Canadian commercial real estate: quarterly outlook

Following the most dramatic plunge on record, the Canadian economy appears to be on the mend. As the number of new coronavirus infections has slowed down, authorities have eased, albeit gradually, social distancing requirements and have allowed aspects of the economy to reopen. This resulted in an improving labour market environment, with Canada creating 290,000 and 953,000 jobs in May and June, respectively. While these numbers look encouraging, they reveal that the economy is still far behind where it was at the beginning of the year. Job gains in May and June recouped only 40% of the jobs lost in March and April.

Although by most measures the economy is in recovery, the path to pre-COVID-19 levels is a challenging one, as both consumers and businesses will likely remain under pressure, even once pandemic-related restrictions are lifted. The shock of the past few months as well as an elevated unemployment level, which is likely to persist through the second half of the year, is set to be a drag on household income growth. With the added burden of elevated household debt levels and meeting deferrals payments, consumer spending will likely remain subdued throughout the rest of the year. Business investment is also likely to remain low, at least in the near term, as weak global demand and uncertainties related to the actual path to recovery will likely keep businesses on the sidelines. In the longer term, ongoing low interest rates, availability of credit, and government support will be instrumental in sustaining economic growth.

Following the COVID-19 outbreak, markets reacted with a flight to safety and quickly repriced a wide range of assets, including commercial real estate. In the first half of the year, economic headwinds affected property valuations with investment activities falling far below normal levels. Historically high occupancy rates in most Canadian real estate markets likely provided a buffer by absorbing some lost demand before severe supply-and-demand imbalances could materialize. The market is now seeing glimmers of a recovery. Improving economic conditions are helping to restore market confidence and third-party appraisers are beginning to gradually remove COVID-19 qualifying language from their property valuations.

Looking out into the second half of the year, the economic downturn may continue to affect real estate sectors differently, with some stabilizing or recovering more quickly than others. The long-term nature of commercial leases may provide a property income shield against short- to medium-term market fluctuations. Multifamily and industrial may benefit from exceptionally strong property fundamentals and solid long-term demand drivers, while retail, hotel, and some segments of the office market could see a more pronounced impact.

Investing in real estate remains a compelling proposition given the low interest-rate environment. Prior to any price adjustment, the cap rate in MSCI’s core property fund index was 4.4% above the Government of Canada 10-year bond yield as of the end of the second quarter of 2020.¹

In the second quarter of 2020, uncertain economic conditions together with the challenges posed by social distancing put pressure on the office leasing space. National office net absorption fell to negative 1.9 million square feet (SF) while average vacancy rates rose by 50 basis points (bps), from 10.3% to 10.8%. This slowdown in market activity follows a very strong first quarter in which net absorption reached 3.2 million SF, a record cycle high.

The Canadian real estate market has a competitive advantage due to its accommodating immigration and foreign worker policies, a quality that's especially attractive to technology firms that have become increasingly dependent on a global talent pool to fuel growth. In particular, the Toronto, Vancouver, Montreal, and Ottawa office markets have reaped the benefits of strong demand from the technology sector—average downtown office vacancy in these markets remains tight, at just 4.5% as of the end of Q2.² Although technology firms won't be untouched by the economic slowdown, COVID-19’s physical distancing protocols will likely have the effect of boosting the digital economy for sustained sector growth in the long term.

As a result of COVID-19, office demand fundamentals will be tested. The widespread work-from-home experiment prompted by the pandemic could prove that many employees can continue to work from home and be productive. While we do envision that employers will be more flexible around the employee workplace arrangements, we feel that priorities such as preserving a firmwide culture and maintaining collaborative/creative functions will depend on having employees under one roof. The right office space can help attract talent, establish credibility, and provide prestige. De-densification of office space and increased provision for social areas and larger collaborative spaces can help offset some of the negative impacts associated with COVID-19.

While it's uncertain whether demand for office space will be substantially affected, we do expect that demand-based structural changes will take place. For example, the desire for a shorter commute and economic constraints could result in a revival of demand for office space in suburban markets.

The industrial real estate market is best positioned to weather the COVID-19-related downturn. In Q2 2020, seven out of ten major markets tracked by CBRE reported positive net absorption figures. On the national level, net absorption in Q2 was negative 0.3 million SF with average vacancy rates rising by 20bps, from 2.1% to 2.3%. Despite the slowdown in demand, asking rents continued to improve with average net asking rents per SF increasing by 5.5% year to date.

The steady build-out of retail distribution networks and e-commerce fulfillment platforms has helped sustain demand for industrial spaces from both existing and new tenants. Large-bay, high clear height warehouse spaces and smaller, lower clear height facilities near urban areas, which can serve as last-mile delivery facilities, are especially benefiting from e-commerce-related demand. On the supply side, the industrial market has been experiencing constraints over the past few years; as a result, this market has experienced exceptionally low vacancy rates and rapid rental rate growth.

Going forward, industrial real estate may experience an increase in demand driven by structural changes in manufacturing and supply chains. With COVID-19 challenging global trade and supply chain networks, businesses are likely to pay more attention to local manufacturing and the build-up of inventories in local markets rather than outsourcing and importing from abroad. These changes could result in net positive demand drivers for industrial real estate in the long term.

COVID-19 and social distancing requirements have had the greatest effect on the retail real estate sector. Needs-based retail, such as grocery stores and drugstores, saw sales remain relatively unscathed, while leisure retail sales came to a near halt and will likely experience a sluggish recovery. Weakness in leisure sales coupled with greater health concerns over malls affected market fundamentals. While vacancy rates in most centre types stayed relatively flat, we've seen significant negative absorption in shopping malls, with vacancies increasing by 150bps year to date, from 1.7% to 3.2%.

Retail sales growth will likely remain sluggish for the rest of the year, weighed down by elevated unemployment levels and wavering consumer confidence. The brick-and-mortar retail segment will likely take the greatest hit in the short term, with forced closures and curtailed hours of operations. In the long term, e-commerce will continue to put pressure on the physical retail space, but this will likely be a moderately paced transformation. This is due to bottlenecks in logistics infrastructure, lack of modern warehouse space close to urban centres, and heavy investment required to modernize inventory management and delivery systems. We believe we'll see retailers gravitating toward an omnichannel strategy, with a physical retail space holding firm as an integral part of the overall sales strategy.

Despite the economic downturn, multifamily real estate continued to show impressive resilience, with stable vacancies and high tenant rent collection rates. In Q2 2020, conditions were tight across most markets, with the exception of Calgary and Edmonton, where vacancies rose to almost 4.0%. On the national level, the average multifamily vacancy rate in major markets, tracked by CoStar,³ remained unchanged at 1.5%. In addition to this solid vacancy rate, rental income collected from tenants for multifamily has been affected the least compared with other property types. RealPAC’s survey of multifamily rent collection for May reported a rate of 94.0%, the highest among all property types.

The outlook for the multifamily rental market is balanced, as both demand and supply dynamics could be constrained in the near term. On the demand side, slower household formation, scaled-back immigration, and more gradual wage growth could impede the expansion of the renter pool. On the supply side, work stoppages and construction restrictions are delaying completions and are slowing down the rate at which new residential units are coming to market. A recent study by the Canada Mortgage and Housing Corporation forecasts that in the second half of 2020, housing starts in Canada could see a pullback ranging between 51% in Ontario and 75% in Quebec relative to the prior year.⁴

While homeownership is typically a risk factor for rental demand, it isn't in the current environment. Tightened mortgage regulations are making it more difficult for Canadians to purchase their first home, therefore keeping more individuals in the rental market.