Returns for some of Canada’s biggest pension funds were weak in the first half of 2024, as their real estate investments suffered losses, Morningstar DBRS said in a report released Tuesday.
The rating agency reported that weak performance in the big funds’ real estate assets — which represent 10% to 15% of their portfolios — provided a drag on gains from equities and other asset classes with positive returns.
“Similar to 2023, real estate weakness continued in [the first half] as high interest rates adversely affected property valuations and the cost of servicing mortgages,” Morningstar DBRS said.
“Macroeconomic trends pressured capitalization rates, affected liquidity, and kept market transaction volumes low with the most adverse impacts seen in the U.S. and Canadian office sectors.”
This weakness in real estate assets came in the face of “very strong” returns from public equities, led by gains in large tech companies such as Microsoft, Amazon, Meta, Apple, Alphabet, Nvidia and Tesla.
“Large-cap stocks in communication, energy, and healthcare sectors also contributed to the strong equities performance,” the report said.
The funds also generated positive returns from private credit assets, the report noted. OMERS, for example, gained 7.8% in private credit in the first half.
According to Morningstar DBRS, pension funds are participating in this market both directly and indirectly through third-party credit funds. “But, increasingly, we see them building internal underwriting capacities to enhance in-house investments capabilities and reduce reliance on third-party credit funds to ensure better monitoring standards,” the report said.
Looking ahead, Morningstar DBRS said pension funds are expected to continue repositioning their real estate portfolios “away from traditional office and retail to better performing real estate subsectors.”
The report said there may also be some rotation toward asset classes such as infrastructure and private credit, “spurred by higher returns and the shorter duration of these loans, serving as a diversifier to existing asset allocations.”
However, Morningstar DBRS noted that private equity performance is “becoming pressured by high interest rates, lower earnings growth, less distributions from portfolio companies, and fewer exit opportunities.” As a result, some of the big funds have been reducing their exposures to this asset class, and the agency said it expects “that they will continue to selectively trim their exposures throughout 2024.”