Pension funds are bringing whole new classes of capital into the Atlantic Canadian real estate marketplace

John W. Lindsay Jr. has three good reasons to be proud of the recent announcement that his commercial real estate company, East Port Properties Ltd., will be building a six-storey, 182,000-square-foot office building at 351 Water St. in downtown St. John’s. Reason One: It’s the first new office building to be erected in downtown St. John’s in 25 years, a gap that marks the time it has taken for the capital of Newfoundland and Labrador to remake itself from a city of mariners and fish barons into an international player in the offshore oil industry. 

Reason Two: The structure will be built to LEED (Leadership in Energy and Environmental Design) gold standards and the first in the province to be heated and cooled by seawater. And Reason Three—the most significant, in Lindsay’s opinion—is that the more than $60 million in investment represents the latest foray into
Atlantic Canada for Regina-based Grey-stone Managed Investments Inc. The ninth-largest pension asset manager in Canada, with $35.4 billion in assets under management as of the end of 2010, it aggregates pension assets from institutional clients across Canada such as Regina’s Capital Pension Plan, a defined contribution pension plan established in 1976 that provides pensions for 60 private and Crown corporations.

“The pension funds bring whole new sets of money into the marketplace,” says Lindsay during an interview at East Port’s headquarters in Dartmouth’s City of Lakes Business Park. “They can transform a place like St. John’s.” Lindsay also represents the Healthcare Organizations of Ontario Pension Plan (HOOPP), with $35.7 billion of assets, for which he’s building a 90,000-square-foot industrial building in Phase 9 at the Burnside Park.

The reason HOOPP and other pension plans can be game-changers in Atlantic Canada has to do with scale. With a steady stream of contributions from its 170,000 members, HOOPP takes huge amounts of cash to the table annually. While a $60-million building may seem like a big deal in St. John’s, it’s tiny compared to a pension fund’s overall portfolio. For example, HOOPP’s 2010 annual report states that its $3.9 billion in real estate holdings represented only 11% of its total portfolio, and its Atlantic Canada properties accounted for only 2% of that portion.

Scotiabank’s senior vice-president and chief economist, Warren Jestin, said at a recent 2012 economic outlook conference sponsored by the international real estate brokerage CBRE that “Canada is a really good place to be.” He meant not just during the recession of 2008 but also during the current recovery and heading into an uncertain future that could include a financial meltdown in Europe and slow growth, if not another recession, in the United States. He cited Canada’s credit culture (as opposed to the U.S.’s lending culture), more political will to deal with issues, and—tooting Canad’s horn—the “best banking system in the world.”

As a region, Atlantic Canada survived the recession better than some other parts of Canada. Following the lines on economists’ growth charts for Atlantic Canada can be pretty dull. While the wild West’s boom-and-bust line looks like a spiky haircut, the East’s has the gentle undulations of a carefully maintained comb-over. It’s not exciting, but it’s attractive in the current low-interest-rate environment as collapsing equity prices and shrinking bond yields have revived interest in real estate as an asset class among pension (or any) funds that need to provide steady returns. 

Bob Mussett is the senior vice-president and senior managing partner with the Atlantic division of commercial real estate broker CBRE Ltd. “It’s a question of scale,” he says. “Our market is small, and it’s difficult for pension funds to acquire the scale here they would see in larger centres, so the primary focus is on Halifax, Moncton, and St. John’s. Our challenge now is finding the investment product to sell, not the capital that wants to buy.”

One pension fund that has invested in New Brunswick is Cadillac Fairview, the real estate arm of the Ontario Teachers Pension Plan (OTPP), which owns three shopping malls in New Brunswick. The huge fund, which had $107.5 billion in assets at the end of 2010, operates the 150-store Champlain Place in Dieppe, the 110-store McAllister Place in Saint John, and the 115-store Regent Mall in Fredericton, which it recently renovated to the tune of $13 million. Those locations are the only ones in the province that can sustain malls of that size.

In addition to pension funds, real estate investment trusts (REITs) sprang up during the 1990s as means of raising non-bank equity to acquire, develop, and manage commercial, industrial, and housing real estate that would provide a steady stream of income to investors. The oldest of them, Canadian Real Estate Investment Trust (CREIT), was first listed on the Toronto Stock Exchange in September of 1993; it clearly demonstrated both the opportunities and the challenges of the Atlantic Canadian market. “We’re always striving to be active on the acquisition and development front,” says Adam Paul, CREIT’s vice-president of investments in Toronto. “We have developed about 500,000 square feet of industrial real estate in the Burnside Park over the past five years, including 181 Joe Zatzman Dr., an 82,000-square-foot building that is being completed. The challenge for CREIT in Halifax will be our ability to grow given the size of the market combined with our current position. For instance, we own 1.2 million square feet in Burnside, the dominant industrial area in Atlantic Canada, which has a total inventory of about six million square feet in the park.” 

There’s a delicate balance between the economies of scale derived from being a major player in a market and the risks involved in going all out in a single marketplace. CREIT has interest in 43 properties in Atlantic Canada, 42 of which are in the Halifax Regional Municipality (the outlier is in Dieppe, N.B.). “Because we manage almost all of our own properties, it’s important for us to have people on the ground through our operating platform in the markets we own real estate,” says Paul. “Keeping the portfolio geographically close to our management offices provides for a more efficient operation. For that reason, our focus in Atlantic Canada will remain on Halifax for the foreseeable future. It may not be a large market, but it’s a stable market in which CREIT has had a lot of success over a long period of time. We feel like Halifax is insulated to some degree; it hasn’t been subject to the same boom-and-bust cycles as certain markets.” The $3.9-billion trust generates approximately 15% of its net operating income in Atlantic Canada.

PRACTICALITY VS. PRESTIGE
There’s a reason why 351 Water St. is the first office building to go up in downtown St. John’s in 25 years: Its owners were willing to build to the city’s height restrictions, which means the structure will only have six storeys. The years-long struggles of developers to win approvals for downtown developments in cities such as Halifax have become legendary, but they haven’t stopped building; it is just taking place elsewhere. 

The 85,000-square-foot Waterside Centre in peninsular Halifax, for example, is on hold while developer Armour Group, which has spent years struggling to gain municipal approval, tries to pre-lease it in a soft market. At the same time, it has built the five buildings of Park Place, a hotel-and-office complex, in suburban Burnside Park. Its 228,000 square feet is almost as much as the 250,000 square feet Armour Group is proposing to build in Queen’s Landing on downtown land owned by the Waterfront Development Corp., a project that our grandchildren may see.

The difficulty is twofold, according to CBRE’s Bob Mussett. First, peninsular Halifax needs 10,000 more people to make new office development commercially viable. “There are fewer people living on the peninsula now than there were in 1961,” he says. “Second, this isn’t a head office region, so companies aren’t willing to pay a premium to locate downtown.” He notes that while downtown office space in most urban centres across Canada commands a 30% premium, in Halifax the premium is only 10%, reflecting companies’ unwillingness to value prestige over practicality. “They’re interested in employee retention, so they’re looking for places that are convenient, have lots of parking, and are close to where their employees live,” he says. “At the moment, suburban nodes offer a better value proposition than downtown.”

The huge size of the pension funds can be a problem when it comes to investment in Atlantic Canada. An example of the scale on which the pension funds operate is the recent announcement by Oxford Properties, the real estate arm of the Ontario Municipal Employees Retirement System (OMERS), that it will build a $15-billion assortment of residential, commercial office, and cultural buildings totalling 12.7 million square feet of space by covering over the two city blocks currently occupied by the Hudson Rail Yards on Manhattan’s West Side.

By comparison, Halifax—Atlantic Canada’s largest urban area—contains
9.5 million square feet of office space, according to Bill MacAvoy, the managing director for Atlantic Canada at commercial real estate broker Cushman & Wakefield. “Introducing a one-million-square-foot property would have a tremendous impact on the local market,” he says. “The vacancy rate would go up instantly from 8% to 18%, unless the development came with a roster of new tenants. Real estate investment is driven by tenancy, and we don’t have enough net new absorption in the market of late to allow for speculative development.”

Another difficulty for the funds is investment size. “Most institutional buyers have a pre-determined minimum on size of purchase, and there aren’t that many projects around here that qualify,” says MacAvoy. That’s another reason East Port Properties’ John Lindsay is excited that Greystone and HOOPP are investing in Atlantic Canada; he has found a source of money that’s willing to look at an accumulation of smaller projects that are Atlantic Canada’s bread and butter. They’re vital to continuing development in the region, now that the big banks have pretty much withdrawn to the consumer housing market. “With banks, you could only dream as big as your balance sheet,” he says. “With the funds, there’s no dream I can dream in Atlantic Canada that is too big.”

That’s the challenge—getting new developments financed. “All the funds want to buy existing revenue in this market,” says MacAvoy. “The biggest challenge in Atlantic Canada is that most of the trophy assets aren’t on the market. Look at Purdy’s Wharf in Halifax. It’s owned by a syndicate of pension funds, it’s not for sale, and there aren’t any more 550,000-square-foot complexes kicking around that you can scoop up. The problem is that there’s too much money chasing too little product. It would be a seller’s market for Purdy’s Wharf. I know about 15 buyers who would love to snap it up.”

One factor that has been slowing the inflow of investment cash from pension funds is their charters, which often limit the percentage of total funds that can be invested in any single asset class. “In late 2008, when other asset class values were melting down, in terms of pure relative value, the pension funds were overweight in real estate because those values hadn’t gone down as much,” says MacAvoy. “That meant the funds weren’t able to acquire additional properties because it would put them over their limits in terms of their asset allocations.”