Counsel Views – Episode 13: Michael Kitt
Insights into today’s commercial real estate market
Counsel Views, hosted by Stu Morrow, Chief Investment Strategist, 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 guests: Michael Kitt: Head, Private Markets and Real Estate Equity Investments, RBC Global Asset Management
This episode of Counsel Views features real estate industry thought leader Michael Kitt, Head of Private Markets and Real Estate Equity Investments for RBC Global Asset Management (RBC GAM).
Always timely, always insightful, Michael leverages his broad and deep industry experience to provide important analysis of today’s commercial real estate market. With conditions evolving rapidly regarding return to work and the future for real estate given the COVID-19 pandemic, Michael provides his outlook for this important asset class and the 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.
Hello out there to all of our listeners. I’m your host, Stu Morrow, Chief Investment Strategist at RBC PH&N Investment Counsel.
I am happy to welcome back our guest for today’s discussion, Michael Kitt. Michael is Head, 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 needs of both institutional and affluent investors.
Michael brings more than 25 years of direct real estate investment experience to the firm. And prior to joining RBC, he was Chief Financial Officer & Executive Vice President, Finance & Strategy at Oxford Properties. He also held senior positions at Cadillac Fairview Corp. and Ontario Teacher’s Pension Plan Board, all related to commercial real estate investing in Canada, the United States, and in Europe. And he served as a trustee, a board member for two public REITs, Invest REIT and Choice REIT, and was a member of the audit committee and governance committee throughout his term at both entities.
Hi, Michael. Good to see you again, and welcome back to Counsel Views.
Hi, Stu. It’s nice to be back. Thank you.
Yeah. We’ve come a long way. I actually went back to our last discussion, and we were pretty much in lockdown still across Canada. Our vaccine campaigns had just begun, or barely begun. Today’s picture seems to be a much more optimistic one in terms of a possible end date for some lockdowns and restrictions.
So I wanted to begin our discussion and talk about that gradual reopening of the Canadian economy. I guess, depending where people live, still disparities. Some are fully open. Some are still in some form of lockdown, in Ontario, for instance.
But for the commercial real estate sector, can you give us an update on activity levels within retail, industrial, and perhaps residential sectors?
Yeah. Happy to. Listen. From a macro perspective, you’re right. Real estate, I would say, across the board is really flashing green. Canada has embraced vaccinations. That’s helped a lot. We need to keep going. We’re one of the most locked-down countries globally and, therefore, are really only starting to enter the upside phase of our recovery. Hiring intentions are at an all-time high in the Bank of Canada Business Outlook Survey, the most recent one.
And so, from a fundamental perspective, you really do have a strong tailwind growing across the board. If you drop down into the sector fundamental perspective on the retail front, you look at the Canadian household spending numbers, 11% above pre-pandemic levels. The retail spending up 6% in June. Both strong, with clothing and restaurants actually bouncing back nicely. Eric Lascelles of our team likes to call them the forbidden fruit. I think people are looking at the clothing and restaurant sectors as a breath of fresh air. It’s nice to have them back. And we’re definitely seeing this translate into leasing at our retail office. Our leasing program on the retail front is on target. Foot traffic continues to build. So, it’s good news there.
In the industrial sector, there continues to be strength across the country, with Toronto and Vancouver vacancy levels right around 1%. That’s what’s driving rents higher.
And growth and distribution now is being supplemented by growth and manufacturing. So now you’ve got two cylinders working in the industrial sector. June’s Manufacturing Purchasing Index was strong. And so tailwinds not only continue to exist but are actually building and continue to build in the industrial market.
On the residential side, listen. We’ve all read, and I think we all feel, to some degree, housing affordability is at all-time lows. There was a stat in Vancouver, 75% of a person’s income goes to home-ownership costs, and Toronto is close to 70%. Those are big numbers. All-time highs. That’s not great news if you’re buying a house, but it is good news if you own rental assets like we do. And so this is driving, I think, a turn and an increase in momentum around expected rent growth.
And with immigration starting to reopen, we all know about targets being raised by the federal government over the next three years; that’s good news. And now this new Express Entry program that’s in place and already doing its thing. We’re seeing immigration quickly increase.
So what you’ve got is the demand side also building on the residential rental front, and which is good news for occupancy and rent growth.
On the office front, listen. The same story. Positive momentum continues to build. CBRE’s Q2 report saw a swing-up in sentiment. Sublets are either being leased up or pulled off the market. That was a big theme over the past year or so. A million square feet actually got pulled off the market nationally in the last quarter, half a million square feet in Toronto alone that we saw this as well in our portfolio.
U.S. Bureau of Labor Stats found only 15% of workers are now remote versus 35% earlier this year. So, people are heading back into the office. And Canada’s a little bit behind that. But I know I can speak for ourselves, with the Private Markets Group at GAM is back into the office inside of two weeks, on July 19th. So I think you’re starting to see that slow march back into the office.
And I continue to really like the bet of a potential space shortage issue on the office market. I know it’s hard to talk about something like that, but if you’re leasing space you can’t just flip your fingers in the office world and expect the right space to be available in the perfect building at the right moment. It’s not unlike buying a house; sometimes it’s going to take you a long, long time.
And so, if you’re a business that all of a sudden thinks they’re going to need space or does need space, it becomes a tight market in a hurry. And there may be only one or two buildings or one or two floors that you look at that fit, that make sense. And all of a sudden, that kind of demand tension can start to drive office rents higher quickly.
So, overall, I really like the story being diversified across all sectors. I don’t think there’s any need to bet all of the chips in one of these sectors. There’s tailwinds behind each one. And at the end of it all, two things really drive real estate values: population growth and job growth and related income levels. And if you follow these patterns, and they tend to heavily long term favour large, urban markets, for obvious reasons, then you’re going to be rewarded long term.
Yeah. Yeah. No, I picked up on the return to work. That’s obviously the buzz around the virtual office.
The thing I find interesting is, there’s this bifurcation, right? Even within industries, like you’ve heard from the CEO of Citigroup who’s kind of made people or led people to believe that perhaps work from home for longer is the way to go at Citigroup. Very opposing views, perhaps, at maybe a Goldman Sachs or a JPMorgan Chase, right?
So how do you think about that? There seems to be, even within industries, a bit of differing views of what return to office may mean. And it doesn’t seem you’ve changed your kind of views as to how this will kind of end or go towards in the Canadian market.
But just sort of checking back on that, do you think there is sort of any changing dynamic that’s taking place as to how people will return and when they will return?
Yeah. If I was to characterize it, I would say we’re at the stage now where there’s a growing tension that didn’t exist before between employers who are increasingly becoming more definitive and more publicly definitive about the importance of returning to the office.
And you mentioned a couple of U.S. banks. I mean, there’s actually three that have been very prescriptive about, you are now going to return to the office on this day. And there’s a reason for that, and I’ll get to that. And so the employers are definitely trending towards returning back to the office. Some are more subtle about the messaging than others. And I think the reason for that subtle messaging is, they don’t want to upset or offend or drive away employees. And on the employee front, there is a group who, quite frankly, grew to like working from home. And even to the point of threatening to leave their job if they were forced back to work.
Microsoft had a big survey recently released, and they estimated over 40% of a huge labour group was ready to leave their job because they didn’t feel threatened that they could find another job quite quickly on the conditions they wanted. And so you’ve got this group that doesn’t feel like they have much risk in standing up for what they see as their right to work from home. At the same time, though, that same group is reporting being stressed and overworked from too much work at home. So it’s kind of hard to understand what they want. They might not even know themselves what they want. And so this is going to take time to resolve. The bottom line is that employers are going to have to work through the situation. And recruitment and retention have always been important. So they’re going to have to be sensitive to employee needs, listen to them, but also understand the client comes first and their business comes first. And that will all work itself out.
I would say there’s a couple of observations here. Number one, the office still clearly matters. There isn’t a company that says, I am now convinced that the office isn’t going to be a central point. It’s quite the reverse. More companies, and I would say the vast, vast majority is again reinforcing the fact that the office still matters and is the central hub, and most of the staff will return to the office in some way, to be determined. So that’s number one.
Number two, flexible work is here to stay. But I think it’s likely not going to be working from home. There’s too many IT and security challenges, equipment and support challenges. I was speaking with the ex-second-in-command of WeWork, who had left to form a new company called Daybase. And so this is a person that’s very familiar with office strategies. WeWork was growing quickly on the corporate side. They had done a number of transactions with banks. And this person was actually ex-Citi.
And their theory is, working from home does not work. Period. It worked during the pandemic because it was virtually the only thing that we could do to keep the lights on. But midterm, long term, even today, it doesn’t work. And that is the reason that companies need enterprise-grade IT. And you just look at all of these cyberattacks that are happening right now and all of the access points, the risk points, that especially banks are focused on. You look around your house at how many listening devices that you either wear or you sit beside, your TV, your Google Home. Many of us are restricted from even printing and using the Wi-Fi at home And so, enterprises just can’t take that risk, and they need and enterprise-grade IT solution. All of them have it in their core office. The question is whether they can open up satellite offices and have that same enterprise-grade IT solution.
So that’s the Daybase theory. This is the WeWork spinoff; effectively, a new company that says, okay, maybe we can create satellite offices for banks closer to where people live, 5,000-square-footers. So they’re small. Think of a small office in a strip mall, so to speak—and literally, that’s what they’re thinking about—that will give people an option to go work there for a day or two instead of coming downtown. That’s the theory.
Now, question is whether employees will be happy with this solution. Is the group that likes working from home going to be happy going 10 minutes away to a strip mall and working in an office? Or are they going to be saying, well, that doesn’t work, I kind of liked the couch and the fridge and the back yard? You take those away, I might as well go back into the office, the main office.
So, again, that whole thesis is going to evolve over time. And at the end of the day, the final takeaway I’d say is that the company needs to put the customer and the client first. Productivity, security errors are always going to matter most. And they know, companies know what format has worked, does work. They know what they need to do to drive productivity. And so this is going to be a journey about listening to employees and trying to find those conditions where they’re comfortable coming back in.
For sure. Have balance, a balance for sure.
Michael, my last question for our discussion today is focused what’s on top of mind of most market commentators and probably most investors out there is the interest rate environment. And we’ve seen bond yields in most developed markets sort of peak out in the early part of spring this year, and they’ve since been on the decline. So this narrative that we came to know as lower for longer, lower interest rates for a longer period of time, continues to almost play out in global markets.
So how does that scenario, which seems to have come back a bit, how does that impact commercial real estate as a sector? And then how does that impact your investment strategy?
Yeah. It’s a really good question, Stu. We’ve lived in an environment for, gosh, over two decades where really the only direction for interest rates was down, and so we’ve all become accustomed to decreasing rates. And those that have run a personal mortgage program borrowing against their house on a short-term basis instead of locking in for long term have been rewarded by that.
It was, I think, a natural discussion to say, well, we must have bottomed, and how much lower can interest rates go. And so it felt like an inflection point. And there’s certainly a number of indicators pointing to higher inflation in the future, which would lead you to believe that there’s higher interest rates coming. That may or may not be true, and it may be transitory, short term. And then inflation may recede and yields stabilize again at a lower level.
All that to say, even the very best interest rates prognosticators, it’s a tough business to get right. We ladder our maturity curve so that we’re not overexposed to the short-, middle-, or long-term points of the interest rate curve.
So, if rates are stable here at 10-year bond yields at 1.5%, that’s a positive for two reasons. We can create positive leverage opportunities, investment opportunities.
And so, with 10-year weighted average lease term, with rent escalations, you lock in nice low interest rates with a 10-year mortgage, you’ve created the conditions for a very sustainable positive leverage investment opportunity. And so it’s a version of a carry trade, I suppose, as it relates to us. And so that would be number one. So if rates stay low here, we can create these positive leverage opportunities for investment.
Number two, if rates stay here, capital flows into real assets will remain very strong. You just saw an Ontario Teachers announcement this week that they’re going to move their private asset allocation from 50% of their—to 50% of their assets, meaning reallocating $70 billion of their $220 billion balance sheet into real estate infrastructure and private equity. And the reason that they gave was trying to escape the punishing effects of low interest rates. That was their stated public reason.
And so here you have a single example, and this is being played out across institutions. They need to generate returns to meet their liabilities. This low-interest-rate environment doesn’t allow them to do that in the traditional way where they were just putting money into the fixed income market and forgetting about it.
And so they are reallocating assets towards real estate and infrastructure, asset classes like that. Now, the challenge is finding these high-quality real asset investments. And so that challenge is in front of them. They understand that. But that’s the direction they’re going to move.
So long story short, if interest rates stay at these levels, I think it’s another tailwind for the real estate sector. I think if rates start to bump up a bit, and because there’s economic growth, so inflation is attached to that growth and that’s driving interest rates up. The real estate market has been pretty good at confronting that challenge as well. We’ve got the ability to reset rates, rental rates on a regular basis, specifically in the residential world where you get, effectively, built-in inflation growth on your rent. So that’s a nice important part of a diversified portfolio.
Contractual leases, longer-term contractual leases, office, industrial, and retail all include some kind of escalators, and usually attached to inflation or conceived around inflation. So you’ve got built-in revenue growth. And on the expense side, many of our—the majority of our leases would be net leases, so meaning the tenant would be paying the operating expenses.
So what you have is an industry or an asset class that has some ability to actually see their income grow through inflation. And that income growth is positive and can protect any detrimental impacts to discount rates or valuation metrics that are caused by increasing interest rate levels. And that tends to follow. So meaning that, if interest rates rise materially, cap rates or valuation metrics could also increase for real assets. They will increase for all assets, including equities, infrastructure, real estate, all of them. But because real estate has the ability to pass this through, there is a built-in shock absorber or buffer that actually makes real estate a good place to hide in times of increasing inflation.
So, long story short, again, we’re feeling quite good about the interest rate environment we’re in.
Excellent. Michael, always a great discussion with you. Thanks for taking the time to speak with me today and to speak to our clients at RBC PH&N Investment Counsel. I know they appreciate your insights into the market. And I hope that you get to enjoy some of the summer while it lasts before we’re back into it and into the fall. So wishing you well and talk to you soon.
Thanks, Stu. We’ll see you soon.
This episode was recorded on July 17, 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.
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