Hi everyone, and welcome to our Institutional Beat podcast. I'm Slava Sherbatov, institutional portfolio manager with PH&N Institutional and your host for today. And I'm very excited to have Jennifer Schillaci join us to talk about Canadian commercial real estate market. Jen is managing director and head of real estate equity and mortgage investments at RBC Global Asset Management Inc. So really the perfect guest to talk about this topic today. Jen, thanks so much for making the time.

No thank you. I'm happy to be here.

So clearly no shortage of things for us to talk about. But before we focus on sort of the present and then the future, I wonder if you can take a minute and reflect a little bit on 2024 and anything that stood out to you or you found especially surprising?

Sure. So just I'll start with the equity side here. So, the year did start off slow and then it picked up. So we've seen strong underlying performance within all of our property types, or four food groups as we like to call them. So industrial, retail, multi-residential, and office. We saw a significant uptick in leasing, about a 40% increase within our portfolio over the year over 2023.

Tenants are signing long-term leases. Rents are up across the board and we've been able to maintain our high occupancy. So it's very strong from an underlying operating performance across the different geographies within Canada. And then we also started to see an increase in trading. So up until this point, it's been a more muted volume coming out of the pandemic. And then obviously the uptick in inflation, the corresponding response of interest rates. And we have seen properties trade, including office. And what we're seeing here really is more of the institutional owners selling and the private owners buying, which is typically what you see when you come out of more of this stalemate investment of the Canadian market.

And when I'm looking at things that surprised me, within 2024, I guess I would have to say it would be the continued disconnect between the NOI (net operating income) and value of the properties. So when I look at our multi-family industrial retail properties. So the values were up about 21% over the last few years. The NOI is up 21% over the last few years, and value was down 1%.

And when you look at the portfolio just for last year, the NOI was up 7%. However, value is down 2%. So this disconnect is not something that you generally see over the long- term within real estate. If you have your NOI that is growing and your valuation metrics that are staying the same, the value of the buildings go up. And that's just math or capping, a higher NOI value. So this disconnect really isn't stable, so we expect this to turn next year where you have positive NOI and then positive value growth.

And – so this is more from the equity perspective – was there anything on the on the lending side as well that stood out?

So the lending side was more of the, of the opposite, when I look back at 2024. So this market started off really strong. There was a lot of, refis in the market, there was construction debt that was coming off, meaning that they needed term debt, to take out the construction loans for the new properties that were being built.

And then it slowed in the back half, with people waiting for more rate cuts. So, as we know, the Bank of Canada started cutting mid-year in 2024. We saw rate cuts through the year continuing into 2025, and people basically stopped and paused waiting for more rate cuts to come in. I will say there was a large amount of liquidity within this market.

So the lifecos, the banks, the asset managers are all very active. So we are starting to see with the fewer product coming out, a lot of spread compression, which is how the pricing works on loans, as the capital is chasing deals. And then again, the credit performance has remained exceptionally strong again across the board, across geographies, across property types.

So with this segment of what we do within our jobs, I like to refer to ourselves more as like the Maytag repairman from this perspective, which is a good position to be in. Now, mind you, my comments here on both the equity and the debt was before the tariffs conversation came into play, as well as the implementation of tariffs, which basically threw a wrench or more aptly, a grenade into the certainty and expectations of the market.

Yeah, I guess grenade is the appropriate analogy here. Let's just hope that we can manage to disarm it before there's too much damage done. But I guess we cannot not talk about tariffs. So can you elaborate a little bit more on the impact that it's, not just the tariffs, but even just the threats of tariffs has had on our market?

Sure. So a tariff is a shock to the economy. And we've experienced these before. We experienced the, the GFC affecting the financial sector. We obviously had the pandemic and then inflation and then the run up in interest rates. So we've experienced these before. They all come from different spots, but they do impact the whole market quite significantly.

And what we know from these experiences is the first thing that happens is a pause. So, from a real estate perspective, this means that business leaders are going to pause leasing decisions. They're going to pause capital decisions. They're going to pause financing decisions as well as investment – so, buying and selling properties. And that is what we've seen already within what's happening with all the noise around the tariffs.

And it's hard to really tease out exactly what's going to happen here, because there's been so much back and forth and they will impact different sectors of the economy as well as the tenants within the portfolio in a different way. It really depends on how trade dependent the tenant is and then how elastic their product or services or how much they can sub those out for either a domestic alternative or something from overseas.

But when you actually look at it from a real estate perspective, I'll look at it from first the short term and then the long term. So short term you would expect the initial impact would come on the industrial products. So these are tenants in the industrial space, warehousing distribution. We don't really have a lot of manufacturing within institutional investment portfolios. So it really is more the warehouse space and I would think would be more small bay. So these are smaller tenants typically, maybe up to 20,000 square feet. And this really again, depends on where their businesses lie, are they more domestic oriented or do they trade a lot with the U.S? So that's where we expect to see a little bit more stress from tenants.

And then indirectly, we would see a slower economy. So this could be as a result of GDP slowing and unemployment increasing. And this would, in fact, impact the broader economy. So this would impact retail, the more fashion-oriented side of retail, with people pulling back consumer spending. We would likely see maybe an increase in demand for apartments as people pause making big purchases of housing, as well as office employment – we would expect people, again to pull back in the short term in terms of their hiring needs and growth expectations. So that's all for what we would expect in the short term. And there'll be variations here, but that's generally what we would expect. And then the long term, the supply chains will be realigned. We'll have new partnerships, new trading relationships formed, and people will work around whatever new framework that is ultimately implemented here.

And just as a little bit of an aside here, if you've listened to Frances Donald, who's RBC's chief economist, she talks a lot about the, I guess, the silver lining of this potential trade war and the impacts and how we can make Canada just stronger or more self-reliant. And there's really a lot of positive levers that we can pull here, because Canada is nobody's doormat, and it's about time that we start acting like it.

We do have a lot of potential here, and we need to almost get out of our own way in order to make that happen. So, make new trading relationships, go forward with pipelines, really invest in the productivity per capita here. There's a lot of smart people here, and I feel like we have a lot of potential that we can really harness here.

And just to quote Churchill, we should “never let a good crisis go to waste”. So this is really our time to focus inward and bring Canada back to the prominence that it did have before. So that's more of an aside, but yeah.

That's awesome.

This could be great for us.

No, I agree and it is exciting to see, obviously this is going to be challenging, but also there is going to be good opportunities for us and hopefully we can take advantage of that. So clearly tariffs will remain a source of uncertainty, at least in the near term. But let's try to take more of a medium-term view and just talk a little bit about what's happening fundamentally across different sectors in our market. And perhaps we'll start with office.

So we're actually recording this on a Friday. Both of us are in the office. But looking out the window, it's not all that busy in downtown Toronto, but it does feel like we've reached some sort of a steady state, or at least some uncertainty around the future of office is clearing. What are you seeing?

Yeah. So actually, on my way into the office today, the GO train parking lot was more busy than it's ever been on a Friday. And I kind of like the quiet Fridays, but it looks like, that's not going to be with us for very much longer. So just in terms of, I guess, the overall real estate climate here, I would say that we are positive on the overall sector.

So the values have been reset, we have interest rates that are coming down, they’re accretive again, real estate tends to come into focus in a lower rate environment and construction's at a 20-year low. And all of these things are really going to impact the office market and where we go from here. Because we are seeing, increase in occupancy, increase in people coming into the office, people coming in more on a five-day-a-week basis.

Obviously, we have the sentiment south of the border where it's being mandated, so we expect that to trickle up here. And when you look at the office component, like I'm a fundamental believer in office, and people being in the office and that really providing that productivity and the growth within the knowledge sectors that technically make up the bulk of the office space.

I will say that if you look at office on a whole, and this has been spoken about a lot, is the difference between the haves and the have nots in office. So I'm speaking more to the haves of the office space. Within Canada, especially in Toronto and Vancouver, the office market was a little bit distorted based on the supply-demand dynamic that led us into the Covid pandemic, which obviously had a significant impact on office usage.

And that was just, the vacancy was too low. So we had vacancy here about 2 to 3% on average, you pick your number around there, and that's really going to distort markets and make people do funny things in the sense that it was basically a rising tide that floated all boats. And now the tide has come back and you really need to focus on the assets that really have the long term longevity to them, and the ones that can actually provide – because it is a product, a product to your tenants or your clients, your end users.

So the fact that all of these older offices are now being hurt, they should have been adaptively reused or taken down a while ago, they were just artificially buoyed by this smaller vacancy that we had in the market. So now we've swung a little bit too far to the other way, but we would get a balance in like the single upper, single digits in terms of vacancy and where we should be.

So we had strong construction come in and now we have all this new product, which is filling up and really driving demand within the office space. And I will say tenants, the ones in the higher-end space, they are committing to space. They're signing ten-year leases. They are either maintaining or growing their footprint.

And they are paying higher rents. So when you look at our portfolio, we were actually able to have rent reversions that were positive to the tune of like, they were in lower double digits, like 10 or 15% across the board, within our portfolio here. And we are obviously concentrated in the higher-end asset classes, which is where you would want to be within this property type.

But office will always be a fundamental component of real estate portfolios. And that's because it provides a real advantage to companies, again, in the knowledge space where their assets go up and down the elevators every day. So having people together really generates that productivity and the ideas sparking with each other, which is one thing that Canada really needs to focus on, right now.

And I will say that this is just kind of an evolution of what we've seen before. Is office dead, or is office going to be hugely curtailed? This is not something new to the Covid pandemic, like we saw this ten years ago when people started reducing the size of the office footprint per employee.

So they went from about 200 square feet to maybe around 110. And people were crying, oh no, you know, office space is going to go down by half, and then the values are going to plummet. And you know what happened? Values went up, base needs went up. Because if you took everyone's space down to 110, then you require more meeting rooms, you require more kitchen space where people can actually eat, because nobody has these huge offices anymore. So it actually was a catalyst for more space. And it makes people more productive because they're out of these offices and they're together in the space. And then fast forward a few years later, it was hoteling was the biggest thing. And like, oh, that was going to shut down the space needs for office.

And what happened? People needed more space, because people like to come in and sit at the same desk every day. So hoteling didn't work. So this is kind of like the latest iteration. Obviously this was on a pretty much a bigger scale, but I do believe that when you're looking at just the office that should be there in the first place, it's going to be positive and it's going to be positive on both rents and occupied space. And the economy’s growing, too, so that's going to be an important factor for office. I feel like I spoke a lot about office there, but I'm really passionate about this part of real estate. It's not even close to dead, and I would bet on it.

I can see that, Jen. Thank you. And clearly, some of those analogies from history are always a helpful reference. So, if I was just to summarize, sounds like we're cautiously optimistic, but also recognize that recovery is likely going to be uneven given some of the regional differences and also pretty wide spectrum in terms of quality of office space in Canada.

Another sector that's been undergoing quite a bit of change is retail. And there's lots of different subcategories, even just within the sector itself, but at a high level. What are some of the trends that you're seeing and that you think will influence performance in the sector in the medium term?

Okay. So retail's always been a very dynamic portion of the real estate property types. It tends to evolve a lot faster and with trends. And the interesting thing here is that when you have a property, the merchandizing – so the tenants that you put within that property – are actually important because they have to effectively complement each other and be able to drive business.

So it's not just having, you know, one tenant at a retail property. If you actually have a collection of retail tenants within a property, you can really drive sales. So it's like one plus one equals three effectively is what you want to try to do with retail. And retail is more prone to trends, so what we're seeing now is obviously you have your necessity-based retail, which is your grocery-anchored retail.

And this will always be a fundamental component of most people's portfolios, and that will continue to drive growth. People do like, obviously, to be able to get to their grocery stores, and that's more of a non-discretionary, so we continue to see more stable growth within there. But the more interesting part is actually the enclosed malls and what we're seeing now.

So with the latest news, which probably shocked absolutely no one, is that HBC (Hudson's Bay Company) has declared bankruptcy, and that's coming out of mostly the enclosed malls. So what we are seeing now is effectively the death of the large department stores, because no one really shops in that middle market anymore. You have your high-end retailers and then you have more of your lower-end retailers, and it really is the missing middle there that the malls used to command.

And what they've done is they've actually evolved beyond the department stores. And this is just the latest of, you know, big names, obviously, Sears, if I want to really go back, Kmart; Target was a big one as well, that we had to readapt these large spaces. And what mall owners have done successfully is really changed it to be more of an experiential location.

So you go to the mall not just to buy a new pair of jeans, but you also go to have lunch with your friends, or I like to go meet my mom -- we always go to the mall, and we always have lunch and then go shopping. And then they've also added obviously the movie theaters, and an interesting one that we've actually just put into our mall out west is a company that's called Active Video – or it's not called that, but it does active video games. So it is something that is like an experience, to do live action video games, it’s done very well. But again, it's bringing people to experience things in addition to shopping. So we're seeing that switch now, which I think is going to be very positive for the future.

And then it will keep evolving as we go. So the mall is not dead. It's just changing its value proposition as it always has.

Perfect, thanks Jen. Certainly going to miss our Bay Days. And it is unfortunate to see this retailer struggle as it has, but I guess it's nothing new and it's been in the making for some time now.

Yeah. And we'll see if it can reinvent itself and like a much smaller footprint to cater to a smaller clientele.

Yeah. The other sector I want to talk to you about is industrial. And it's been you know, we talked a little bit about the pandemic and this clearly has been a winner coming out of the pandemic just given the strong demand. But it is facing some headwinds today. What's driving that? And how are you thinking about that sector?

So I think there was a lot of pent-up demand that happened within the sector. And that was exacerbated when Covid happened, when people couldn't go to stores and relied more on, you know, internet shipping. And everybody needed to be close because you need to provide the one-day shipping in order to compete with the likes of the Amazons and whatnot.

So what happened there is construction took off, construction for industrial, like that's your shortest term, like taking 4 to 5 years to build an office and construction, you can do in 18 months. So supply comes online a lot quicker. So we did see a lot more of the big boxes come online, which obviously impacted the supply-demand dynamic.

And then the push into the distribution that Covid allowed to happen, that did pull back a little bit. So as stores open, people, they’re social creatures, so they do like to go into the malls, into the retailers. And they do like this omni-channel component.

So they will still buy stuff online, but just not they're not buying everything online anymore. And we also saw the rents obviously in some cases triple, if you're looking at Toronto and Vancouver, to rents that were really high. When you're looking at warehouse and distribution companies, they run typically on very slim margins.

So being able to support these higher rents was going to become more and more challenging as the rents continue to go up. So we've seen an increase in supply. We have seen a slight decrease in demand. And because of that, we are seeing rent come down. Not a lot, they're not going way back down.

But we've seen maybe, you know, a 5 to 10% drop off of the highs. And I really want to put that in context. That's off the highs that we saw probably like last year, it was already coming off last year. So maybe I'm talking like 2023 and 2022. But a lot of people whose leases didn't roll in that time, they're still seeing significant jumps in their rents.

And that's where we've actually been benefitting. The people who are rolling off a $10 or $11 rent, they're still rolling to $17, $18, which is primarily where we're seeing it in the GTA markets as just an example, as we are able to capture that increase, but it has softened a bit. And now with the softening of the rents, it's basically shovels down for construction.

So we've seen a lot of people pull back on construction. Construction's down like on every single asset type, which will be a positive tailwind going forward in the next few years. But in industrials, it’s almost like a tap that you can turn off, and it's been turned off.

Got it. So maybe it's the case where fundamentals are still good, but some of the excitement, or the run-up that we saw because of the excitement post-Covid, that's coming out a little bit out of that market.

Yeah. Trees don't grow to the sky and it always surprises people and I don't understand why, I'm like, that's not sustainable. It needs to go back to more of a level growth trajectory.

So let's wrap up with multi-family. And generally this is a very steady, you know, defensive sector, but lower and potentially negative population growth has injected some uncertainty here as well. So how are you thinking about dynamics in multi-family?

So we do like the multi-family space. And when you look at it from more of a holistic view, especially from the Canadian perspective, we need a lot of housing, we're very short on housing. So it creates a very distorted supply-demand dynamic that we frankly can benefit from here. So it isn't a sector that we are looking to actively add to; it does typically run like countercyclical versus the other sectors. So it does act as more of a stabilizer. So again here, although we've seen – it's the same thing as industrials, so we’re seeing these headlines, rents are coming down, they’re off –but they're off these highs that were effectively not sustainable.

When you look at your renter base, and what they can actually afford, again it doesn't go to the sky. There is a natural limit on what people can actually afford. And we've seen that come down as more properties have come online or people have made different decisions in terms of their living requirements.

But it is still a higher rent than what we currently have within the portfolio. And we're still clipping these rent reversions that are positive from that. So we do like the space, we like the stability of the space. We like the diversification of the space. We're not beholden to one major tenant that's backing the leasing and the revenues and the effectively, the value of the assets. So that driver, diversification is very strong and it's sticky.

Yeah. And just stepping away from the fundamentals and the outlook for the sector, you know, for a long time we talked about housing shortage and all the challenges that come with it. And finally we may be seeing a little bit of relief there, and that’s not necessarily a bad thing. And so you talked about this is one area that we may be looking to add.

Are there any other examples of opportunities that you're excited about? We don't want to give away any secrets, but to give us a little bit of a preview of some of the work the team is doing and what you're interested in.

Yes, I'm very glad you asked that, because I would love to talk more about land leases. And this is a segment of the multi-res property type that we entered with our latest acquisition that happened in Q4 of last year. We are very excited about land leases. So this is effectively a segment of the market, like the economics, they just make sense. So this is a sector where you buy the house, but you don't own the land. So when you do that, you're buying into communities where everybody buys the house and then as the property owner, we own the land. And from a tenant or an owner perspective, it's about 40% cheaper to buy a land leased property than it is to buy a freehold property.

About 50% less. And your up front costs, so the down payment as well as there's no land transfer tax here because the land's not changing. And then your carrying costs over the term, when you look at it, they are about 20% lower. So you can mortgage these properties, so that's not a problem, but you're mortgaging a lower amount and then you're just paying a land rent as well, and when you add those together, that’s still 20% lower than what you would be paying on a freehold.

So the economics just makes sense. But what I get really excited about is actually like the social component here. So land lease communities, it's very much like Pleasantville. So picture a gated community in Florida. You walk into these communities and we walked around with the property manager, and it was like walking around with the mayor. He knew everybody. He knew everybody's names. He knew what they were doing. It's very much a communal society. And a lot of these are retirement oriented. So you get a lot of seniors and they have their houses, which are typically, I don't know, like 1,000, maybe 1,200 square feet.

And these houses are immaculate, when you look at the outside. The gardens are pristine, the grass is cut, everything is perfect effectively. And then you have these community centers, which have their community associations, which are very popular. And we go into them, we walk into like Zumba classes and everybody's, you know, doing the Zumba classes.

And we walked into a bunch of bridge games and everybody is together, talking, laughing. And when you think about, as a society and where the seniors are like, rather than have them isolated in these high rise towers, if you have them in these beautiful communities where everybody is together, everybody knows your name, the impact on your mental health is almost palpable here.

There's this really strong, basically amazing impact on seniors and how they're able to live their lives and really flourish, I think this is a phenomenal thing to be able to add to that or be able to build to foster relationships and get out of this loneliness epidemic that we could potentially be faced with.

And then to boot, the pricing. So the yield, I get 100 basis points higher yield on these types of properties versus traditional multi-res. So very excited about these.

So Jen, we don't get to hear but these opportunities very often. Is this an emerging area in Canada, or has it always been around, but just very closely held? Or why has it not been a bigger part of portfolios in general?

Yeah, it's traditionally not been a typical institutional style property type. And that's basically because of the fragmentation of the ownership here. So a lot of these were traditionally held by the mom and pops, and that was very fragmented across the country. So they've been there for decades and decades.

So through our partnership with QuadReal and BCI – and this is one of the huge benefits of this particular partnership – is they saw the potential here of consolidating, and have done that over the past 10 to 15 years of their ownership of this particular property type. And then they've institutionalized it.

And it is pretty big, within the U.S. as well. So they're a little bit ahead of us in terms of consolidating and institutionalizing this particular space.

Very interesting. So I think if we just look back, we talked about how all the sectors were generally constructive, obviously with some caveats and nuances in every area. But I just wonder how you think about risk. So if we would just highlight a couple things that are really top of mind for you in terms of what could go wrong, what could derail some of our outlook.

Can you speak to what you're thinking about, and your team is focusing on?

Sure. So real estate as an asset class is really impacted by two things. You're looking at GDP and you're looking at population. And then again this is a long-term view. It's a long-term product. So population, you know right now, we're talking about population not growing. But what we're really saying is the population is not exponentially growing.

It is still positive. It's just doesn't have this hockey stick type growth trajectory, which I've said this numerous times, if you have this type of distortion and growth, you're really going to impact your market. So I much prefer a more steady population growth, which when you're looking, when your outlook is like 5, 10, 15, 20 years, when you look over that time frame, is population going to be positive?

Yes. And same with same with GDP. Obviously we're going to have some noise here with the tariffs and we'll be able to work through. But over the long term where do we see positive GDP? And Canada I think checks those boxes. And then the other thing that's kind of like your unknown unknowns, is the black swans.

So we get hit with these, the economy gets hit with these, every wave; it's hard to even say a cadence anymore, but just to be prepared for those. And that's basically what we're looking at from a general macro perspective. And if you're looking at real estate specific, you really want to look at your leverage and your liquidity.

So these are in an illiquid asset class. So if you are overly levered or if your liquidity gets squeezed, if you’re doing huge development projects and something turns or slows down, like for instance what we're seeing in the condo market right now, you want to make sure that you really have different levers of liquidity, because when you're looking at owning properties, like it takes me three months to sell a property, and that's only if everything goes well, which it never does.

So there's always something that pops up. So you just want to be cognizant of that when you're dealing with illiquid asset classes. One of the benefits here of real estate is the contractual nature of the revenue, so the leases, which really underpin the value. So if I'm concerned about what can go wrong, I take comfort in the fact that, you know, leases to large companies with strong balance sheets and defensible business models that are, operating in properties that are owned by experienced owners with their own strong balance sheets, they generally can withstand temporary shocks in the economy, wherever they're going to come from. And they're going to come from somewhere. So it's just a matter of when.

Well thanks, Jen. And so maybe as we wrap things up, we can spend a couple of minutes just talking about how your team is navigating this environment, specific things that you're doing that you think might be helpful for other investors in real estate to keep in mind as well.

Sure. So the strategy that we've employed is really focused on core income producing assets. It is designed to deliver stability through any market cycle. And we have consciously built a diversified portfolio. And diversity really is the key here, because you never know where the next impact is going to be. And we have a diverse portfolio across geography, property type, and industry.

We have 89 assets, 1000 commercial tenants, 3,700 residential tenants. And now we have 6,300 land leased sites. So we really are very diversified. And what you want to do during these times is focus on what you can control, which is income. And that is going to be whether you're doing blending, extending of leases, or if you're really pushing the marketing experience is going to be extremely important during these times.

So who's actually running your assets is very important. We have a very strong team at both the property level, the asset level, as well as the portfolio management level. And you're going to want to stay close to your tenants, understand how these tariffs or the short-term shocks are impacting their business, what you can do to work with them, they're not just your tenants, they’re also your clients.

And then maintaining that diversity. As well, we will look to take advantage of the dislocation that we could potentially see in the market. We're in a very beneficial position to have access to capital and a strong balance sheet, and we will use it.

Well, that's a great way to sum it up, Jen, thanks very much for sharing it. And thank you again for taking the time to join us today. We hope to have you back before the end of the year. I also want to thank all the listeners for joining us. I hope you enjoyed this podcast.

And if so, please subscribe. Thanks, everyone.