.

Stu Morrow (Host):

That's true. I actually looked back to the archives and the last time you were here on Counsel Views was actually our inaugural Counsel Views recording. That was in July of 2020. So a lot's changed. I would argue for the better, in terms of the economy and the markets. But maybe if you want to just walk us through how core Canadian real estate has been performing over this period, maybe just relative to your expectations over that time.

Michael Kitt (Guest):

Yeah. Hard to have expectations going back to the middle of last year. No one had expected to be in that place and there we were coming out of 2019 feeling really good, January, February, really strong. And then all of a sudden March came and the world changed. And so at that point, a year ago June or July, we were just trying to get our arms around our assets and conversations with tenants. And I think just much like the rest of the world, we were trying to get our arms around what this was going to look like and what kind of decisions we faced going forward. And I think it's interesting, it sort of was an inflection point for the markets.

As you said, I think things started to feel a little better, and valuations have stabilized. We've seen the investment markets rebound, especially this year. I think there's a lot of capital trying to find its way into real estate. And we can talk about that a little later if you're interested. But in 2020, we managed to fight through it. And our portfolio came through in pretty good shape. Our values were down, like the rest of the markets, but our income return was solid.

And our long-term return expectations really haven't changed. We're targeting a 6 to 8% long-term return. And I want to emphasize long term because we're focused on building a sustainable story, a balanced core down the middle of the fairway model. We're in complete alignment with a long-term investor in BCI {Note: British Columbia Investment Management Corporation]. RBC of course has been around a long, long time and they hold a long-term perspective. And so we're still after that setting, giving investors that access to an investment that fills that gap and strengthens between stocks and bonds and strengthens their portfolios. So 2020 is nice to have behind us. And quite frankly, we're actually feeling really good about 2021 and going forward.

Stu Morrow (Host):

That's a great summary. I would say that still focused long-term returns clearly aligns with our investors as well. Maybe on that, for 2021, I'm not sure about my team and myself, but I suspect vaccines are being rolled out, to some dismay, not as quickly as some people like. But nonetheless, I think the return to work's probably going to move quicker than, than people expect. How are you thinking about the office sector today and what are you kind of hearing on the ground in terms of that speed of return to work, or the trends in urbanization that we talked about last time that were on, we just said we're focusing on the long-term? So is there anything sort of lasting changes you would comment on, as it relates to the office space and work arrangements that would maybe be of interest to our investors?

Michael Kitt (Guest):

Yeah, sure. There's a bunch of things to talk about in your question. I guess to unpack it, a question often asked is when am I going to be back to work, or when am I going to be asked to go back to the office, or when is that going to be an option for me, I suppose. And on that front, we're kind of in a fortunate position in Canada, unfortunate in that we're six months behind many countries, not just on the vaccination front, but what they've gone through, they've gone through a little bit ahead of us. And so we actually get a little bit of a glimpse into our future through the eyes of other countries.

And so what are we seeing? We're seeing in China, 60, 70% now of their workforce is back into the office. Australia, the number is 25 to 50%. And so if you transpose that into Canada and say, we live in a world where behaviorally, we're not really that different because offices and companies are global. You could probably expect to see 75% of Canada's workforce back in offices in September say. So that's probably the path we're on, if we follow the trends that are happening right now in other parts of the world that are, as I said, ahead of us. An early indicator of how people are feeling is actually on us right now, I think with some of the retail openings that we've seen this week, actually with our code system improving. And so now retailers can accept 25% of normal traffic. That's going to give us an early glimpse into how comfortable people feel.

And I think that's an important indicator. I don't think any company is going to want to force people back to work. I think everyone understands that we're probably better off just being patient with this. There's no sense to rush. There's no sense in rushing things and having to back up again. So that feeling of safety and comfort's really important. And so watching people's behavior with these retail openings, seeing how the retail openings that they lead to restaurant re-openings, if this leads to increased capacity limitations through the spring. And if people are comfortable getting, quote unquote, back to normal, and I know that's overused, but we'll use it here, again, it's a really good early indicator that the same kind of concept will apply for the return to work pacing. And I think September is going to be a key month for that. So I wouldn't be shocked to see, call it 70 to 75% of workers generally back to work in September.

Your other question was around if we're going to see any lasting changes. It's interesting, the office world, people tend to focus on the current and having just gone through a global pandemic, you can't blame people to have sort of a current view of what they've just been through. But if you step back and you'll look at things over an over an extended period of time, the concept of an office and its importance to a business, or even for that matter to an employee and the role it plays in their life, it's gone through many adaptations and changes. And even in the more recent history, things like portable computers. I'm old enough to have gone through the transition to portable computers and to cell phones and to business travel and to even a globalization of business. And the fact that you're competing globally.

And offices adapted and grew through those periods of time. And I think office buildings quite frankly, are going to come out the other side of this even stronger. They're going to adapt to what employees and employers need. What do employees want? They want to feel engaged. They want a career. They want to feel challenged. They want to work with others. They want balance and they want flexibility. Having an office as part of this equation, survey after survey after survey finds virtually no employees want to be told they have to work from home. They all want to have the choice, but that's very different than being told that they have to work from home. So everyone acknowledges that the office is part of the equation. And then from the employer's perspective, well they want to engage in productive employees.

You and I work for RBC. It isn't the “Try Hard” league. This is a results league and we have to produce. And the bank wants a strong culture, and they want us to put the client first and they want us to put the community in focus, and all of these things matter. And having an office is also key to this and survey after survey after survey emphasizes that. And so if both sides see an office as part of an important and necessary part of the equation then the office is going to survive and come out the other side of this stronger.

It won't be 2019's office. Furniture will move around, it'll change. I think public spaces are going to change. There's going to be new technologies in place to make us feel safer. But again, it is tied to that general feeling of safety and comfort. And we get this vaccine in place. We get people feeling comfortable that it's okay to live again and live out, quote unquote, normal life. I think the office environment will just move along at that pace. And I think we're likely to be having a very different conversation next year.

Urbanization. Yeah. That's a big topic. I don't think the views there have changed. Cities have been tested again historically many, many, many times, and have always adopted. They just dominate job creation, finance education, healthcare culture, “walkability”. And again, this crisis, I think in the past year, has forced cities to become stronger. It's going to force them to think about green and open and livable conditions. I think we all benefit from that and cities are also competitive. And so at the end of the day, we may be in a better place, all of us because of what we've gone through. And I know it's been really difficult for many, but we've been forced to adapt and learn. And I think in a microcosm sense, offices and retail and real estate in general, cities and urbanization, we all have to adapt to what the new conditions are and learn from it and come out the other side stronger. But I do believe across the board, that's going to be true.

Stu Morrow (Host):

I agree. Thanks for unpacking that. There was a lot of questions in there. You did great.

I agree with the coming out on the other end stronger. I even look at our RBC PH&N Investment Counsel, how we've adapted to work from home. So this sort of leaves us in a, when we returned to the office, which I believe we're going to, that flexibility and adaptability of the business model is even stronger now. So you're right. I completely agree.

One of the things you touched on in your last remarks was more of the retail sector and the retail footprints. And I just wanted to pick your brain there about exposure today, your thoughts there, perhaps maybe longer term.

Michael Kitt (Guest):

Today I'm even more bullish, it's interesting, on retail. And you can analyze it, I suppose, in the same way that we just talked through the office spaces. Start with what shoppers want. And it's been pretty clear that on the fashion, the food, the entertainment side, these are in-person businesses. There's a reason why fashion sales are down. I think overall total retail sales have held up pretty well, but certain segments have been hit really hard. And people, they want convenience yes. But they also want an experience. They want customer service. They want to be fulfilled immediately. They all have impulses. And so shopping is much more than just a needs-based or a necessity based exercise, and retailers understand that. So you ask shoppers, well, they want the same thing that office workers want. They want flexibility and choice.

And so they want this omni-channel concept where they can buy anything anytime. But that includes a physical store. Physical store sales still dominate. Even last year, the retail industry was effectively closed, shut down, but still over 80% of retail sales were done in person. People found a way to get into stores and buy. And retail is an in-person, quote unquote, business. And what do retailers want? They want to sell and sell more. And they know that an online targeted acquisition is good. It's nice to sell something to someone, true, but they'd rather cross sell, and they'd rather take advantage of those impulses. And they'd rather sell two things in the same sales transaction than one. And they really rely on that part of the business. That's an important marginal part of a retail sales model, virtually across the board.

And so they want the physical stores to educate and to sell and to take advantage of that impulse and to immediately fulfill people and to provide the customer service. And they want them coming back and they feel that that's a competitive edge for them. And so notwithstanding, they don't have to worry as much about logistics. It's always helpful when the customer comes into the store and picks up the item versus this this experience of deliveries, constant deliveries that we've had through the year. So retailers, they're not industrial or logistics companies or retailers, but logistics have become such an important part of their world in the past year. So I think, again, if shoppers want a physical store, if retailers want a physical store, there's going to be a physical store.

And again, a little insight into other countries. Sure enough, in Asia, when retailers started to open up, people came. And I think there's very good demand indicators around retailers growing physical store networks and taking up more space and shopping traffic really quickly bouncing back. And again, it reinforces this observation that the store still matters, but it matters in the context of retailers needing to fulfill across multiple channels. And so they need to understand how to do business physically, but also complimented by online. And they do have to understand the logistics and the distribution of their products more than ever. So the retail world is much more complex. There's going to be winners and losers, but physical retail is again, is going to survive. And it's likely to come out the other side of this stronger.

And I still like it as an asset class a lot, because it's so adaptive. We call them groundscrapers versus skyscrapers. So when you buy a tall building, like an office building or a resy [Note: residential] building, you're buying buildings that go up and the skyscrapers, and they're taking advantage of density. Whereas retail assets tend to be along the ground. You could say that industrial assets are similar, but industrial assets tend to be located in relatively fringe locations, not high-density locations. Whereas retail assets tend to be in very strong, high-density locations, right on highways and major roads. And so getting that land, those groundscrapers and having an asset that's really adaptable, you can put pretty much on anything, subject to municipal requirements, but you can put pretty much anything on a great retail location or a retail site. Retail is an asset class. There's multiple reasons to like it. Today, if it's selling at a discount and then long-term for its future adaptability.

Stu Morrow (Host):

That's great. I noticed too, when my region got out of this, the lockdown zone, and into some retailers being opened up, parking lots very quickly fill up again, which were previously empty. Like you said, the same sort of thinking along the lines of return to work, return to retail, I think also holds true in most respects.

The last question I was going to ask you, Michael, today, was more recently there's been concerns in the market around this idea of rising interest rates. And we've certainly seen that in parts of the bond market and some concerns about inflation, not immediate, but maybe it's somewhere down the road. How do you think about the strategy today in an environment where you may see some fits and starts with respect to inflation, and possibly higher rates over time? Not anything dramatic in terms of something near term, but possibly just higher rates progressively over time. How do you think about portfolio management in that respect?

Michael Kitt (Guest):

Yeah. Well at the pension fund, from a top-down perspective, we did lots of work on this topic and real estate was one of the few asset classes where inflation was generally positive, had a positive correlation to returns. And I had the provision that was, if it was inflation driven for the right reasons, so economic and population growth. The reason was pretty simple, that the real estate's income growth was generally positively correlated with inflation. So it's ability to grow rents. If you take the retail sector as an example, retail rents are generally tied to retail sales, or how about a positive association with retail sales. And so inflation, as it passes through retail sales levels, there's going to be a rising retail rents, industrials tied to activity, GDP. And so if you see a little positive GDP boost through inflation, you're going to get rent growth there, same association for office.

And the beautiful thing about retail, office and industrial asset classes, so not residential, let's remove residential for a minute, those three asset classes in Canada generally are based on net leases, which means that the tenant pays the real estate taxes and operating expenses for the space they lease. And the landlord gets an effective net rent. And so if that net rent is tied to economic growth, then you get inflation protection and the added benefit that the tenant is bearing the inflationary impact of the expense growth. So as property taxes go up or operating expenses go up, the tenant's taking care of that. So the landlord's protected on the expense side and gets the benefit of inflationary growth on the revenue side. So there is a positive correlation there.

On the residential side, it's a little different because there you do, the landlord, the owner, does get inflationary growth, typically. Rental rates are tied to CPI plus. And so there's an immediate and annual very nice correlation with inflation and top line growth for landlords, residential landlords. But residential landlords pay expenses in that business, generally. They aren't net leases. So all the tenant does is pay their rent and that's the end of it. And yes, that's tied to inflation, but the landlord is exposed to the, quote unquote, the middle of the income statement. So there, it's mitigated slightly, and the landlord absorbs that part of the inflation risk equation. But bottom line is the residential NOI [Note: Net operating income] growth is also positive and correlated to inflation. So overall, across the board real estate is one of those asset classes where inflation is actually good for it, in a healthy, controlled way.

And because many of these asset classes have longer-term leases in place, like a weighted average lease term for example, is pretty close to six years non-residential. So you get rent bumps built into your contracts. You've got some inflation, let's say volatility protection. So you've got some growth built in, but you've also got some leases turning over annually. And so you've got a little bit of inflation protection annually as you're renewing your leases. So it's a really nice asset class, actually, if your view is that inflation is going to increasingly become a factor and you want to incorporate some protection into a portfolio, real estate makes a lot of sense. And that's historically been the case and there's no reason to expect that to change in the future.

Stu Morrow (Host):

That's great. I couldn't agree more. Inflation hedge, and certainly a great compliment to existing portfolios. So I wanted to thank you again, Michael, for coming on. I know our clients and our Counselors, we really appreciate your insights into the Canadian real estate market. Hopefully you remain well, and I'm looking forward to seeing you again, either back on Counsel Views, or maybe back in the office in person sooner than later.

Michael Kitt (Guest):

Yeah. Listen, I can't wait. And I want to thank you and thank everyone who's listened all the way to the end. I should have thanked everyone at the start, but listen I appreciate all the support. I'm always happy to do this.

Stu Morrow (Host):

Great. Take care Michael.

Disclosure

This episode was recorded on March 11, 2021.

This has been provided by RBC Phillips, Hager & North Investment Counsel Inc. (RBC PH&N IC). All opinions and estimates contained in this recording constitute RBC PH&N IC and RBC Global Asset Management Inc. (RBC GAM Inc.) judgments as of the date of this recording, and are subject to change without notice. This recording is not an offer to sell or a solicitation of an offer to buy any securities. Persons, opinions or publications quoted do not necessarily represent the corporate opinion of RBC PH&N IC. This information is not investment, tax or legal advice and should only be used in conjunction with a discussion with your RBC PH&N IC Investment Counsellor, qualified tax and legal advisors respectively.

Information obtained from third parties is believed to be reliable but neither RBC PH&N IC nor any of its affiliates assume responsibility for any errors or omissions or for any loss or damage suffered.

RBC Global Asset Management (RBC GAM) is the asset management division of Royal Bank of Canada and includes RBC GAM Inc.

Some of the products or services mentioned may not be available from RBC PH&N IC; however, they may be offered through RBC partners. Contact your Investment Counsellor if you would like a referral to one of our RBC partners that offers the products or services discussed. RBC PH&N IC, RBC Global Asset Management Inc. and Royal Bank of Canada are all separate corporate entities that are affiliated. RBC PH&N IC is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. ® /  Trademark(s) of Royal Bank of Canada.

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