Real Assets Market Report...Office The national office vacancy rate was 13.0% as of Q4-2017 (see...

THE POWER OF DISCIPLINED INVESTING®

Real Assets Market ReportDecember 31, 2017

Table of ContentsINVESTMENT AND ECONOMIC OUTLOOK ................. 4

CANADIAN COMMERCIAL MORTGAGE MARKET ...... 6

CANADIAN COMMERCIAL REAL ESTATE MARKET .... 8

OFFICE ............................................................................. 8

RETAIL ............................................................................. 9

INDUSTRIAL .................................................................... 10

MULTI-UNIT RESIDENTIAL ............................................ 11

GLOBAL INFRASTRUCTURE MARKET ......................... 13

CONCLUSION ............................................................. 14

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Quarter 4, 2017 |

Our base case for 2018 is a continuation of the same themes from last year, although it does mark an interesting phase in the economic cycle. Most estimates of capacity utilization indicate that Canada and the U.S. have only recently reached full potential. Globally, measures of developed market unemployment also indicate that excess labour capacity has been reduced. At the same time, central bankers have taken a cautious approach to raising interest rates due to tempered inflation (CPI) levels, which remain low relative to long-term targets. In our view, CPI is a lagging indicator of the economy and markets may be underappreciating the potential for higher inflation, particularly through the latter half of 2018.

Forecasts are for Canadian commercial real estate investment activity to surpass $40 billion in 2017. This is following a record high in the previous year of $34.7 billion.1 This is largely due to the stable political and economic environment in Canada and the demand for accretive yield opportunities that is provided by commercial real estate. The average capitalization rate (“cap rate”) in Canada is 5.69% (see Figure 1). This is a decline of 1 basis point (“bps”) from the previous quarter. The spread differential between cap rates and Government of Canada (“GoC”) bond yields narrowed to 365 bps, which is below the long-term average.

Figure 1: Capitalization Rate

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Q1-04 Q1-06 Q1-08 Q1-10 Q1-12 Q1-14 Q1-16

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Spread Cap Rate GoC 10-Year

Source: CBRE Limited. As at Dec 31, 2017.

In 2017, Canadian commercial mortgage spreads compressed across most sectors. However, the commercial mortgage market continues to offer compelling yield enhancement when compared to a traditional fixed income portfolio.

1 CBRE Limited.

Within the infrastructure space, a record-breaking amount of capital was raised in 2017. Unlisted infrastructure funds raised a total of US$44.2 billion, representing a 24% increase over the 2016 record of US$35.5 billion.2 This trend underscores continued interest from institutional investors to diversify investment portfolios towards privately held infrastructure assets. Other notable trends include a new government led funding paradigm, increased confidence of European institutional investors and a surge of corporate Power Purchase Agreements (“PPAs”) with renewable generators on the basis of monetary and nonmonetary incentives.3

2 InfraDeals Q3-2017 Project Finance League Table and Trend Report, Infra-News, 2017.3 2017: The Year of Infra, Infrastructure Investors, 2017.

Investment and Economic Outlook

Dundas Edward CentreOffice, Toronto, ON

Greystone.ca/Mortgages

Quarter 4, 2017 |

Five and 10-year GoC bond yields ended 2017 at 1.86% and 2.04%, respectively (see Figure 2). This was an increase of 75 bps for the five-year term and 32 bps for the 10-year term over the last 12 months.

Figure 2: Government of Canada Bond Yields

0

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Dec-16 Mar-17 Jun-17 Sep-17

%

5 Year 10 Year

Source: Bank of Canada. As at Dec 31, 2017.

The Bank of Canada maintained the overnight rate at 1.00% in December based on their outlook for inflation and their assessment of risk identified in the Monetary Policy Report. However, the expectation is that there will be further rate hikes in 2018.

Figure 3: Overnight Rate

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%

Source: Bank of Canada. As at Dec 31, 2017. The prime rate is typically impacted by changes to the overnight rate. At the end of 2017, the prime rate was 3.20% after two increases throughout the year. The prime rate impacts variable rate commercial mortgages as the income generated by these loans tends to be linked to the prime rate.

Figure 4: Prime Rate

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%

Source: Statistics Canada. As at Dec 31, 2017.

Spreads for fixed commercial mortgages are 150 – 165 bps for five-year and 160 – 175 for 10-year terms. Fixed commercial mortgages are typically quoted on the GoC rate plus a spread.

Figure 5: Commercial Mortgage Spread

5-Year Term 10-Year Term

Mar 2017 175 – 195 190 – 210

Jun 2017 165 – 185 180 – 200

Sep 2017 155 – 175 165 – 190

Dec 2017 150 – 165 160 – 175

Source: CMLS Financial. As at December 2017.

Commercial mortgage spreads have compressed by five – 15 bps over the fourth quarter. This is largely the result of the increased supply of capital availability from lenders and strong real estate and economic fundamentals in Canada. We still continue to see healthy yield enhancement opportunities for commercial mortgages when compared to traditional fixed income products. We anticipate the commercial mortgage market will remain active throughout 2018 with increased participation by insurance companies and private debt lenders.

Canadian Commercial Mortgage Market

One YorkOffice, Toronto, ON

The Hub @ KGSOffice, Surrey, BC

Greystone.ca/RealEstate

Quarter 4, 2017 |

Office

The national office vacancy rate was 13.0% as of Q4-2017 (see Figure 6). This is a decrease of 24 bps from the prior year. The national vacancy rate has been impacted by the above average vacancy in the Alberta office market, as the Alberta market has faced challenges from oversupply and the drop in commodity prices. Excluding Alberta, the national vacancy rate is 10.3%. Overall vacancy rate is forecasted to decrease slightly in 2018 as absorption (demand) is expected to outpace supply.4

Figure 6: Vacancy Rate

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Vancouver Calgary Edmonton Winnipeg Toronto Ottawa Montreal Halifax National

%

Downtown Suburban Total


The demand for office space is likely to be driven by technology, advertising, media, information, financial services and the consumer sector tenants.5

Expectations are for property fundamentals in Vancouver, Toronto and Montreal to remain strong. RBC expects weak demand for the energy-related markets, however, it is still anticipating a net positive absorption for Alberta in 2018. Calgary is expected to continue to feel the impact from increased supply (i.e. direct and shadow vacancy) and below average demand stemming from depressed commodity prices.

There is approximately 10.9 million square feet of construction activity underway. The majority of which is expected to be delivered between 2018-20.

4 RBC Capital Markets. Jan 7, 2018.5 Ibid.

Figure 7: Construction Completions

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On average, there is 6.3 million square feet of completions each year. The yearly completions forecast over the next five years are below that of the long-term average. The majority of new construction projects are focused on the downtown Toronto market.

Canadian Commercial Real Estate Market

320 Bay StreetOffice, Toronto, ON

Quarter 4, 2017 |

National retail vacancy was 4.4%. This was a decline of 24 bps from the start of the year (see Figure 8). Projections are for vacancy rates to increase given the impending Sears liquidation, with more pressure felt in secondary and tertiary markets. Sears footprint is estimated to be 15 million square feet, which is similar to Target Canada before its 2015 closure.

Figure 8: National Retail Vacancy

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%

Average

Source: CBRE Limited. As at June 2017.

There was 3.2 million square feet of new supply delivered in the first half of 2017 with a further 2.2 million square feet expected to be completed by the end of 2017. The majority of the construction activity is occurring in Toronto and Vancouver with a focus on urban mixed use sites.

Figure 9: Scheduled Completion

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Figure 10: Construction by Retail Type

51.4

15.6

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Mixed Use + Other

Community Centre

Regional Mall

Power Centre

Neighbourhood Centre


Given some of the headwinds facing the retail sectors, landlords are focusing on offering the optimal tenant mix. This is leading to an emphasis towards experiential-based retail. For example, food and beverage are increasingly acting as anchor tenants at retail centres. The International Council of Shopping Centers ("ICSC") forecasts that the space dedicated to food and beverage in Canada, the U.S. and the U.K. can reach up to 20% of the gross leasable area by 2025 and could surpass 30% in Asia. Although there are operational challenges related to the food and beverage space, such as increased parking demand, opening/evening hours and ventilation within the retail space, these challenges are outweighed by the increase in foot traffic and time spent at the centre.6

6 ICSC. April 2017.


Retail

Deerfoot CityRetail, Calgary, AB

Quarter 4, 2017 |

The industrial market continues to show strong fundamentals across the country. The national availability rate is 4.1%, which is at a 15-year low (see Figure 11).

Figure 11: Availability Rate

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%


There was 23.7 million square feet of positive absorption in 2017. This is an increase of 16.4% from the prior year. Absorption (demand) continues to outpace new supply across most parts of the country, particularly in Toronto and Vancouver.

Figure 12: New Supply vs. Absorption

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Construction activity is stable with 13.8 million square feet currently under development. This is below the 10-year average. Construction activity represents only 0.8% of total inventory.

Figure 13: Construction Activity

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As seen in Figure 13, major markets, such as Vancouver and Toronto, have been the most active in terms of construction activity.

Over the last several years, development costs for industrial properties (land prices, development charges, and hard costs) have increased at a rapid pace, particularly in the Vancouver and Toronto markets. The market has generally not seen an equivalent rise in rental rates,7 resulting in challenging economics for new development projects. This, combined with the lack of availability of land for development, has tempered the supply response that has typically followed low availability rates seen in prior cycles.

With the low levels of construction activity, strong property fundamentals (i.e. low availability rates) and increased development costs, we are starting to see rental rates rise for industrial space. RBC Capital Markets is forecasting a 5% increase for 2017 and expects a similar increase in 2018.

7 RBC Capital Markets. Jan 7, 2018.

GTAA LandsIndustrial, Mississauga, ON


Industrial

Quarter 4, 2017 |

The Canada Mortgage and Housing Corporation (“CMHC”) released its market survey, which highlighted vacancy rates for purpose-built apartment buildings down 70 bps (year over year) to 3.0%. This is in line with the long-term average (see Figure 14).

Figure 14: Vacancy Rate

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

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Source: CMHC. As at October 2017.

Vacancy rates across the country have generally declined with the exception of Saskatchewan and Newfoundland, which saw a 30 bps and 20 bps increase, respectively (see Figure 15).

Figure 15: Vacancy Rate by Province

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YoY Change Vacancy


The national average two-bedroom monthly rent reached $992. This is an increase of $27 from the previous year (see Figure 16).

Figure 16: Average Two-Bedroom Monthly Rent

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Figure 17: Average Two-Bedroom Monthly Rent by Province

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2016 2017


The multi-unit residential property type continues to show strong fundamentals. This is a result of increased immigration to Canada, improving employment prospects for the younger generation, baby boomers looking to downsize and housing affordability issues facing many Canadians. These factors will likely lead to steady net operating income growth moving forward.

8515-8532 Jasper AvenueMulti-unit Residential, Edmonton, AB


Multi-unit Residential

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Social Circle Solar FarmGeorgia, USA

Greystone.ca/Infrastructure

Quarter 4, 2017 |

According to InfraDeals, 1,027 transactions totaling US$278 billion closed globally in the first three quarters of 2017. The power, renewables and transportation sectors accounted for 41%, 27% and 20% of deal value, respectively. Investment in Brownfield assets accounted for US$113.8 billion in deal value, which is up from US$111.2 billion in the same period last year and highlights the continued demand for infrastructure assets among fund managers.

Figure 18: Sector Activity by Value

4%

25%

30%

36%

3%

2%

4%

27%

20%

42%

3%4%

Social Infrastructure

Renewables

Transport

Power

Environment

Telecoms

Q3 2016

Q3 2017

Source: InfraDeals Q3-2017 Project Finance League Table and Trend Report, Infra-News, 2017.

Infra Deals also reports that unlisted infrastructure funds raised a total of US$44.2 billion in the first nine months of 2017, which is up approximately US$8.7 billion from the US$35.5 billion secured in the first nine months of 2016. With the average size of infrastructure funds continuing to rise, 2017 stands to be the largest year on record for fundraising.

Figure 19: Global Unlisted Infrastructure Fundraising 2006-17

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Source: Fundraising Round-Up Q3-2017: Capital Continues to Pour In, Infra-Deals, 2017.

North AmericaAccording to Inframation News, Alberta and Saskatchewan continue to be strongholds for Canada’s power generation market. On December 13, Alberta Electric System Operator awarded PPAs to 595 MW of wind projects, some of which could seek financing next year, while SaskPower qualified 15 developers for its 200 MW wind procurement with winning bidders expected to be announced in fall 2018.

EuropeBloomberg New Energy Finance reports that Microsoft has entered into a PPA with Vattenfall, which is a 180 MW wind farm in the Netherlands. Microsoft will purchase 100% of the energy generated to power its regional datacenters, which provide long-term cloud services to its global customers. This agreement represents the largest corporate PPA ever signed in Europe. An increasing number of large corporations are seeking renewable PPAs that unlock fossil-free energy usages, provide cost certainty during periods of high wholesale electricity price volatility, and take advantage of incentives from federal and state tax credits.

The Local Government Pension Scheme (“LGPS”) pooling initiative, which is part of the U.K.’s green finance strategy established in Q3-2017, has recently doubled their target allocation towards infrastructure investments. The LGPS is currently pooling the management of assets of 89 pension funds with aggregate assets under management of £216 billion. The revised target will increase infrastructure allocation from its initial target of £8 billion to £16 billion.8

Demand for European Brownfield infrastructure assets is expected to remain high in 2018. The next 12 months are expected to see high levels of M&A activity with a large number of asset sales set to kick off in early 2018. Headwinds such as rising interest rates and political risk are not deterring investors as more money is expected to move into the sector. Brexit fears are not discouraging investments in the U.K.’s infrastructure due to the long-term nature of the asset class.9

8 The Renewable Energy Infrastructure Investment Opportunity for U.K. pension funds, City of London Corporation, 2017.9 Outlook 2018: European Brownfield Multiples to Reach New Highs, Inframation News, 2017.

Global Infrastructure Market

Quarter 4, 2017 |

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This report is confidential and no part of this material may be duplicated by any means for distribution to any person who is not an employee, officer, director or authorized agent of the recipient without Greystone’s prior written consent.

This report is for informational purposes only. It is not meant as investment advice and is not an offer, solicitation or recommendation to purchase or sell any security. There is no assurance that any predictions or projections will actually occur. Past performance is not necessarily indicative of future results. Commentary reflects the opinions of Greystone Managed Investments Inc. as of the date of the document. This document was developed from sources believed to be reliable, but is not guaranteed to be accurate or complete.

Greystone is a registered portfolio manager, exempt market dealer and investment fund manager.

* An eligible employee is defined as contributing one or more years of service to Greystone.

© Greystone Managed Investments Inc. All rights reserved.

Canadian commercial mortgage spreads compressed in 2017, however, the increase in overall GoC yields absorbed the spread compression resulting in relatively unchanged absolute mortgage interest rates. Notwithstanding any unforeseen issues in the mortgage market, we anticipate commercial mortgage spreads to be relatively stable in 2018 (150-200 bps range).

Supply and demand factors in the Canadian commercial real estate space are generally stable across the country. Office space will likely continue to see demand from the Technology and Financial sectors. Quality retail properties located in major markets are likely to be less impacted from store closures announced in 2017. Industrial properties are likely to see growth in rental rates given the strong fundamentals. Immigration and housing affordability issues will likely lead to increased demand for purpose-built rentals.

2017 was characterized by strong fundraising from unlisted infrastructure funds and robust deal flow in the renewable energy sectors. Meanwhile, the sector is expected to see strong demand for European Brownfield infrastructure assets with a large number of sales set to kick off in early 2018.10

10 Outlook 2018: European Brownfield Multiples to Reach New Highs, Inframation News, 2017.

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Headquartered in Regina, with additional offices in Winnipeg, Toronto and Hong Kong, Greystone Managed Investments Inc. is a Canadian-based institutional asset manager, providing investment management services to its broad client base since 1988.

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