Headwinds for commercial real estate could have a dire impact on pension plan holders

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Few asset classes face as many challenges in the post-pandemic era as commercial real estate – specifically, the office segment.
These troubles present potential concerns for institutional investors, including pension plans that have allocated significant capital to the space during the past decade. And that, in turn, could be a big issue for Canadians who rely on these pension plans as cornerstones of their retirement, says Jennifer Tozser, senior wealth advisor and portfolio manager with Tozser Wealth Management at National Bank Financial Wealth Management in Calgary.
“This is a big risk that might only get bigger,” she says. “With this whole work-from-home [trend] not going away, you have [many] tenants of Class A space – typically considered the safest of all – asking increasingly whether they want all that office space.”
Vacancy rates in downtown office properties remain persistently high even as life has returned to pre-pandemic normal in most major cities – although mostly among Class B or lower-rated properties, according to Jones Lang LaSalle IP Inc.’s recent Canada Real Estate Outlook report.
Pension funds’ exposure to commercial real estate ranges generally from about five to 15 per cent of total assets for most small to medium-sized plans to as much as 20 per cent for some large plans, says Lewis Gascoigne, lead for research on real assets for actuarial consulting firm Eckler Ltd. in Vancouver.
Office space only makes up a small share of most of these allocations, which are diversified across various types that include industrial and multi-family residential, which have strong fundamentals, and retail, which faces similar headwinds to the office segment, he adds.
Yet, for “some of the mega [pension] plans … there is a greater proportion of assets in office.”
Mr. Gascoigne further explains that large pension plans have much bigger sums to invest, so investing in Class A office space was an attractive proposition thanks to its superior yield in the low-interest-rate environment for most of the past 15 years.
Of course, that has changed markedly in the past 18 months, and the office segment is experiencing greater vacancies and reduced rent income. At the same time, higher interest rates have led to rising borrowing costs for owners. Furthermore, the value of many assets has fallen as low-risk investment vehicles are paying significantly more than they did a few years ago, Mr. Gascoigne says.
These problems are unlikely to go away soon and may actually exacerbate as asset owners with fixed-rate terms on their debt renew in the next few years at higher rates, Ms. Tozser says.
“All of this doesn’t necessarily show up in any current real estate metric,” she says, further noting pension plans’ positions in private real estate can also be somewhat “opaque,” and writedowns may trickle out over the next several years.
Signs of stress are emerging, says Arthur Salzer, chief investment officer with Northland Wealth Management, a multi-family office in Oakville, Ont.
“On the equity side, some are already bleeding red ink because of the vacancy issues, and walking away, giving their lenders the property,” he says about the instances in which debt is non-recourse, and creditors only can pursue collateral – the asset itself.
One notable example is an investment fund connected to Brookfield Properties, which recently defaulted on more than US$750-million in loans for two downtown Los Angeles properties, he adds.
Whether any Canadian pension plans walk away from their stressed office holdings is unclear, but Mr. Salzer notes these investors are often well-diversified and use various risk-hedging strategies to limit these downside outcomes.
However, other exposure through submanagers can also pose risks.
Real estate investment firms such as Hazelview Investments, which serves institutional clients, including pensions, are also facing challenges. Its flagship private fund Four Quadrant Global Real Estate Partners has been under pressure due to rising requests for redemptions.
“There are definitely headwinds in [the] office [space],” says Michael Tsourounis, managing partner and co-head of real estate at Hazelview Investments in Toronto.
Still, the need for office space, while diminished, is not going away, but asset owners must be creative with their assets, including providing more amenities along with more flexible leasing terms, he adds. In other cases, repurposing is required, including office-to-residential conversions.
“The long-term fundamentals for housing are good,” Mr. Tsourounis says, adding that Hazelview Investments has been at the vanguard of this trend.
Prior to the pandemic, the firm completed two conversions of former Class B office buildings, including a low-rise in downtown Calgary and a downtown high-rise in Winnipeg that previously catered to medical professionals, to housing.
“Both were pretty successful from our vantage point because the floorplates they already had were conducive to a conversion, but not every office asset can do that,” he says.
The stresses in the office category also present an opportunity, Mr. Tsourounis adds.
“Having good liquidity is important because you can find great opportunities when there’s great dislocation in the market.”
For advisors, the focus is less on the opportunities and more on overexposure for clients to these stressed assets not only in their portfolios but also in workplace pension plans, Ms. Tozser says.
“You’re not going to convince your client who has been at [Canadian National Railway Co.] for 20 years that they need to get out of the [defined-benefit pension] plan because they have too much exposure.”
But she has minimized allocations to commercial real estate, especially the office segment, in clients’ portfolios.
Even so, the risk exists – however small – that clients’ workplace pension plans could sustain larger than expected losses. In turn, they might face higher contributions while working or even reduced payouts upon retiring.
At the same time, other retail investors could be surprised by losses in their own portfolios from exposure to office real estate they may not even realize they had. These include investments in liquid alternative funds and even preferred shares.
“If you look at the preferred shares market, many issuers have been commercial real estate companies,” Ms. Tozser adds.
Risks aside, commercial real estate remains an important diversifier for pension plans and all investors, for the matter, Mr. Gascoigne says.
“Within the asset mix studies and liability work we do, we still believe real estate has an important role in asset mixes despite the current headwinds,” including the beaten-up office segment, he says.
“A lot of the managers we speak to expect [the] office [segment] will recover, but it could be two or three years before we see some normalcy,” Mr. Gascoigne adds.
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