Vacancy inches higher with anticipated new supply to largely deplete construction pipeline by year-end: CBRE

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Tenant preferences are growing increasingly evident and exerting a notable influence, according to a recent CBRE report.

The report revealed that rental performance of Suburban Class A properties has displayed remarkable strength, witnessing a substantial 7.8 per cent increase since Q1 2020. In contrast, Downtown Class B properties have experienced declining rates, indicative of the growing emphasis on high-quality office buildings with excellent amenities that minimize commuting times.

During Q2, there was a trend towards moderation, with most markets reporting a softening of conditions, according to the report. However, this softening was not as pronounced as observed at the beginning of the year. For instance, national quarterly net absorption in Q2 was only half of what was observed in Q1, yet it remained in negative territory. Notably, only two markets, namely Calgary and Halifax, reported a reduction in vacancy rates.

In the same quarter, sublet vacancies experienced a marginal increase while maintaining parity with 3.4 per cent of the total inventory. The report noted that eight out of ten markets had sublease levels below 3.0 per cent of their inventory.

Construction activity has been on a steady decline since Q2 2022, primarily due to the completion of existing projects and a limited number of new projects commencing. If this trend continues, the anticipated deliveries in Q3 and Q4 will reduce the pipeline from 11.5 million sq. ft. to 4.2 million sq. ft., marking the lowest level since 2005.

Source: CBRE

Downtown Class A maintains its position as the most constrained sector, although the difference is slight. Its vacancy rate has experienced a gradual increase over recent quarters due to the introduction of new supply amid subdued demand. Currently, the average net asking rents stand at $29.44 per square foot, marking a 4.6 per cent rise compared to Q1 2020.

In contrast, Downtown Class B exhibits the highest vacancy rate at 23.3 per cent, undergoing a year-over-year increase of 250 basis points, the most significant among all segments. It is noteworthy that this is the only category where average net asking rates have decreased since the onset of the pandemic.

While the Suburban Class A segment is witnessing a gradual uptick in vacancy rates, it boasts the most robust rental performance. Rents within this category have shown a year-over-year increase in most markets, maintaining a slow yet steady upward trajectory, with a cumulative rise of 7.8 per cent since Q1 2020.

These trends mirror the preferences of tenants seeking high-quality office buildings that offer ample amenities, strategically located within office nodes to minimize commuting times for their workforce.

The overall national office vacancy rate has surged to 18.1 per cent, according to the report. The majority of this increase is attributed to the downtown area, although both segments have experienced a softening in the market. Notably, the gap between these two segments continues to widen, with the suburban rate now sitting 180 basis points lower than the downtown rate.

During this quarter, only two markets, Calgary and Halifax, reported a decrease in vacancy rates. Calgary’s decline was fueled by expansion in sectors like engineering, construction, and education. Furthermore, alongside ongoing office building conversions, landlords are innovatively repurposing previously vacant spaces into additional amenities.

Comparing downtown areas to suburbs, three markets saw improvements in their suburban sectors over the quarter (Calgary, London, and Halifax), whereas only two downtown areas saw improvement (Calgary and Waterloo Region).

Source: CBRE

The softening trend persisted, with just three markets showing positive net absorption. Although national quarterly net absorption remained negative in Q2, it moderated from the beginning of the year, accounting for about half of the total observed in Q1.

Among the markets with negative net absorption this quarter, the decline was less pronounced compared to the first quarter in three markets: Waterloo, Toronto, and Ottawa. Toronto experienced its mildest quarter of negative net absorption since Q2 2022.

Calgary, Vancouver, and Halifax were the sole markets reporting positive absorption this quarter, with Vancouver benefiting from the completion of two fully pre-leased properties.

Sublet offerings continued to gradually increase, marking the fourth consecutive quarter of growth. Sublet vacancy rates grew nationally this quarter, although the increase was more modest compared to Q1, maintaining equilibrium at 3.4 per cent of the inventory. Eight out of ten markets had sublease levels totaling less than 3.0 per cent of their inventory.

In the current quarter, sublet space nearly reached 1.0 million sq. ft., approximately 5.9 per cent higher than the previous peak in Q2 2021. This increase was predominantly driven by downtown centers, as suburban areas remained relatively stable.

On a year-over-year basis, four markets saw an increase in sublet space as a percentage of inventory, most notably in Ottawa (+130 basis points) and Toronto (+110 basis points), primarily due to rightsizing within the tech sector. Meanwhile, five markets experienced a decrease in sublease levels over the same period, with Montréal holding steady.

Calgary, on the other hand, exhibited the most significant improvement, with a year-over-year decline of 100 bps, no longer holding the highest sublet vacancy rate in the market.

Source: CBRE

The construction pipeline is on track to reach a level last observed in 2005, with 11.5 million sq. ft. of office space currently under construction nationally, accounting for 2.4 per cent of the existing inventory, of which 50.7 per cent is pre-leased.

Construction activity has been steadily decreasing since Q2 2022, with more projects completing than new ones commencing. Should this trend persist, the projected deliveries for Q3 and Q4 will lower the pipeline to a level last seen in 2005. To provide context, the national vacancy rate was approximately 11.0 per cent during that period.

As has been observed, the majority of the construction activity is concentrated in Toronto, Vancouver, and Montréal, with pre-leasing being highest in Montréal, thanks to the new 1.0 million sq. ft. National Bank tower.

Construction activity in the remaining markets across Canada is limited, negligible, or non-existent.

The tail end of projects initiated during the 2018-2019 wave is expected to be delivered by year-end. Over the past year, very few construction projects have advanced, with only 81,000 sq. ft. commencing this quarter in Halifax.

Approximately 4.3 million sq. ft. or 37.7 per cent of active projects under construction have been ongoing since before 2020. These projects tend to have higher pre-leasing rates compared to those that began in 2020 or later.

Vancouver stood as the sole market to deliver new supply this quarter, including the South Tower at The Post, which was part of the wave of projects initiated in 2019.

In total, 7.3 million sq. ft. is projected for delivery in the second half of the year, marking the completion of the remaining projects initiated in 2018-2019. This includes the North Tower at the Post in Vancouver and 160 Front Street in Toronto. The delivery of these and other buildings will bring the total annual new supply for 2023 to 8.5 million sq. ft., a level not reached since 2016.

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