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Apartment demand exceeds supply

It's getting 'harder and harder to find product,' expert says

Globe and Mail - March 16, 2004
by Terrence Belford

Unprecedented demand among investors for apartment buildings has driven prices up and returns down in almost all major Canadian markets. While statistics indicate that building sales flagged last year in some cities, the problem was definitely not a lack of buyers.

"It is just getting harder and harder to find product," says Karl Innanen, vice-president of the multifamily advisory group at Colliers International, a national real estate brokerage. "There is an unprecedented amount of cash chasing apartments right now. When something comes up for sale, competition often drives prices well above asking."

The factors fuelling the buying binge are straightforward. Record low interest rates mean buyers can leverage even low capitalization rates (a commonly used market indicator calculated by dividing the operating profit by the value or selling price of a property) into solid double-digit cash flows.

Demand from tenants, although currently affected by a cross-Canada condominium boom, will likely remain stable or even increase over the long term, many institutional and foreign buyers believe. The stability offered by residential investment is also in sharp contrast with the volatility of financial markets.

Finally, widely held ownership in the apartment sector continues to offer major players such as pension funds, real estate investment trusts and institutions the ability to assemble major portfolios. Large holdings allow considerable cost savings through the application of modern management techniques.

"On the buyer's side, the yields generated by apartment investments are a lot better than 2 per cent sitting in a GIC [guaranteed investment certificate]," says Gregory Bell, vice-president of apartments at Royal LePage Commercial Inc.

Capitalization rates are a solid indicator of demand. Low cap rates indicate high selling prices and, in effect, a seller's market. Last year, cap rates ranged from 5 per cent in Vancouver to 9 per cent in Montreal. Calgary reported a 6.4-per-cent cap rate and Toronto 7 per cent.

"In the mid-nineties in Toronto, you could buy Toronto apartments for $35,000 to $40,000 a door. Now it is closer to $90,000," Mr. Bell says.

To encourage reluctant sellers to part with apartment buildings, brokerage firms are making a strong case that 2004 is a perfect time to sell.

"It is not just the low cap rates, there is also a host of other factors supporting that recommendation," says David Montressor, vice-president of the national apartment group at CB Richard Ellis Ltd. in Toronto. "There has been a tremendous increase in value since 1997. We think values have peaked and will level off for the next few years."

He also predicts relatively high vacancy rates in cities where there has been and continues to be a boom in condominium construction. Landlords used to nearly 30 years of 1-per-cent or lower vacancies may have difficulty adjusting to rates in the 4-per-cent to 5-per-cent range, which is where Toronto now sits, despite Canada Mortgage and Housing Corp. statistics, which place the 2003 vacancy rate at 1.1 per cent, he says.

While cap rates in the 5-per-cent to 7-per-cent range might well put off pension funds, which buy for cash, other private investors, which leverage investment through mortgages, can take purchases in the higher end of that range and parlay them into returns bordering on double digits.

"Granted, pension funds and institutions are being very selective right now but there are others looking to assemble portfolios to turn into REITs [real estate investment trusts]," Mr. Bell says. "There are also a lot of German and Israeli investors who love residential for its stability."

While the apartment market across Canada might still be enjoying a great deal of investor interest, some cities are considered more desirable than others. Vancouver, for example, has the lowest cap rate at 5 per cent.

At the same time, average rents in Vancouver continue to rise ($805 a month last year, up from $793 in 2002) and vacancy rates continue to be low (2 per cent against 1.4 per cent). The problem Vancouver faces is shared across Canada: A great deal of money chasing too few deals. That situation is reflected in sales, which dropped 14.2 per cent to $333-million last year, according to statistics compiled by CB Richard Ellis.

"You go to owners and tell them this is a great time to sell and they say 'Suppose I do, where do I put my money?' " Mr. Vassos says. A large part of the problem in Vancouver rests with geography, he adds. "We can only go up or to the east. Even with an unprecedented condo boom and prices in the $400- to $500-a-square-foot range, we still have demand for both condos and rental units."

The market also seems to split evenly between new, large structures and older smaller ones, says Mark Gallagher, associate vice-president at Royal LePage Commercial Inc. in Vancouver.

The only other major centre to report a drop in apartment sales last year was Montreal, and the drop was a dramatic 51.5 per cent to $351-million, according to figures from CB Richard Ellis. At the same time, properties were trading at an average 9-per-cent cap rate, with vacancy rates almost steady at 1.2 per cent and rents up 4.1 per cent to an average of $564 a month.

The drop is simple, says Germain Villeneuve, an agent with CB Richard Ellis. "There is no supply; people just don't want to sell," he says.

Montreal has enjoyed a boom in multiunit residential sales in the past five years. It was the entry point for Israeli investment in Canada, and pension funds, REITs and institutions took advantage of a combination of reasonable cap rates and widely held ownership to assemble large portfolios. Today there are few large, concrete structures left untraded; what remains are small brick-and-frame buildings held by families or smaller firms.

Calgary is another unique market, says Karen Barry, vice-president in the investment and financial service group at Royal LePage Commercial. While total sales in the multiunit sector rose last year to about $269-million from $178-million the previous year, a large chunk of that gain came from a single transaction. The Quality Apartment Portfolio, with 900 units split between Calgary and Fredericton, was sold late last year to Morguard Investments Ltd., which was acting on behalf of a pair of pension fund clients. The asking price was a cap rate of 7.9 per cent.

"Right now," Ms. Barry says, "there is a very large amount of money chasing very little product."

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