The post-pandemic era produced the most drastic interest rate increase in fifty years and has propelled Canadian capitalization (“cap”) rates 20% higher, resulting in downward pressure on real estate valuations.¹ So, it does beg the question: how has Canadian commercial real estate provided stable returns in the face of such severe valuation headwinds and what do we expect of performance going forward?

A new article from TD Global Investment Solutions looks to answer those questions.

In 2022 and 2023, we witnessed the “battle of rising cap rates and income,” with the winner determining the direction of real estate valuations. The cap rate expansion of +20% outpaced the income growth of 17%, causing overall valuations to fall. Considering the magnitude of the cap rate expansion, the drop in valuations was minimal due to robust income growth. However, valuations are only one component of real estate returns. The current income streams coming into the portfolio are another factor. In 2022 and 2023, the current income performance outweighed valuation changes, thus providing positive overall performance.

The severity of the recent cap rate expansion indicates compelling entry points from a valuation perspective. However, as demonstrated by the stable performance amid the fastest rising cap rate cycle on Canadian record in 2022 and 2023, it is the income that will ultimately drive performance.

Historically low vacancy rates, office aside, augmented by elevated Canadian population growth and scant construction starts are indicating robust income growth in the years ahead. While cap rates could witness continued near term pressure if fears of economic contraction and interest rates rise further, the historical move higher in cap rates is indicating an attractive entry point for investors from a valuation perspective alone.  Commercial real estate portfolios with a focus on quality and an overweight allocation in multi-unit residential are well-positioned to weather potential cap rate or economic turbulence and participate in attractive long-term supply demand dynamics.

For more details, read the full article.

¹CBRE All Property Type Capitalization Rate.

^{For Canadian institutional investment professionals only. Not for further distribution.}

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