Disclaimer: The information and materials prepared are for internal use only and on how the Dancap Family Investment Office (“Dancap”) views current market dynamics. Dancap does not guarantee the accuracy or completeness of the material and it is not intended in any manner to be investment, financial, legal, accounting, tax or other advice and should not be relied upon.
Dancap's Current Real Estate Strategy
Dancap has over 30 years of track record investing in real estate through third party funds, co-investments, and direct investments in major cities across North America. This market overview focuses on Dancap’s current real estate holdings based on type of investment and location and looks to provide an update on current market dynamics, outlook, and future risks.
The vast majority of the Dancap real estate portfolio is now comprised of co-investments in B-class, US multifamily value-add properties in high-growth cities. Our real estate portfolio focuses on US multifamily value-add opportunities because of the strategy’s strong risk-adjusted returns coming from cost-effective CAPEX programs, organic rent growth, stable operating expenses, and strategic exit timing. We are a passive limited partner and target a net 15% IRR and 2.0x MOIC over a five year hold for value-add opportunities.
A smaller portion of our real estate portfolio holdings are invested in multifamily residential high-rise condo developments in the Greater Toronto Area. We are a passive limited partner and target a net 20% IRR for new construction developments.
United States Strategy
High interest rates, persistent inflation, and the denominator effect took a toll on private real estate in 2022. Private real estate funds raised $128B across 267 vehicles, a 28% decline from the $179B raised by 549 funds in 2021. Dry powder levels also experienced a downward trend, dropping from a peak of $486B in 2021 to $423B in 2022. Opportunistic real estate funds accounted for the largest proportion of the overall capital raised, with $67B or 52% across 166 vehicles, marking the highest percentage since 2008; Brookfield’s mega-fund closing on $17B represented 25% of the fundraising total for the strategy.
The strategy that experienced the most significant decline between 2021 and 2022 was value-add, which raised only $30B in 2022 compared to $56B the previous year. Unlike opportunistic funds, value-add strategies do not have a high enough return profile for investments in the space to offset the negative effect of higher interest rates on returns. Additionally, it is possible that value-add capital was raised through vehicles that were not captured through closed-end real estate fund data, which may explain the dramatic drop in fundraising.
Source: Pitchbook H2 2022 Global Real Estate Report
In 2022, private real estate diverged in valuations from public real estate. According to the National Association of Real Estate Investment Trusts, the public real estate index was down 25% for the year, while private real estate posted a return of 7%. This suggests that private real estate may have offered investors a more stable investment option during a period of market volatility
Multifamily Rent Growth Continues
While new construction remains at a high of 300,000 units per year (a 15% increase), only 10% of the new builds are entry-level homes (up to 1400 sqft). This means that there is a significant shortage of entry-level homes in the US. Occupancy rates are currently at 95% and are expected to increase to 95.5% by the end of 2023. In 2022, rents increased by 15% year over year, as shown on the chart provided by Fannie Mae. Our view is that rents will continue to grow but at a slower annual pace of 3%.
Source: Fannie Mae – 2022 Mid-Year Multifamily Market Outlook – Demand Remains Resilient
In the US, there are over 780,000 new multifamily units slated for completion by the end of 2023, consisting primarily of Class A units, which are the most expensive to rent. However, due to inflation, the increase in unemployment, and construction delays resulting from labor shortages and elevated materials prices, it is unlikely that all new units will be delivered as scheduled. This makes it unlikely that the new supply will have a significant impact on affordability nationwide.
US Multifamily Cap Rates
Multifamily real estate’s ability to provide stable rental income is attractive in a low-yield endowment. Furthermore, multifamily real estate acts as a hedge against the risk of higher inflation. While cap rates have been rising across the board, the general consensus is that there is no need to add additional turns to cap rates (industry standard it 50 to 100bp) for exit prices. Cap rate spreads of 4% were not sustainable for the long term, however, during times of volatile interest rates, spreads can compress to very low levels. Based on historical data, cap rates could be expected to increase at a moderate level for the remainder of 2023, but do not expect to increase much more than the 100bps they have already increased since mid 2022.
That said, Dancap’s current underwriting continues to assume cap rate expansion over the next five 5 years. Dancap continues to expect multifamily real estate to generate net double digit returns in the years ahead driven by strong macroeconomic fundamentals and higher rent growth. We maintain our minimum net return target of net 15% IRR and net 2.0x MOIC over a five-year hold period.
US Multifamily Outlook
Dancap continues to see opportunities in the Multifamily Real Estate sector and our outlook remains positive. As we stated above, cap rates and interest rates have increased resulting in multifamily prices decreasing. Sellers are not ready to sell their properties for these lower prices so they are continuing to hold onto them and wait out these interest rate hikes. Prices are expected to stabilize by mid 2023 and sellers will begin to add inventory to the market. Based on demographic trends, expected job growth, and household formation trends, the near term outlook for multifamily remains positive. However, persistent inflation and recessionary fears are potential headwinds facing the asset class.
Greater Toronto Area (GTA) Strategy
New condo prices for multifamily residential high-rise developments in the Greater Toronto Area remains firm and reached a record-high average of $1,453 psf in Q2-2022, up 4% quarter-over-quarter and 20% year-over-year, partly the result of an increase in inventory at higher-priced projects. As developers deal with rising construction costs, labour shortages, increases to development charges, higher interest rates, and lengthy approval timelines, lower new supply will likely keep condo prices from falling dramatically. Furthermore, the slight decline in condo resale prices thus far, which decreased 4.9% from a high of $988 psf in Q1 to $940 psf in Q2, is not creating an urgency for price reductions for new units.
It has been estimated that Ontario alone needs 1 million new housing units just to meet current demand. The entrance of over 400,000 new immigrants/year into Canada (half of which are expected to settle in the GTA) requires that around 200,000 new units be built a year, or 1 million over the next five years. Restrictive local planning and escalating supply chain costs will continue to limit new supply and keep prices stable.
GTA Mutlifamily Outlook
Q1 2023 saw rents reach a record high average of $3,002/month in the GTA. Annual rent growth for rentals in Q1 2023 was 13.8%, based on units that turned over in Q1 2023, compared to Q1 2022. This represented a slower rate of annual rent increase than the 15.1% in Q4 2022. Vacancies remained under 2% for the 5th quarter in a row. An additional 7,520 units are expected to be completed by the end of 2023, which is an increase of 174% over units completed in 2022, but this will likely not offset demand. Furthermore, new construction has dropped by 60%, which goes to show the problems developers are facing as the demand continues to increase.