Canada regulators seek comment on regulating foreign auditors

The Canadian Securities Administrators is seeking comment on a proposal mandating potential oversight requirements for foreign audit firms.

“Auditors are important gatekeepers in our market, and we are seeking input on our current oversight requirements to ensure there continues to be public confidence in the integrity of financial reporting,” said Louis Morisset, CSA chairman and chief executive of Quebecs Autorité des marchés financiers.

The move recalls the Sino-Forest scandal. An OSC review of Chinese companies listed on Canadian stock exchanges that followed the Sino-Forest revelations revealed a number of concerning issues. Foremost among them were the challenges faced by the Canadian Public Accountability Board (CPAB) in accessing audit work performed in a foreign jurisdiction.
 
CPAB requested that the CSA amend its rules to require all audit firms involved in a significant portion of an audit (component auditors) to register as a participating audit firm (PAF), which would give CPAB a legal basis to inspect the audit work done by these firms.
 
According to CPAB, audits that involve foreign components in the United States, United Kingdom and Australia, comprise 37 per cent of the total number of reporting issuers whose audits involve foreign component auditors, and 90 per cent of the market capitalization. But CPAB has acknowledged that these are not high risk jurisdictions.
 
The difficulty is that even if PBA registration was in place, access to auditors’ work in China would still be restricted. The extent of access to working papers in at least five other emerging markets was also unclear.  
 
For  its part, the CSA acknowledges that requiring PAF registration for component auditors might present challenges in finding auditors willing to subject themselves to CPAB inspection. Some auditors might raise these fees in reaction to the new requirements.
 
The CSA is also considering whether to require additional transparency in situations where CPAB access has been denied or impeded.

Financial Post

CPPIB inks US$4.3B deal with investment manager to take international school company private

TORONTO — The Canada Pension Plan Investment Board and Baring Private Equity Asia have signed a deal to take Nord Anglia Education private in a transaction that values the international school company at US$4.3 billion, including debt.

The cash offer of $32.50 per share represents a premium of 17.7 per cent to Nord Anglia’s Monday closing on the New York Stock Exchange.

Hong Kong-based Nord Anglia has 43 schools that teach a total of 37,000 students from kindergarten through to the end of high school in China, Europe, the Middle East, North America and Southeast Asia.

CPPIB said the deal is its first direct equity investment in private education.

Baring Private Equity Asia controls 67 per cent of Nord Anglia.

Funds affiliated with the investment manager have been investors in Nord Anglia since August 2008 when they completed a previous privatization transaction with company management.

The deal includes a so-called go-shop period, during which Nord Anglia can evaluate proposals from other buyers for 30 days.

In March, CPPIB, along with Singapore wealth fund GIC and property owner Scion Group LLC, said their joint venture had bought three U.S. student housing portfolios for about $1.6 billion.

The transaction is subject to shareholder approval and customary closing conditions.

With a file from Thomson Reuters

Great-West Lifeco to cut 1,500 jobs, 13% of its workforce, as industry competition heats up

WINNIPEG — Great-West Lifeco says it will cut 1,500 positions over the next two years in response to changing technology and customer expectations.

The cuts are equal to 13 per cent of the Winnipeg-based company’s 12,000 employees in Canada.

Great-West says the job cuts are part of a transformation of its business as it faces heightened competition.

More to come …

08:04ET 25-04-17

Conflicting rulings in Ontario and B.C. muddy the waters in Eco Oro Minerals board battle

A layer of drama was added to the fight between Eco Oro Minerals Corp. and a group of dissident shareholders Monday after an Ontario regulator and a B.C. court came to different conclusions regarding the battle over control of the board.

The shareholder group, which is trying to oust the board of the precious metals exploration and mining company in favour of their own slate, got a boost when the Ontario Securities Commission ruled early Monday that a disputed share issue by the company required a shareholder vote.

But a ruling from the B.C. Supreme Court later in the day — in response to a separate claim — found that the minority shareholders of Vancouver-based Eco Oro had not met the test for shareholder oppression. It also adjourned a special meeting at which a different vote — over board composition — was to take place Tuesday.

“In effect, the OSC’s decision and my decision are at odds,” wrote The Honourable Mr. Justice G.P. Wetherill in the B.C. court decision. “In my view, it is not realistic that the April Meeting can proceed tomorrow.”

He ordered that the board must set a new meeting date by Sept. 30, “to allow the parties to take whatever steps they deem appropriate to resolve the conflict between the OSC’s decision and my decision.”

The OSC’s ruling set aside an earlier decision by the Toronto Stock Exchange that allowed Eco Oro to issue 10.6 million new shares to four parties — Paulson & Co. Inc., Trexs Investments LLC, Amber Capital LP, and the company’s executive chair Anna Stylianides. Those shares diluted the support of the dissidents, led by Courtenay Wolfe and Harrington Global Opportunities Fund Ltd.

The OSC decision requires Eco Oro to get shareholder approval in order to issue the new shares. After it was released Monday morning, Wolfe and Harrington Global issued a news release expressing confidence that the exploration and mining company’s board would be “reconstituted” at this week’s meeting.

Wolfe told the Financial Post that proxies representing more than 50,700,000 votes, or 48 per cent of those issued and outstanding, had already been submitted in favour of the group’s board nominees.

But the outcome wasn’t clear — even before Monday’s conflicting rulings delayed the meeting.

Last week, Eco Oro issued a news release that claimed the company had enough votes to keep the incumbent board. The company noted that proxy advisory firms Institutional Shareholder Services and Glass Lewis had recommended shareholders vote in favour of the management’s nominees to the board.

The dissident group has argued that management and the current board are “out of touch.” Among the issues they are upset about is an earlier transaction that transferred 78 per cent of the proceeds of an ongoing arbitration to a select group of shareholders and insiders.

Eco Oro issued a statement late Monday afternoon summarizing the day’s regulatory and court decisions, and said the company “will provide further information to shareholders as it becomes available.”

Wolfe remained confident after the B.C. court ruling.

“While it would appear that the vote will be delayed, we are comfortable that we have the votes to win,” she said.

Financial Post

Dare heiress files appeal in ongoing legal battle with brothers and fellow shareholders

Carolyn Dare-Wilfred, an heiress to the Dare Foods cookie-and-candy dynasty, has filed an appeal to the Ontario Court of Justice after her lawsuit against her brothers, who are fellow shareholders in the family firm, was dismissed last month.

Dare-Wilfred had claimed in her 2015 lawsuit that her brothers Bryan Dare and Graham Dare had shut her out both personally and as a shareholder of the privately-owned processed foods conglomerate — which sells products such as Breton Crackers and Bear Paws in dozens of countries — leaving her unable to access the hefty value of her stake.

She had asked the court for relief under a provision of the Ontario Business Corporation Act called the “oppression remedy.”

In March, Justice Barbara A. Conway disagreed with Dare-Wilfred’s assertion that the court should order her brothers Bryan and Graham Dare to buy her shares of the Kitchener, Ont.-based company at fair market value or put the shares up for public option, and dismissed the case.

Dare-Wilfred submitted an appeal to the court, dated April 19, in which her lawyers argue “the Judge erred in law by enforcing the strict legal rights of the parties as opposed to a fair and equitable remedy.”

Financial Post

The lax oversight of syndicated mortgages is hurting Ontario investors with little relief in sight

Arlene McDowell began investing in syndicated mortgages in 2012 and continued to commit more of her money as the initial eight-per-cent payments rolled in.

Other investors have also been piling into this growing segment of the real estate market. The syndicated mortgage market grew to $6 billion in 2016, from $3.7 billion two years earlier, according to the Financial Services Commission of Ontario (FSCO).

Many investors, like McDowell, were likely unaware that two reports in 2014 criticized the way FSCO, a key financial regulator that oversees mortgage brokers, was handling its duties.

Now the payouts promised to McDowell have dried up, leaving much of her retirement money, close to $250,000, wiped out or in limbo after the developments she invested in, including one in Barrie, Ont., ran into trouble.

“I just never anticipated … this (money) was really at risk,” said McDowell, 62, who lives in Toronto. “I would never have entertained all of this.”

The Ontario government last year announced a plan to overhaul FSCO, replacing it with a new regulator as recommended by an expert advisory panel. But the changes, announced nearly two years after the critical reports and still many months in the making, are quite likely too late for investors like McDowell.

With the help of a lawyer, McDowell took her complaints to a litigation firm that has filed five separate lawsuits claiming a total of $137.5 million in connection with the sale of syndicated mortgages to assorted clients. 

The lawsuits, filed in the Ontario Superior Court of Justice, target a fraction of the overall syndicated mortgage market and have not been tested in court. But David Franklin, one of the lawyers involved with the suits, believes the government should have kept a closer watch on FSCO, which is accountable to the Minister of Finance.

Both Ontario’s auditor general and the International Monetary Fund in 2014 had identified shortcomings at the market watchdog that regulates the mortgage brokerage sector in addition to loan and trust companies, parts of the auto insurance industry, and provincial pension plans in Ontario. 

“The province bears responsibility for its agency,” said Franklin, who introduced McDowell to lawyers at Levine Sherkin Boussidan, the litigation firm that filed the lawsuits.

There is nothing inherently wrong with assembling a group of investors to back real estate developments through syndicated mortgages, and many do so without issue. Some of these investments back commercial and large-scale residential real estate developments in their early stages, and projects include condominium, office, and retail complexes.

But the lawsuits against a handful of purveyors under FSCO’s watch, and others involved with syndicated mortgages including Fortress Real Developments Inc., which has denied any wrongdoing, allege that retail investors were sold securities that were far too risky for them.

The suits also claim the true nature of the investments was not disclosed, and investors — who were led to believe the syndicated mortgages were attractive real estate investments to hold in their RRSPs and other savings vehicles — were not properly advised about what recourse they had if things went wrong.

For example, the lawsuits say investors were not told that developers receive less than 50 per cent of the funds raised, which is crucial information for investors to properly assess the likelihood of a project’s ultimate success. 

One lawsuit alleges that approximately 35 per cent of an investor’s money is held by Fortress “as anticipated profits (years before any profits are actually earned).” The statement of claim states that funds also go to broker and agent commissions, and for legal advice provided to investors. They are told this advice is independent, but the lawsuit alleges it is not. 

“Additional funds are retained to pay investors their ‘interest’ over the term of the loan. This means investors are paying themselves their own ‘interest’ from their capital they invested,” the lawsuit alleges.

I just never anticipated … this (money) was really at risk

When the number of lawsuits reached three late last year, Fortress issued a statement calling the claims “untrue” and “highly misleading,” and said they are “clearly aimed at damaging the reputation of Fortress and Fortress projects in an attempt to benefit its competitors.” 

The firm moved to have the lawsuits thrown out, which will be heard by the court in late May, according to Fortress spokesperson Natasha Alibhai.

“As previously said, Fortress will vigorously defend the proposed class actions,” she said in an emailed statement.

Alibhai said the biggest sources of funding for Fortress projects are large institutional lenders such as banks and credit unions.

As a real estate development company, Fortress is not regulated by FSCO, she noted, though “Fortress projects have also been financed in part by syndicated mortgage loans, which are offered to members of the public in Ontario by mortgage brokers and agents who are licensed with and regulated by FSCO.”

As the lawsuits wind their way through the system, the regulatory overhaul creeps along.

Jonathan Hayward/The Canadian Press

Jonathan Hayward/The Canadian Press

Last June, an expert advisory panel convened by the Ontario government to review the mandate of FSCO concluded that there were “regulatory gaps” in the syndicated mortgage market, and recommended the sector be subject to the same level of scrutiny applied to other financial markets.

The report, referencing the shortcomings identified in 2014, recommended replacing FSCO and reconfiguring the role of other components of the province’s capital markets by creating a more credible, better-resourced regulator with a more proactive approach to enforcement.

“FSCO hasn’t shown a sense of urgency in protecting consumers,” said Neil Gross, a securities lawyer and president of Component Strategies Consulting in Toronto.

“There really is no other way to interpret the findings of the auditor general in 2014 and the Expert Advisory Panel (that recommended replacing FSCO in June) last year,” added Gross, who was, until recently, executive director of the Foundation for the Advancement of Investor Rights (FAIR Canada). “Their verdict — harsh but true — is that FSCO’s perceived as an agency unable or unwilling to take effective enforcement action.”

Many of the changes recommended by the expert panel are now under way, but in a recent draft statement of FSCO’s priorities for 2017, the regulator described the transition as a “complex project” that will take more time, with many government decisions yet to be made.

One industry source close to the overhaul estimates that, even once legislation is proclaimed, the new system for syndicated mortgages won’t be fully in place for a couple of years. The earliest estimate by another source familiar with the government’s process is mid-2018. 

As an interim step, sources suggest Ontario’s government on April 27 may earmark more funds for FSCO in its spring budget, and possibly flesh out plans to bring syndicated mortgages under the purview of a more able regulator, perhaps one that already exists.

THE CANADIAN PRESS/Darren Calabrese

THE CANADIAN PRESS/Darren CalabreseFinance Minister Charles Sousa.

“The government is taking steps to ensure that strong investor protection is provided under the regulatory framework for syndicated mortgage investments,” said Jessica Martin, press secretary for Ontario finance minister Charles Sousa, in an email.

Among them, she said, is the establishment of a working group composed of representatives from the ministry, Ontario Securities Commission and FSCO that is developing recommendations for the government’s consideration.

Martin said she could not comment on the lawsuits targeting syndicated mortgages, and did not respond directly to a question about whether weaknesses at FSCO identified in 2014 led to problems in the market going unchecked. 

The auditor general’s report highlighted several problems at FSCO, and found that complaints “with high risks to consumers take several years to address.” 

The report said 95 per cent of complaints involved the mortgage broker and insurance sectors, and it highlighted both “significant delays” and “weak enforcement action.”

Among the examples given was a case where it took FSCO more than two years to issue a proposal to revoke a mortgage agent’s licence following an anonymous report that he had declared bankruptcy, pleaded guilty to three charges under the Bankruptcy and Trustee Act for failing to comply with conditions of his bankruptcy, and failed to disclose this information as required by the regulator on licence renewal applications in 2010 and 2012.

FSCO hasn’t shown a sense of urgency in protecting consumers

The auditor general also criticized FSCO’s market conduct division on proactive investigations — those that are not triggered by a complaint.

“Based on the examination activity, it would take the Division about 10 years to examine mortgage brokerages, brokers and agents, even without the other sectors being examined,” the report said.

Given the significant issues raised by the auditor general, some industry watchers were surprised that little seemed to change following the report’s release, particularly since the regulator had already been flagged by an international monitor earlier in 2014.

The IMF, as part of a global survey on how regulators supervise business conduct, concluded FSCO was “constrained by limited resources” and deemed “reactive.” The IMF was less critical of other Canadian regulators and singled out Quebec’s Autorité des marchés financiers for operating “in line with international best practice.”

From the outside, there has been little indication FSCO directly addressed the issues raised by the pair of critical reports.

The regulator’s first major syndicated mortgage enforcement actions relating to a licensed broker or brokerage didn’t occur until Oct. 20, 2016, when it issued five licence suspensions and one cease and desist order. (It did, however, issue a “warning notice” on its website in March 2015 stating Titan Equity Group Ltd. was neither a licensed brokerage nor authorized to deal in syndicated mortgages in Ontario.)

Anecdotally, stories have made the rounds in investment circles for years that industry players who found themselves in the crosshairs of other regulators — such as the OSC, Investment Industry Regulatory Organization of Canada and Mutual Fund Dealers Association — would shift their focus to selling products regulated by FSCO, such as segregated funds.

Last year, FSCO took steps to reduce this regulatory arbitrage by pledging to share disciplinary decisions and sanctions with IIROC and the MFDA, two national self-regulatory agencies with oversight over investment products including mutual funds.

The same month FSCO posted its website warning about Titan, Ontario Finance Minister Charles Sousa appointed a three-member “expert advisory panel” to review the mandates of FSCO, the Financial Services Tribunal and the Deposit Insurance Corp. of Ontario.

A preliminary report landed in November 2015, and the final report was delivered in March 2016 (though it was not released publicly until June).

The report, authored by lawyer and former OSC vice-chair Larry Ritchie, former insurance executive George Cooke and journalist James Daw, raised specific concerns about the syndicated mortgage market and noted an increase in what they called non-standard services including syndicated mortgage promoters. 

While these relatively new players should be subject to existing legislation, “there are those who feel the regulator has not applied adequate scrutiny,” the report said.

The panel urged “active” monitoring of companies raising money from small investors for property development through the sale of syndicated mortgages. 

It also suggested that it might be preferable to assign oversight and scrutiny to a securities regulator — rather than FSCO or even its replacement — to apply a more consistent approach to ensuring compliance with legislation and regulations governing investments.

The authors said a consistent message they received during their consultations was that the “credibility of the regulatory regime is undermined by the perception that FSCO is unable or unwilling to undertake effective enforcement.”

Peter J. Thompson/National Post

Peter J. Thompson/National PostToronto's Queen's Park, home of the Ontario Legislative Building.

Last August — two months after publication of the panel’s final report and nearly than two years after the auditor general raised a red flag — FSCO finally issued a warning about the syndicated mortgage market.  

A statement that remains on the regulator’s website warns, “FSCO considers SMIs (syndicated mortgage investments) to be high risk, and notes they may not be suitable for the average investor.”

It goes on to state that while there are “many legitimate SMI opportunities, FSCO warns consumers to be wary of SMIs with advertisements promoting a high return or ‘fully secured’ investment.”

In October, the regulator suspended the licences of two firms and a handful of individuals operating in the sector including Tier 1 Mortgage Corp. and First Commonwealth Mortgage Corp., alleging that certain syndicated mortgage transactions had contravened the Mortgage Brokerages, Lenders and Administrators Act.

Grant Thornton Ltd. was appointed by the courts to administer 11 corporations previously performing mortgage administration functions on behalf of syndicated mortgage investors in Tier 1 real estate development projects.

Jonathan Krieger, senior vice-president at Grant Thornton, said the situation illustrates a range of issues that can sometimes crop up with syndicated mortgages under the current system of regulation.

“One issue appears to be around the adequacy, completeness and transparency in the disclosure of information to investors, so that they fully understand the nature and risks associated with the investment,” he said.

Investors are drawn in by the high yield relative to other investments, and might not be familiar with the real estate underlying their investment, Krieger said. Institutional investors can be counted on to conduct sufficient due diligence on a syndicated mortgage investment, but retail investors typically do not.

Another issue, he said, is that in some cases “there isn’t accurate monitoring of the borrower to ensure that mortgage funds advanced are being used for their intended purpose.”

Despite the government’s pledge improve oversight, Franklin, the lawyer who kick-started the syndicated mortgage lawsuits, said not enough has been done to justify the continued marketing of such products to ordinary Canadians.

One issue appears to be around the adequacy, completeness and transparency in the disclosure of information to investors

As recently as March 28, he notes, FMP Mortgage Investments Inc., a mortgage brokerage, issued a news release touting syndicated mortgages as an alternative to volatile financial markets for retirement savings.

The FMP news release tells prospective investors there is “stability and predictability in a syndicate mortgage, where your money is secured against the value of the land and not a variable share tied to markets.” It also states that “an increasing number of Canadians are using their RRSPs and TFSAs to invest directly in Canadian real estate through a syndicate mortgage.”

FMP is named in two of the lawsuits that target syndicated mortgages. Fortress spokesperson Alibhai said “Fortress is not affiliated with FMP,” while the lawsuits claim it is one of three mortgage brokerage firms that have agreements with Fortress “to market the mortgage investments widely to other mortgage brokers and agents who, in turn, solicit interest from members of the public in the Fortress investments.”

Peter Natyshak, executive vice-president at FMP Mortgages, said the firm is aware of the lawsuits, and added that “virtually all of the defendants are bringing motions to strike,” including FMP. He said his firm offers lenders the opportunity to fund Fortress projects, but the two companies do not share any common ownership, officers or directors.

Asked whether regulators had approached FMP or taken any issue with the news release in March, Natyshak said the mortgage brokerage “has ongoing regular dialogue with FSCO, and ensures all rules mandated by the regulator are followed.”

Ontario’s new framework for syndicated mortgages, once in place, should increase scrutiny on the sector, close some of the monitoring gaps, and go some way to enforcing the rules consistently rather than waiting for a complaint or audit.

Such changes would be welcome by investors, but still leaves them with at least one question: What took so long?

Financial Post

bshecter@nationalpost.com

twitter.com/BatPost

Ontario’s Fair Housing Plan, Joshua Varghese, a professional real estate investor gives his views

This week the Ontario government announced the Fair Housing Plan, a 16-point program that included a number of supply and demand measures, all designed to curb some of the excesses of the housing market. As expected reaction has been mixed with some arguing that it will create even more distortions; others argue that the changes represent a common sense proposal designed to make housing more affordable. Lost in those divergent views are the opinions of the professional money manager, those charged with investing client money in public real estate securities.

One such manager is Joshua Varghese, the lead Portfolio Manager of Signature Real Estate Pool and assists with the portfolio management of Signature High Income Fund and Signature Diversified Yield Fund, three funds managed by CI Investments Inc. 

Signature Real Estate Pool and Signature High Income Fund each invest in Interrent REIT.

Here are the views of Varghese:

I’ve spent many years analyzing and investing in large real estate companies. In real estate securities investing, the biggest differentiating factor for successfully performing real estate companies over time tends to be the quality of the management team and the capital allocation decisions they make. These management teams are able to “compound capital” at a superior risk-adjusted rate, meaning that they create significantly more wealth for their shareholders over a long period of time. In fact, many of these companies have provided their investors significantly higher long-term returns than those same investors would have earned in the Canadian (and more specifically, Toronto) housing markets.

One of the biggest lessons I’ve learned from observing these management teams comes from how they make their investment decisions. They have a tendency to take rather conservative approaches to investing, meaning that they rarely overpay for expected growth, and they provide themselves strong “margins of safety” should their investment thesis not play out. This strategy serves as a compelling framework for any property investor to follow, and the basic message is simple: invest rationally.

While largely helpful, part of the Ontario government’s Fair Housing Plan will now limit property investors’ abilities to invest rationally.

To understand this, one needs to first understand how money is often made in real estate investing. Investment returns often come primarily from two things 1) income earned and 2) property price appreciation. Income is the amount that one earns on a property after collecting rent and paying property level expenses. The income earned divided by the total price paid is the yield, or in real estate terms, the cap rate. Property price appreciation is simply the growth in value of the property over time. If you were to buy a property at a 5% yield, with the potential for income to grow at a rate of 2% per year, then you can expect an annual unlevered return of around 7%. If you are really optimistic you might expect out-sized rental growth, so perhaps your expectation is that rents increase by 4% per year, taking your annual return to 9%. However if you are wrong, and rents only increase (as they often do) in line with inflation, then you still can earn a good return, since the income yield was there. If rents or property values decrease, you can still be relatively well protected with the income generated. In this case, growth is a bonus, not a requirement.

However what if the yield is not there? What if your earned rent is not enough to cover your current and long-term expenses? Let’s say your yield is 2%. If that is the case, you will require annual growth of 5% to earn your return of 7%. In an asset class where growth over the long term is typically closer to inflation, this is a leap of faith in something beyond your control. It will significantly depend on your expertise and ability to make accurate predictions on property pricing. If rents decline, there is a significant chance you don’t earn anything close to what you need, and a good chance you lose money. Add leverage (e.g. mortgage debt) to the equation and these losses can get significantly magnified. In this case, growth is an absolute requirement, and not a bonus. The smart real estate investors I’ve observed tend to not make a habit of making these investments unless they have developed a significant edge in understanding growth potential.

Back to the Toronto market.

A recent example of a condo I analyzed showed me that the initial yield on the property was around 2.5%. Add to that realistic long-term maintenance capital expenditures, plus the costs of interest and principal payments and that equates to negative monthly cash flow for a prospective buyer. In this situation, the only way to earn a decent return on one’s equity investment is to experience outsized growth (i.e. growth significantly above inflation) in value. It may happen, it may not, and it is entirely out of the investor’s control. If for some reason, growth is negative and the property price declines by a total of 10% over 5 years (that’s a 2% annual decline) then assuming one has paid a 20% down payment, an investor could see an annual return on their investment of negative 15%, due to the effects of leverage. Long-term successful institutional property investors tend to not make investments with this type of risk/reward profile.

On the other hand, what types of return does an institutional investor get on an apartment investment? In 2016 Interrent REIT, a successful Ontario Apartment REIT purchased a three-building apartment complex in Ottawa for a reported 5.3% yield. While the management team indicated that it is really excited about the growth prospects of the area, they paid a price that does not require outsized growth to make a decent return. This is a risk/reward profile that is extremely difficult for a condo buyer in Toronto to find.

Rental levels in Toronto have been growing strongly. They have finally reached a point where a sophisticated, risk-averse institutional investor is willing to take on the development risk of building a property because rent levels (or their yield on development) is attractive enough to give a reasonable risk adjusted return.  There are currently pending apartment developments in Toronto that expect to yield 5.5%-7%.  However the ability to be able to increase rents on the property adds significant upside to potential returns.

Institutional apartment development has come at a very important time in Toronto’s housing market. My belief is that individuals should consider renting (instead of owning) and using the money they save from down payments and housing costs to invest into more rationally priced investments. This view is highlighted in Alex Avery’s recent book “The Wealthy Renter”. Individual residential property ownership over time can produce good returns, but relative to other investment alternatives those returns are not as strong as many people think. And at a time where home price levels, debt levels, and price-to-income levels are at all time highs; my opinion is that individuals should seriously consider renting now more than ever. Institutional apartment development is in my mind a good way to create properly managed rental options for Torontonians. Institutional apartment supply transfers the risk of home prices to a more sophisticated owner, the apartment building builder (or owner).

But new rent controls could very likely cause a pause for many apartment developers. The upside potential to their investment returns was just seriously cut off, and building an apartment becomes a less rational investment than it was before the measure was announced. If they start to pull back their developments, then we could very well see a further ramp-up in condo developments. Note the risk transfer here: in a condo development, the builder bears the risk for the period it takes to develop the project (let’s say 2 years). After that, the long-term holder is the individual buyer of the condo unit. So the risk gets transferred very quickly from the sophisticated, experienced developer, to the less sophisticated individual homebuyer. Contrasting this with apartment development, the developer often ends up being the long-term owner of the building. So the risk stays in the most sophisticated investor’s hands.

The measures announced by the Ontario government seems to be predicated on the assumption that Canadians need to own their homes; with an approximate 70% home ownership rate in Canada, this view would seem to be supported. However with home ownership rates around 50% in Germany, and below that in Switzerland, is that a view that needs to be reconsidered? Are we really better off owning our homes vs. renting and investing our money elsewhere? It appears not. In my opinion the goal should be less about home ownership affordability and more about creating more long-term affordable options for living space in Canada, with a focus on creating more rental options. While rent control may cause a relief on rental rates, is a sure way to limit the development of more long-term living options.

Ontario’s Fair Housing Plan, Joshua Varghese, a professional real estate investor gives his views

This week the Ontario government announced the Fair Housing Plan, a 16-point program that included a number of supply and demand measures, all designed to curb some of the excesses of the housing market. As expected reaction has been mixed with some arguing that it will create even more distortions; others argue that the changes represent a common sense proposal designed to make housing more affordable. Lost in those divergent views are the opinions of the professional money manager, those charged with investing client money in public real estate securities.

One such manager is Joshua Varghese, the lead Portfolio Manager of Signature Real Estate Pool and assists with the portfolio management of Signature High Income Fund and Signature Diversified Yield Fund, three funds managed by CI Investments Inc. 

Signature Real Estate Pool and Signature High Income Fund each invest in Interrent REIT.

Here are the views of Varghese:

I’ve spent many years analyzing and investing in large real estate companies. In real estate securities investing, the biggest differentiating factor for successfully performing real estate companies over time tends to be the quality of the management team and the capital allocation decisions they make. These management teams are able to “compound capital” at a superior risk-adjusted rate, meaning that they create significantly more wealth for their shareholders over a long period of time. In fact, many of these companies have provided their investors significantly higher long-term returns than those same investors would have earned in the Canadian (and more specifically, Toronto) housing markets.

One of the biggest lessons I’ve learned from observing these management teams comes from how they make their investment decisions. They have a tendency to take rather conservative approaches to investing, meaning that they rarely overpay for expected growth, and they provide themselves strong “margins of safety” should their investment thesis not play out. This strategy serves as a compelling framework for any property investor to follow, and the basic message is simple: invest rationally.

While largely helpful, part of the Ontario government’s Fair Housing Plan will now limit property investors’ abilities to invest rationally.

To understand this, one needs to first understand how money is often made in real estate investing. Investment returns often come primarily from two things 1) income earned and 2) property price appreciation. Income is the amount that one earns on a property after collecting rent and paying property level expenses. The income earned divided by the total price paid is the yield, or in real estate terms, the cap rate. Property price appreciation is simply the growth in value of the property over time. If you were to buy a property at a 5% yield, with the potential for income to grow at a rate of 2% per year, then you can expect an annual unlevered return of around 7%. If you are really optimistic you might expect out-sized rental growth, so perhaps your expectation is that rents increase by 4% per year, taking your annual return to 9%. However if you are wrong, and rents only increase (as they often do) in line with inflation, then you still can earn a good return, since the income yield was there. If rents or property values decrease, you can still be relatively well protected with the income generated. In this case, growth is a bonus, not a requirement.

However what if the yield is not there? What if your earned rent is not enough to cover your current and long-term expenses? Let’s say your yield is 2%. If that is the case, you will require annual growth of 5% to earn your return of 7%. In an asset class where growth over the long term is typically closer to inflation, this is a leap of faith in something beyond your control. It will significantly depend on your expertise and ability to make accurate predictions on property pricing. If rents decline, there is a significant chance you don’t earn anything close to what you need, and a good chance you lose money. Add leverage (e.g. mortgage debt) to the equation and these losses can get significantly magnified. In this case, growth is an absolute requirement, and not a bonus. The smart real estate investors I’ve observed tend to not make a habit of making these investments unless they have developed a significant edge in understanding growth potential.

Back to the Toronto market.

A recent example of a condo I analyzed showed me that the initial yield on the property was around 2.5%. Add to that realistic long-term maintenance capital expenditures, plus the costs of interest and principal payments and that equates to negative monthly cash flow for a prospective buyer. In this situation, the only way to earn a decent return on one’s equity investment is to experience outsized growth (i.e. growth significantly above inflation) in value. It may happen, it may not, and it is entirely out of the investor’s control. If for some reason, growth is negative and the property price declines by a total of 10% over 5 years (that’s a 2% annual decline) then assuming one has paid a 20% down payment, an investor could see an annual return on their investment of negative 15%, due to the effects of leverage. Long-term successful institutional property investors tend to not make investments with this type of risk/reward profile.

On the other hand, what types of return does an institutional investor get on an apartment investment? In 2016 Interrent REIT, a successful Ontario Apartment REIT purchased a three-building apartment complex in Ottawa for a reported 5.3% yield. While the management team indicated that it is really excited about the growth prospects of the area, they paid a price that does not require outsized growth to make a decent return. This is a risk/reward profile that is extremely difficult for a condo buyer in Toronto to find.

Rental levels in Toronto have been growing strongly. They have finally reached a point where a sophisticated, risk-averse institutional investor is willing to take on the development risk of building a property because rent levels (or their yield on development) is attractive enough to give a reasonable risk adjusted return.  There are currently pending apartment developments in Toronto that expect to yield 5.5%-7%.  However the ability to be able to increase rents on the property adds significant upside to potential returns.

Institutional apartment development has come at a very important time in Toronto’s housing market. My belief is that individuals should consider renting (instead of owning) and using the money they save from down payments and housing costs to invest into more rationally priced investments. This view is highlighted in Alex Avery’s recent book “The Wealthy Renter”. Individual residential property ownership over time can produce good returns, but relative to other investment alternatives those returns are not as strong as many people think. And at a time where home price levels, debt levels, and price-to-income levels are at all time highs; my opinion is that individuals should seriously consider renting now more than ever. Institutional apartment development is in my mind a good way to create properly managed rental options for Torontonians. Institutional apartment supply transfers the risk of home prices to a more sophisticated owner, the apartment building builder (or owner).

But new rent controls could very likely cause a pause for many apartment developers. The upside potential to their investment returns was just seriously cut off, and building an apartment becomes a less rational investment than it was before the measure was announced. If they start to pull back their developments, then we could very well see a further ramp-up in condo developments. Note the risk transfer here: in a condo development, the builder bears the risk for the period it takes to develop the project (let’s say 2 years). After that, the long-term holder is the individual buyer of the condo unit. So the risk gets transferred very quickly from the sophisticated, experienced developer, to the less sophisticated individual homebuyer. Contrasting this with apartment development, the developer often ends up being the long-term owner of the building. So the risk stays in the most sophisticated investor’s hands.

The measures announced by the Ontario government seems to be predicated on the assumption that Canadians need to own their homes; with an approximate 70% home ownership rate in Canada, this view would seem to be supported. However with home ownership rates around 50% in Germany, and below that in Switzerland, is that a view that needs to be reconsidered? Are we really better off owning our homes vs. renting and investing our money elsewhere? It appears not. In my opinion the goal should be less about home ownership affordability and more about creating more long-term affordable options for living space in Canada, with a focus on creating more rental options. While rent control may cause a relief on rental rates, is a sure way to limit the development of more long-term living options.