REAL ESTATE CAPITAL MARKETS AFTER THE CREDIT CRUNCH: The Canadian Experience

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REAL ESTATE CAPITAL MARKETS AFTER THE CREDIT
CRUNCHThe Canadian Experience
Carl Gomez Vice President, Research
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Outline

• The Big Picture Fundamentals
• Capital Markets - Residential Real Estate and
  Outlook
• Capital Markets Commercial Real Estate and
  Outlook
• Implications

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Canadian credit conditions key points

• Despite the recent turbulence in capital markets,
  strains in Canadian credit conditions have been
  less intense than in the U.S. for a few key
  reasons

• Canadian financial institutions, businesses and
  households have healthier balance sheets than
  those in the US
• Canadian banks have less exposure to the
  subprime-mortgage market than the US
• Canadian banks are less dependent on
  securitization for the financing and on capital
  markets for their revenues

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Bank Funding Costs

• Although spreads for market financing have
  increased, funding costs (ie., the absolute cost
  of borrowing by banks) has declined thanks to
  lower Bank of Canada overnight rates

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Overall Credit Conditions

• Growth in household and business credit remains
  strong and was growing well above historical
  average in early 08

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• RESIDENTIAL REAL ESTATE MARKET

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Residential mortgage market

• Posted fixed rates are slightly higher but
  variable rate mortgages (linked to prime) are
  substantially lower net effect still positive
  for consumer

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Residential mortgage market

• Canada has a smaller share of subprime mortgages
  and exotic loans than the U.S. since financial
  innovation is behind the U.S. Still, it wasnt
  the existence of subprimes that caused the bubble
  to burst in the U.S. but it did contribute to
  creating the bubble

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Residential mortgage market

• Federal governments liberalization of mortgage
  insurance market in 2006 (which includes 40 yr
  ams 20 dp insurance for investor mortgages)
  has helped to prolong Canadas housing boom

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Housing valuation metrics

• Like the U.S., speculation is causing home prices
  in Canada to overshoot fundamentals like income
  some correction is warranted going forward

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Regional home price trends

• Speculation runs highest in Western markets,
  modest corrections already occurring in Calgary
  and Edmonton, Vancouvers correction could be
  more interesting!

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• COMMERCIAL REAL ESTATE MARKET

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Canadian commercial RE market
Capital appreciation has accounted for the
majority of commercial real estates recent large
returns
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Canadian commercial RE market
Global compression of cap rates provided the
valuation lift
Canada
CBRE
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Canadian commercial RE market
Compression amplified by reduction in real estate
risk premium and/or robust expectations of
strong income growth
Cap Rate Rf RP g Cap Rate Rf Rp - g
Canada
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Canadian commercial RE market

• A changing climate for borrowers lenders
  seeking to ration capital for the year. Things
  are tighter in the US if only because they were
  much more laxed before.

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Canadian commercial RE market
Compared to the U.S., debt is less of a factor in
driving Canadian pricing
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Canadian commercial RE market
In Canada, equity investors play a far more
dominant role in providing capital for real
estate
Source Bank of Canada, RBC, Pension Fund Annual
Statements
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Canadian commercial RE market
While the cost/availability of debt has also gone
up in Canada, the significant influence of
institutional investors is the offset that should
prevent as severe an adjustment in pricing here
GROWTH IN INVESTED EQUITY - US
GROWTH IN INVESTED EQUITY - Canada
Equity
Source Pension Fund Annual Reports, RBC, CBRE
Source Emerging Trends
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Canadian commercial RE market

• Pricing is set at the margin - the adjustment in
  debt markets will continue until risk is
  correctly priced means the valuation effect
  will likely not be at the back of real estate
  investors

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Implications

• Canada has been affected by the global credit
  crunch but strains in Canadian credit markets
  have been less intense than US
• Residential lending conditions have remained
  favourable and innovations in mortgage market
  have prolonged the housing boom
• But affordability is being stretched and
  speculation has increased, particularly in the
  West therefore a correction is warranted
  though not as severe as the U.S.
• Commercial real estate is experiencing relatively
  tighter lending conditions
• But capital market structure of Canadian
  commercial real estate employs less usage of debt
  compared to the US not as detrimental
• A leveling out of cap rates (or a modest increase
  for some properties) as risk is re-priced
  suggests that the valuation effect will no
  longer be at the back of commercial real estate
  investors