A confluence of factors appears to be pointing to a bright future for high quality investment real estate globally, and Canadian income-producing property in particular.

Strong fundamentals across virtually all types of Canadian property and major Canadian markets are reflected in market statistics. Current high occupancy levels and rising rental rates stem from a disciplined development industry that avoided overbuilding in the run-up to the 2008-2009 credit crisis, an influx of US retailers entering Canada, strong employment and a generally positive economic outlook.

Record low mortgage interest rates have assisted a swift recovery of property values from credit crisis lows, and appear likely to play a key role in the outlook for strong further appreciation in values.

Pension funds need to replace low-yielding bonds with higher-yielding investments to achieve their actuarial expected return assumptions

In addition to providing affordable financing for property acquisitions and refinancing in general, record low benchmark interest rates could drive significant incremental demand for property investments from pension funds and insurance companies in particular. These two groups of institutions share common investment challenges, as they grapple with exceptionally low return prospects for government bonds, which continue to represent very large allocations in their investment portfolios.

Canadian pension funds have an average of 36 percent of total assets invested in Canadian fixed income according to Towers Watson, with the vast majority being in Government of Canada and Provincial bonds. Most Canadian pension funds also have overall return targets, which are employed in the assessment of funding status, in the 7 percent to 8 percent range. With 10- year government of Canada bonds yielding 2.0 percent on a nominal basis and 0.0 percent in real terms based on the Bank of Canada’s inflation target, overall returns of 7 to 8 percent imply average returns from the remaining assets invested in domestic and international equities, real estate, infrastructure, private equity and international fixed income of 10 percent or more, depending on asset allocation and overall target returns.

If the world is in fact in the early stages of an extended period of de-leveraging, and if interest rates could remain low for several years in a low economic growth environment, it seems unlikely that broad equity index returns (equities are still 47 percent of pension fund assets globally) could provide consistently strong 10 percent overall returns in a low growth environment over the next several years. Furthermore, many pension funds and insurance companies are approaching demographic tipping points that will shift these institutions into net redemption positions for the foreseeable future. Under these conditions income-producing investments become increasingly important for portfolios with declining assets.

Unlevered returns of 6 percent or more are achievable on good quality commercial property – with financial leverage 10 percent or more is attainable

Good quality Canadian commercial properties currently provide un-levered income yields of around 6 percent, as well as income growth that could offset inflation and provide capital appreciation, and abundant debt is available to amplify these returns into the low double digits, making such real estate an attractive options for addressing pension funds and insurance companies challenges.

The experiences of pension funds and insurance companies during the 2008-2009 credit crisis have drawn attention to the appeal of property and similar investments that are revalued on a periodic basis, rather than through daily trading, like stocks that are vulnerable to extreme volatility, electronic trading malfunctions, and other distortions of underlying value.

While pension funds and insurance companies tend to be thoughtful and slow moving institutions that rarely make dramatic changes in direction, the case for increased allocations to real estate is now as strong as it has ever been and there are signs that a gradual shift towards higher real estate allocations is already underway among Canadian and other pension funds and insurance companies.

According to Towers Watson, pension fund allocations to other investments, including real estate, has increased nearly four fold, from 5 percent in 1995 to 19 percent in 2010, at the expense of bonds, equities and cash. Still, bonds represent 33 percent of global pension fund assets, and equities represent 47 percent. With bond yields at or near all-time lows in most developed economies, and the outlook for equities seemingly tied to economic growth prospects, alternative investments such as high-quality property assets with favourable rental prospects are likely to continue to garner more attention.