Canada’s largest pension fund, the Caisse de dépôt et placement du Québec, announced $5.7 billion in writedowns earlier this week due largely to commercial real estate loans and private equity investments. Michael Sabia, the Caisse’s new chief executive officer, has made changes to his real estate team and signaled that the fund will take a more conservative approach to real estate in the future.

Commercial real estate values in Canada are off 15% to 20% from their 2007 highs, according to an estimate from Malcolm Musgrove, vice-president and portfolio manager, real estate at Aurion Capital Management Inc. That compares favourably to the U.S., where the market has suffered an historic collapse. Moody’s Investors Services has reported that property values are down 35%, relative to October 2007.

I spoke with Musgrove yesterday about the commercial real estate sector, and the impact it will have on global recovery. (A quick disclosure note: Sun Life Financial is in the commercial real estate business.)

What is your outlook for commercial real estate in Canada?
If you put Canada in the context of what’s going on around the globe, we are like an oasis. We’re a place where people ought to want to come. Things are more challenging here than we’ve had in a number of years, but when you look to the U.S., to the U.K. and emerging markets, you see far more damage done there than you will find done here in Canada. We’re kind of getting caught up on the edges of a global storm. But we’re not in the middle of this storm at all.

What’s been the difference here?
To understand that, you have to identify the fundamental causes of the problem that’s running around the world right now in commercial real estate. In part, it starts with the financial industry meltdown that started last year. It tied up sources of capital for public real estate – both the equity and the debt side, which makes funding, purchasing and operating real estate extremely difficult. You also had the meltdown in the financial sector itself, which is a huge component of the occupancy of major office towers and the major financial centres around the world.

If we look at London, England, you see tremendous job losses and vacancy levels rising, rents falling; same thing in New York. I think you’ll find the same thing in other major financial centres. Not so much in Canada though. Part of this comes from the fact that, whether by good planning, good luck or the nature of our Scottish Presbyterian heritage, the Canadian banking sector is one of the strongest in the world at the moment. As a result, the fallout from the financial sector into both the underlying economy and commercial real estate occupancy and fundamentals has been relatively mild.

The other thing about Canada that has been fundamental is that a tremendous amount of the commercial real estate here is owned by strong institutional parties. They are, by in large, able to weather the downturn. The Caisse may have substantial writedowns, and these will affect their net assets. But this doesn’t affect the viability of the Caisse. The Caisse is very strong; they’re a huge owner of real estate. They’re a major source of capital for real estate in Canada and around the world. Unlike Lehman Bros. in the U.S., they’re not going to disappear. So, you’ve still got good properties held in strong hands, and that’s fundamental to a well-performing industry.

Market commentators say the U.S. market has “collapsed.” Would you use that word to describe Canadian commercial real estate?
No. I don’t see the fundamentals of it. We have a different set of circumstances in Canada and in the U.S. in a number of ways. I talked about the solvency and the strength of the financial industry itself, which is critical to the success of commercial real estate. At the same time, there’s the question of the capital structure of real estate. In Canada, you would probably see around 60% equity and 40% debt, give or take, in the commercial marketplace. That’s kind of average. In the U.S., it’s probably the reverse of that. They’re much more highly leveraged. And being more financially aggressive in the U.S., you also see them adopting different structures and vehicles more readily than you see them adopted here in Canada. I think specifically here of the securitization of debt which occurred tremendously in the U.S. It was really developed there, fostered there and very successfully sold by the Wall Street investment bankers as being a great way for investors to diversify their holdings, reduce risk and get enhanced returns.

And it didn’t work.
And it didn’t work. Canadians, being the suspicious sort that we are, kind of looked at it and said “don’t really understand it, not sure if we really want to do that.” It got off the ground here, it became an important aspect of lending in Canada, but it started seven or eight years later than it started in the U.S. … They’re having a terrible time in the U.S. Fitch Ratings came out with an estimate that commercial mortgage-backed securities delinquencies in the U.S. are now accumulating at a rate of $2 billion a month. They’re up to 3% delinquencies, going to 5% by the end of the year. In Canada, I think the delinquency rate is 0.3%.

To what extent does this threaten global economic recovery?
I’m probably most concerned about it for the U.S., and to that extent it will clearly have an impact on the global recovery because the U.S. consumer represents such a large part of global GDP. The U.S. has got more challenges than I would want to face at the moment. I think that in the U.K. and in the rest of the developed world, the issues are being worked through. Again, the securitized marketplace didn’t really represent as big an aspect of their commercial mortgage market as it did in the U.S. Nobody got as far along the curve as did the U.S. Americans have got something in the neighbourhood of $800 billion worth of commercial mortgages outstanding, that are securitized. That securitized market is non-functional today. That is to say that they are virtually unable to issue new securitized mortgages. And what nobody knows is: where do you find $800 billion over the next six, seven or eight years to refinance all of those mortgages? That’s really the underlying problem for the commercial market.

To the extent that you’re a trading partner of the U.S. – as is Canada, clearly – you need to be cautious about how fast and how durable [you believe] the recovery can be. It’s not to say that we’re heading down a vortex here. That’s not the case, I don’t think. I just find it difficult to see the basis for a robust recovery. This is probably going to take quite a long time to work out. I regularly read things in the commercial real estate press, and from economic prognosticators, that are saying we could be into 2015 or 2016 before this stuff all gets itself sorted out. That may prove to be true.

What is your advice for Canadian investors?
What you should be looking for out of real estate is what commercial real estate provides best: income return. That’s what you should be looking at, that’s what you should evaluate if you are trying to figure out how to access returns from commercial real estate right now. Focus on the income side of things. If you look at the results over the last 20 years in commercial real estate in Canada, you’re going to discover that 90% or more of your return is income. At different times, values go up and values go down, and the capital gains side probably washes itself out. What it produces is recurring income. That’s what you should look for.