RioCan chief executive Edward Sonshine is intimately aware of two of the most pressing macroeconomic risks facing Canadian companies today: interest rates and volatility in the housing market.
Since the end of April, the company that he runs, Canada’s largest real estate investment trust, has seen its share price tumble by more than $3 because of investors’ concerns about the implications of higher interest rates.
And as the owner and manager of Canada’s largest portfolio of shopping centres, RioCan is vulnerable to the knock-on effects of any housing market slowdowns. The bulk of Canadians’ wealth is tied up in their homes, and when they begin to feel house-poor, they cut back on their spending, hurting retailers.
Neither long-term interest rates nor house prices are predictable. To cope with the uncertainty, Mr. Sonshine’s strategy is to plan ahead rather than constantly trying to read the tea leaves.
“I figured out a long time ago that I can’t predict interest rates, and the truth is I’m not sure anybody can,” he says. “I sometimes think economists exist to make weathermen seem more accurate.”
Long-term interest rates, based off government bond yields, began rising in May and spiked further in June after U.S. Federal Reserve chairman Ben Bernanke suggested the central bank might start tapering its asset-buying program. Yields on 10-year government of Canada bonds rose from below 1.75 per cent in May to peak above 2.75 per cent this month, before edging closer to 2.50 per cent.
Investors in real estate investment trusts such as RioCan are concerned about the impact that higher rates will have on these companies’ mortgage and debt costs down the road. (Rising interest rates also hurt the REITs because they mean that there are more securities competing for money from investors who are searching for yield).
Higher rates will pose similar problems for companies in a broad range of sectors.
One of RioCan’s main tools to cope with unpredictable interest rates is to stagger its debt so that no more than 10 per cent to 12 per cent of it comes due in any one year.
“We really can’t predict rates, so we try to protect against that by diversifying our debt maturity schedules,” Mr. Sonshine says. “It takes a long time to set that up.”
In addition to that, RioCan acted early to refinance some debt.
“We recognized at the beginning of this year that these aren’t low interest rates, they’re unrealistically low, and we did, I’d say, at least $600-million worth of refinancing in the first four months of the year,” Mr. Sonshine says. “We paid a penalty to pay off a big debenture we had that was coming due in 2015 and replaced it with a 10-year debenture at 3.72 per cent in April. Today, that same deal would cost you 5 per cent.”
RioCan, which has always been fairly conservative about debt, has also been working to cut its leverage even further. These moves are helping to curb its interest expenses.
“Anyone in business today has to assume that their cost of capital will likely be more expensive in the future than it is today,” says James McKellar, professor of real estate and infrastructure at the Schulich School of Business.
Interest rates aren’t the only risk that Mr. Sonshine worries about.
RioCan is working to take advantage of the rapid urbanization of North America by concentrating on a relatively small number of downtown markets – Toronto, Vancouver, Calgary, Edmonton, Montreal and Ottawa. It has been shifting from the focus it long had on suburban malls to a focus on urban mixed-use projects, which increasingly involve teaming up with residential developers in cities such asToronto.
But by turning its emphasis to downtown markets, and by incorporating residential components in projects, RioCan is heightening its exposure to the whims of the housing market.
While experts and economists have varying opinions on the health of the residential market, most agree that current house prices are too high, and that the house price growth that Canadians have taken for granted over the past decade is likely to stagnate in the next few years. They also agree that the element of the market that’s most at risk in the period ahead is condos in urban centres, especially Toronto.
“Certainly the housing market does have an impact on us,” Mr. Sonshine says.
As real estate brokerage firm CBRE recently pointed out in a report, there is a strong link between the housing market and retail spending. If national house prices lay flat and condo prices decline, retailers are likely to be impacted. And that decline in consumer spending would impact the broader economy, posing a challenge for many businesses.
Mr. Sonshine’s core strategy for coping with the potential of a housing market downturn, or other macroeconomic setbacks, is diversification. This includes having assets in diverse geographies, having a broad base of different retail tenants, and having “as many revenue sources as you can,” he says.
One way that he’s currently considering diversifying his revenue sources is by potentially incorporating rental apartment buildings in a few of RioCan’s Toronto mixed-use projects. The move would also help the company to hedge against falling condo sales, and take advantage of rising apartment rents.
But Mr. Sonshine wants to spend a bit more time weighing that possibility.
“We’ve been doing a lot of analysis over the last while,” he says. “I haven’t made any firm decisions.”
The experts weigh in
Here’s what two experts say about RioCan’s strategies, and why this is a key issue for 2014.
Real estate investment trust analyst with RBC Capital Markets in Toronto
Broadly speaking, we observe three risk-mitigating components to RioCan’s debt management strategy. 1) It keeps its overall leverage at a prudent level, 2) It spreads the maturity profile of its liabilities over many years, which limits the degree of interest rate risk in any given year (currently there is no more than about 15 per cent of total debt that requires refinancing in each of the next three years), 3) it uses multiple forms of debt – including bank lines, mortgages and senior unsecured debentures – which provides for diversification of capital sources.
Adjunct associate professor in economics at the Joseph L. Rotman School of Management in Toronto
(If there were to be a housing slowdown) anything related to consumer expenditure, especially discretionary consumer expenditure, is worth worrying about. Which means you want to worry more if you sell Audis than if you sell carrots. People would feel poorer, and to rebalance their own assets they would consume less.
That’s why it’s quite right for RioCan to worry about the health of its shopping centres, because the chief knock-on other than construction and realtors is on the consumer side.
The possibility that house prices could actually go down, or stop rising to the extent that they have before, is more likely to occur in the hot markets. Winnipeg, for example, might not be as bad off as Toronto or Vancouver or Montreal. A firm that was thinking about protecting itself against this would want to ask where the consumers are that it’s most worried about.