Once-in-a-generation moment for Canadian commercial real estate: CBRE
Safety and stability thrust Canada into the spotlight during the Global Financial Crisis and initiated a transformative decade. An influx of global capital, record construction activity, rising home prices and the pace of technological advancement produced prosperity for many. However, some market participants were caught flatfooted and left behind.
Few sectors have so universally benefitted from Canada’s economic momentum than commercial real estate, says CBRE in their 2019 Canadian Market Outlook report. Record occupancy levels, investment activity and new construction are hallmarks of the largely unprecedented and uninterrupted run for the industry. Growth is often synonymous with discomfort. In many Canadian cities, real estate is at the forefront in both regards.
The past decade of momentum has been a mixed blessing for Canada and commercial real estate’s bull-run is producing similar challenges. Most notably, there is increased competition for commercial space, rising lease and construction costs, as well as an elevated level of exposure to global economic forces. Despite these challenges, Canadian real estate is not a victim of its own success. This is what it is to be a leader in the world. This is what it feels like to live in thriving global cities. These are the challenges that governments, businesses and citizens face when the pace of change accelerates due to rising competition and opportunity.
Canadian commercial real estate, like the country itself, has left the safety of the harbour in search of larger opportunities and greater prominence on the world stage. On this journey, it will be essential to remember the practices that provided stability and initiated a decade of growth. It will be even more important to innovate and advance global best practices to ensure that the real estate industry and the broader economy are able to address challenges, build on our promise and reach the intended destination.
Once in a Generation
Demand for commercial property has never been higher, which makes finding space and negotiating for it all the more complicated. This is true for most property types and is most pronounced in gateway markets like Toronto and Vancouver. To be clear, this is not simply a traditional “Landlord’s Market.” Conditions are so tight that landlords are becoming increasingly particular and are able to control their portfolios like never before.
In the tightest office markets, 10-year lease terms with top pricing are now standard. Discounted sublets are being assumed by landlords who have confidence that they can be re-leased at top dollar. This environment is limiting movement and encouraging renewals, while also encouraging occupiers to consider workplace strategies that allow them to do more with their existing space.
Landlords are equally, if not more confident, in managing their industrial buildings and portfolios. In the tightest neighbourhoods within Vancouver and Toronto, landlords are increasing rents for top-tier product at some of the fastest rates in the world and commonly pushing for 15-year lease terms. Vancouver’s net industrial asking rent increased by 15.9 per cent year-over-year in 2018 to $11.86-per-sq.-ft., the highest on record. While higher rents and longer leases may be hard for some tenants to swallow, this dynamic shift may be mutually beneficial. Tenants are now more likely to consider longer-term occupier strategies, including significant investments in supply chain automation and robotics to improve operations, while landlords can obtain lengthy commitments and an opportunity to future-proof their assets.
Hotels and apartments are also experiencing unprecedented demand and owners of these properties have a similar advantage when it comes to pricing. With the exception of Alberta, the hotels sector currently boasts the best fundamentals in recent memory. Occupancy and per room profit are each at or near their all-time highs, with profit figures growing rapidly. Likewise in the multifamily sector, purpose-built apartment vacancy rates averaged 2.4 per cent nationally in 2018 and availabilities are almost non-existent in major downtown centres. This is adding to frustration around housing accessibility and affordability from coast to coast.
While landlords currently have an unprecedented negotiating position, rising asking rental rates do not necessarily translate into increased cash flows. Tight markets discourage tenant movement and encourage renewals. New workplace strategies allow office tenants to do more with existing space and apartment owners are not seeing the normal 25.0 per cent lease turnover in major downtown markets where rents are climbing the fastest. Limited vacancy also hinders property renovation. A pronounced “Landlord’s Market” is most problematic for tenants, but still presents challenges for landlords.
Red Lines and Red Tape
Strong demand, record low vacancy rates and changing tenant needs are spurring a wave of new construction across the country. While the amount of new space is triggering anxiety amongst some market watchers, the bulk of the 14.6 million square feet of office and 18.5 million square feet of industrial product under construction is concentrated in markets which are currently underpinned by unprecedented strength and demand.
Over 7.3 million square feet of office space is under construction in downtown Toronto, with Vancouver adding an additional 2.9 million square feet, both of which hold the lowest vacancy rates in North America at 2.7 per cent and 3.8 per cent respectively. To alleviate the industrial supply crunch, 6.6 million square feet and 5.0 million square feet is being built in Toronto and Vancouver, respectively, 64.8 per cent of which is pre-leased due to pent-up demand. Even smaller cities like Victoria are reporting the highest number of cranes at work in the city’s history.
While these numbers may seem large, make no mistake, new construction is absolutely needed. A lack of vacancy in any property type hinders economic growth by limiting a company’s ability to respond to client needs and evolve business strategy, while also acting as an impediment for international firms looking to expand into new markets. What is telling about the amount of space under construction is not the overwhelming amount of space, but the fact that it is not a record given a lack of vacancy and availability.
Industrial construction in Toronto peaked at 8.7 million square feet while the availability rate was still a relatively comfortable 4.1 per cent. Despite the record-low 1.6 per cent industrial availability currently, there is development pipeline. While the Canadian commercial real estate industry has traditionally been conservative in terms of development, the fact that record tenant demand on a number of fronts is not spurring even more construction suggests that there are difficulties with the development process.
From coast to coast, developers are pointing to a confluence of issues that are restraining development: record land prices, increasing development charges, rising material and labour costs as well as a prolonged and more involved planning and approval process. The delays in approvals are most problematic. The nine-month approval target set by the Toronto Development
Guide is taking three and a half years to complete on average and commercial developers are finding similar bottlenecks. The commercial real estate industry only has to look to the residential market to see what happens when demand outstrips supply over a prolonged period. Canadian home prices and rental rates have soared with cities like Toronto now exhibiting a ratio of housing units to people that has climbed from 1:190 in 2005 to 1:575 in 2018.
There is a shortage of almost all types of quality modern commercial property. Rising costs and red tape threaten to create an even greater imbalance. While there is a role for municipal planning and protections, government and business interests need to align to ensure that the
Canadian economy has the physical space required to grow so that our cities and the national economy can continue to prosper.
The preceding was an excerpt from CBRE’s 2019 Canadian Market Outlook