Fitch Warns Canadian Pensions Face More Pressure on Real Estate and Private Credit

James Bradshaw of the Globe and Mail reports Canadian pension funds face more pressure on real estate and private credit, Fitch report says:

Canada’s largest pension funds will likely take more losses on real estate and see defaults on private loans rise over the coming year, but have enough financial flexibility to mostly avoid having to sell assets at depressed prices, according to a report from Fitch Ratings Inc.

A higher cost of debt and slower economic growth have created a tough investing environment, pushing down the value of some private assets that pension funds own. That pressure has been most noticeable in real estate, where almost all of the country’s largest pension fund managers suffered losses ranging from 5 per cent to nearly 16 per cent, erasing billions of dollars of asset value last year.

Some pension fund chief executive officers have signalled that the worst pain may be over for real estate investors as central banks have started to cut rates, giving hope that the cost to borrow money could ease. According to Fitch, however, property values “are still adjusting to higher borrowing costs, a scarcity of available financing and a general repricing of assets,” especially office properties that have suffered from falling demand as hybrid working takes hold.

“There are a lot of mortgages that are yet to mature over the next year, year and a half,” Dafina Dunmore, a senior director at Fitch, said in an interview. “To the extent that there is pressure to refinance – which we certainly expect there to be, certainly for office properties – then you’ll see some continued losses over the foreseeable future.”

Private credit has been one of the best-performing asset classes for some large pension funds in recent years, often earning double-digit percentage gains. But high interest rates have also driven up costs to private borrowers, and the market has grown crowded with lenders.

There are no signs of widespread losses on private loans among major pension funds, and the loans tend to be backed by significant collateral. But defaults are rising and as more loans go bad, pension funds that invest directly in private credit “will be put to the test with respect to their workout capabilities,” Ms. Dunmore said.

“We do expect more losses to come in that portfolio, just given the increased competition,” she said. “And as competition grows, in terms of capital providers, that puts pressure on deal terms and pricing.”

In the near term, major Canadian pension funds have built up a considerable cushion against losses. They are accustomed to holding tens of billions of dollars in cash and other liquid assets that give them breathing room to pay pension obligations, make new investments or meet other financial obligations. The liquidity levels maintained by Canadian plans are “viewed as exceptionally strong,” Ms. Dunmore said, and “we have seen a few plans to build additional liquidity, given the volatility that we face.”

Fitch rates three of the largest Canadian pension funds – the Caisse de dépôt et placement du Québec, Public Sector Pension Investment Board and Ontario Municipal Employees Retirement System – and has assigned AAA long-term default ratings to each. Canada’s eight largest pension funds collectively controlled about $2.1-trillion of assets, as of Dec. 31.

For most of the past decade, pension funds have invested an ever larger share of their portfolios into private assets, seeking higher returns when interest rates were at ultralow levels. Now, as funds receive new contributions from members or look to put the proceeds from selling assets back to work, they are shifting more of that cash into bonds, which offer attractive returns with low risk at a time when interest rates are high.

Private assets will remain a major part of large pension funds’ portfolios, as investment executives chase premium returns, but funds are already trimming their exposure in places, rebalancing the mix of their investments.

“In a higher-rate environment, taking the additional risk makes less sense than maybe it did a decade ago,” Ms. Dunmore said.

Barbara Shecter of the National Post also reports Canadian pensions face mounting real estate losses, but won't be ‘forced sellers,’ Fitch says:

Canada’s large pensions are facing rising losses from real estate investments, according to a sector report by Fitch Ratings Inc., which concluded that fund titans are nevertheless well-positioned to absorb near-term market swings.

“Fitch believes Canadian pension fund investment portfolios will remain pressured by a challenging market backdrop, as the increased cost of debt and anticipated slower growth weigh on private asset valuations,” said Dafina Dunmore, senior director of the ratings agency.

However, she said the funds have “exceptionally strong liquidity,” which will provide sufficient cushion to absorb investment volatility and flexibility to work through troubled investments.

“They are not forced sellers of assets,” Dunmore said.

The Canadian pension funds tracked by Fitch managed approximately $2.1 trillion of net assets as of Dec. 31, 2023.

The Fitch report looked at seven large Canadian pension funds: Alberta Investment Management Corp., British Columbia Investment Management Corp. (BCI), Caisse de dépôt et placement du Québec, Canada Pension Plan Investment Board (CPPIB), Ontario Municipal Employees’ Retirement System, Ontario Teachers’ Pension Plan, and the Public Sector Pension Investment Board.

Real estate property values are being hit by a combination of factors including higher borrowing costs, scarcity of financing options and a general repricing of assets. The effect on office properties is amplified by the shift to remote work and Fitch expects continuing losses in Canadian pension fund office portfolios into 2025 as refinancing requirements mount.

he ratings agency said it has not seen widespread private credit losses, though defaults are likely to tick up for the remainder of this year and into 2025 given higher debt service burdens for underlying borrowers and slowing growth. 

“Pension funds that invest directly in private credit will be put to the test with respect to their workout capabilities,” Dunmore said.

Canadian pension funds are responding to market conditions, including higher for longer interest rates, by increasingly reallocating inflows and sale proceeds to government bonds, according to Fitch. Meanwhile, the fund giants were largely net sellers of private equity assets in 2023 after binging on the asset class following several years of strong returns. 

“While further reductions to private equity are expected, Fitch believes the funds continue to be long-term investors in private assets,” the ratings agency said.

Various factors including the appetite for deals led some of the pension funds to become over-exposed to private equity within their larger portfolio of investments. Moreover, private equity plays generally require a high amount of leverage, which works to their advantage in a time of declining interest rates, but becomes a drag when the debt is rolled over at much higher rates.

In May, BCI sold stakes in private equity funds to French buyout firm Ardian for more than US$1 billion. Ardian also bought a private equity portfolio valued at nearly US$3 billion from Quebec’s Caisse de dépôt in 2022.

And late last year, CPPIB, which invests on behalf of the Canada Pension Plan, sold Ardian a diversified portfolio of limited partnership fund interests in mostly North American and European buyout funds for around US$2 billion.

No doubt about it, in a higher rate environment, pension funds don't need to take additional risk as the risk-free rate has risen significantly.

And real estate portfolios have been challenged mostly owing to one sector -- offices-- which remain under intense pressure.

Earlier this week, James Bradshaw and Rachelle Younglai of the Globe and Mail reported that CPP Investments, AIMCo and Brookfield put a downtown Toronto office building back on the market:

Two major Canadian pension funds and Brookfield Asset Management are trying to sell one of their downtown Toronto office buildings for a second time after failing to get the price they wanted in 2022, according to two sources.

The sale of the 20-storey property at 2 Queen St. E. is likely to be closely watched as it will test buyer appetite amid a multiyear downturn in the country’s commercial real estate sector.

Landlords are dealing with the shift to remote working and a slower-than-expected return to the office. The situation is being exacerbated by an abundance of new office space that has come on to the market since the pandemic started.

The office tower is fully leased and includes tenants such as CI Investments, Bank of Montreal and Bechtel Canada, according to the marketing materials viewed by The Globe and Mail. The tenants are paying about a third less than the going leasing rate for similar buildings and, according to the marketing materials, this means the new owner will be able to “capture meaningful rental upside over the coming years.”

Canada Pension Plan Investment Board (CPPIB), the country’s largest pension fund, owns half the building. Alberta Investment Management Corp. (AIMCo) owns 25 per cent and Brookfield Asset Management owns the rest.

The owners first put the tower on the market in the summer of 2022. At the time, the vacancy rate was rising quickly as tenants across the city were shedding space and new office skyscrapers were being completed. CPPIB and the minority co-owners could not get the price they were seeking and pulled the office building off the market, according to the sources this week. The Globe is not identifying the sources because they were not authorized to speak about the sale.

Spokespeople for CPPIB, AIMCo and Brookfield declined to comment.

The failed sale was a sign of how difficult the market has become for commercial real estate deals. Prior to the start of the pandemic, Toronto had an office vacancy rate below 4 per cent and was one of the most desirable cities in Canada for businesses to lease space. The strength of that demand attracted investors, making it relatively easy for owners to sell their buildings.

In 2019, there was $4.5-billion in office sales across the Greater Toronto Area, according CoStar, a Washington-based commercial real estate information provider. Last year, there was $3.1-billion. In the financial core, there were about $600-million in office sales in 2019 and $250-million last year.

Because there have been so few transactions, it has become difficult for buildings to be valued, but the sale of 2 Queen St. E. could help landlords gauge the value of their buildings.

“It is a quality building in downtown Toronto,” said Carl Gomez, chief economist and head of market analytics at CoStar. “This would give us a good understanding of where pricing is.”

The last significant office building deal to close in Toronto was in early 2022, when Crestpoint Real Estate Investments Ltd. bought 121 King St. W. for $379-million. But at the time of the sale, the office tower was not fully leased like 2 Queen St. E.

Since then, the real estate investment firm has been refurbishing the building, adding amenities like a lounge with a patio and installing a dramatic rockface in its lobby.

Almost all of Canada’s largest pension funds, including CPPIB and AIMCo, suffered sharp losses on their real estate portfolios last year. The funds saw billions of dollars shaved off their investments as high borrowing costs drove down valuations on properties, especially in the office and retail sectors. Meanwhile, investors have soured on the sector. Publicly traded real estate investments trusts such as Dream Office, Allied and Slate have all lost significant value.

Although their vacancy rates have risen, the performance of office buildings varies widely depending on their age, location and quality of their amenities.

There's nothing really new here, offices are struggling throughout North America and pretty much the world in a post-pandemic world where hybrid work is the norm.

But it's also important to put things into context. Some offices that are brand new class A buildings with excellent sustainability scores are doing well, signing long-term leases with corporate clients looking to lower their carbon footprint.

The older offices that cannot be retrofitted are struggling as demand has fallen off a cliff in a post-pandemic world.

Higher rates have hit real estate and other private markets like private equity but in general, real estate remains a solid asset class driven by logistics and multifamily properties and niche sectors like student housing, life sciences properties and data centers.

Canada's large pension funds have exposure to offices where most of the problems lie and have taken big writedowns there but they will survive over the long run as they have been cutting their exposure to offices and retail and focusing on strong sectors in real estate.

Is there more pain in the office sector? I certainly think so especially if US unemployment starts rising and rates remain stubbornly high. 

A recession is never good for real estate, commercial or residential.

The same can be said about private equity which relies on strong consumers.

As far as private credit, that asset class hasn't been battle tested in a major recession yet but it will be and that's where you'll see significant divergence in performance between experienced funds and newcomers looking to capitalize on money flowing into that space.

And don't forget, in a downturn, CPP Investments and other large Canadian funds stand ready to seize opportunities in real estate and private equity through their massive credit operations and by taking advantage of their liquidity (they can borrow in bad times to capitalize on trends as they have exceptional credit ratings).

So, it's not all bad news, you really have to take a very long-term view in these asset classes to gauge overall performance, there are a lot of moving parts.

Below, Bruce Ratner, former New York City real estate developer and 'Early Detection' author, joins 'Squawk Box' to discuss the real estate market, state of commercial real estate, mortgage rate outlook, Ratner's personal crusade against cancer, and more.