May 13, 2022 | 13:07
Commercial Real Estate Update
Commercial Real Estate Update
Like the economy, the commercial real estate market held up better than feared at the start of the pandemic, largely due to massive policy stimulus combined with government income, rent and loan support programs. But not all sectors fared equally well. Industrial and multi-family prospered and much of the retail sector has recovered, but offices are taking longer to regain a footing. Continued economic growth should support commercial real estate in 2022, limiting credit losses for lenders. However, higher interest rates will lead to slower price growth and activity, and likely some increase in office loan defaults.
U.S. commercial property prices rebounded faster than expected in the pandemic (Chart 1). After an initial 11% slide, prices shot up 21% y/y in April 2022 and now stand 15% above pre-virus levels. The recovery was remarkably swift compared to the Great Recession, when it took nearly six years to reverse a 37% plunge in prices. Meantime, in Canada, commercial rents retraced earlier losses and are rising moderately, led by the industrial sector, though office and retail have also firmed.
Despite firmer loan demand, commercial construction continued to decline in the U.S. in 2022Q1, with real non-residential structures investment perched 22% below pre-virus levels (Chart 2). Office and retail construction remain weak, contrasting with strength in warehouse and factory building. Canadian builders have fared better than their U.S. peers, with nonresidential structures investment rising in 2021, though still 10% below pre-pandemic levels. Commercial construction is expected to expand moderately this year.
Credit quality remains very strong. The U.S. default rate was just 0.8% in 2021Q4, close to the lowest on record (Chart 3). Despite the initial pandemic shock, defaults hardly rose due to government income and rental assistance, loan forbearance programs, and the rapid economic recovery. A Fed survey shows that U.S. banks eased standards on commercial real estate loans in the three quarters to early 2022, resulting in higher origination. In Canada, business insolvencies surprisingly fell in the pandemic and remain low in early 2022. Assuming a return to more normal interest rates and slower economic growth, default rates on CRE loans are likely to rise modestly over the next two years. However, landlords that have a limited ability to adjust rents in a high-inflation and slower-growth economy will struggle.
Rising interest rates will lift capitalization rates as investors seek higher returns, tempering future appreciation. Investor demand for commercial real estate has been strong amid broad asset-price inflation and the hunt for inflation-protected yields. Canadian cap rates held mostly steady in the pandemic, apart from the industrial sector where rates fell sharply on surging property values (Chart 4). Relative to long-term Government of Canada rates, the average Canadian cap rate (across all sectors) was close to long-run norms in 2021Q4, suggesting the market is fairly priced. In the U.S., strong investor demand drove cap rates sharply lower for industrial and multi-family in 2021, according to CBRE. Investment demand will soften as interest rates rise but is expected to stay healthy given that commercial properties can act as an inflation hedge.
The industrial sector thrived in the pandemic, with higher rates of return and lower vacancy rates. Investors took note, driving property prices higher and cap rates down sharply. The sector was helped by rising demand for warehouse and fulfillment space to support e-commerce logistics, as well as demand for storage space to stock up on spare parts and materials amid transportation bottlenecks and supply-chain disruptions (first due to the pandemic, and now the war in Ukraine and lockdowns in China). Also helping was the need to expand manufacturing capacity in the face of strong goods demand and some limited reshoring of parts production (notably for microchips).
We expect the industrial sector to keep doing well on the back of firm business investment, although the demand for goods will slow as interest rates rise and spending shifts further toward services. A low-valued Canadian dollar against the greenback and elevated (albeit moderating) resource prices should also drive Canada’s industrial sector. The main risk to the industrial outlook stems from a potential recession if monetary policy needs to tighten aggressively to control inflation.
The multi-family segment is enjoying solid rates of return, steady-to-lower cap rates, and low vacancy rates. The segment is supported by high house prices in both countries and, in Canada, a rebound in immigration and limited supply of purpose-built rental units. The sector has fully recovered after facing lower rents and higher vacancies in the early days of the pandemic after immigration plunged, students switched to online classes, and teleworkers fled from downtown offices. Investors see the sector as a partial hedge against inflation with higher wages supporting rents, and Canada’s apartment cap rate (4.2% in 2021Q4) is now the lowest since at least 2004.
Rising interest rates will drive a much-needed cooldown in the housing market, returning sales to more normal levels and reining in rampant appreciation. Cushioning the decline will be rising immigration (in Canada), continued demand from millennials, and low unemployment. A welcomed rebalancing will likely see Canadian house prices retrace a portion of the past year’s record gain, while U.S. prices should level out later this year. We are not expecting a deep, sustained correction in Canadian house prices given underlying support from immigration, low inventories, and an outlook for interest rates to merely return to neutral levels. Demand for apartments is likely to stay strong in the face of limited affordability in many cities. However, Canada’s market is at greater risk of a correction than the U.S. market due to higher prices and weaker affordability (some exceptions are the Prairie Provinces and Newfoundland & Labrador) This risk will increase if interest rates rise much more than anticipated. In this event, lower home values would also depress apartment building values.
After struggling with several rounds of restrictions to control the pandemic, the retail sector is making a decent comeback. U.S. rates of return turned higher after falling in 2020 and early 2021. The segment is supported by healthy consumer demand and high household savings, as well as a notable pivot back to in-person shopping. In the U.S., available retail space fell to a 10-year low in 2021Q4, according to CBRE, amid rising demand and falling supply. Easing pandemic restrictions allowed Canada’s retail sector to enjoy relatively stable cap and vacancy rates (albeit higher in Calgary) and moderate rent growth of 3.8% y/y in 2021Q4, according to Statistics Canada. The number of active retail businesses recently surpassed pre-pandemic levels. While sales will slow in response to higher interest rates, we expect the retail sector to expand as households deploy excess savings amounting to over 13% of disposable income in both countries. Retail vacancy rates are expected to fall, which will help landlords as the last of Canada’s pandemic-support programs (targeted at the tourism and hospitality sectors) expired on May 7.
Concern that the pandemic might drive a permanent shift toward online shopping seems unfounded. E-commerce accounted for 13.0% of U.S. retail sales (excluding food services) in 2021Q4, up from 11.0% in 2019Q4 but off earlier highs and in line with pre-pandemic trends (Chart 5). Shopping habits don’t appear to have changed much, as customers eagerly returned to physical stores when restrictions were lifted.
Some retailers face bigger challenges than others, including those without an omni-channel approach for customers who prefer both online and in-store experiences. Successful retailers are also using physical stores to facilitate e-commerce orders and returns. Successful malls are providing enhanced social experiences. Small, enclosed malls in smaller markets with limited redevelopment potential are at greater risk. Stores that primarily serve office workers face a shrunken market, as even a small change in the commuter crowd has a large adverse effect on revenues given the concentrated nature of this demand. In the same vein, business travel is unlikely to return to pre-pandemic levels as companies strive to cut costs and carbon footprints via more virtual meetings.
The office sector is returning to life as restrictions ease, but to a very different life than before the pandemic due to the widespread adoption of remote working. Despite rising vacancy rates, loan defaults have stayed low due to government support programs and lengthy leases.
In Canada, the sector is seeing surprisingly steady cap rates and higher rents. While demand has dropped off, so too has new construction. Still, the national office vacancy rate of 16.3% in 2022Q1 is up 1 ppt from a year ago and 6 ppts from before the pandemic (Chart 6). Sublease activity is high across the country, and net absorptions were negative in 2021Q3. Accordingly, office rents across 13 metro regions are up a modest 1.8% y/y in 2021Q4, finds Statistics Canada. U.S. office buildings are seeing a small rate of return after slipping in early 2020.
More than two years after the pandemic began, we still don’t have much clarity on the long-term outlook for office demand. Based on unique user card swipes compiled by Kastle System, 43% of office space in 10 large cities was occupied as of early May (relative to pre-pandemic levels). This is up from 31% last August and from 38% in early March, but the rate of improvement has slowed, with still a large amount of unused space to fill. Some workers still worry about health concerns due to the pandemic. But more to the point, surveys suggest workers generally prefer to spend more time at home than in the office. At least half of office workers want a hybrid approach, and more workers wish to work from home full-time rather than in the office each day. A survey of Canadian office workers (Amazon Business Return to Office Report) found that 43% would likely seek another job if asked to return to the office full-time. The longer people work mainly from home, the more likely they are to adjust their lifestyle around remote working. Most firms, in fact 87% according to CBRE’s 2021 Occupier Sentiment Survey, are expected to adopt a hybrid approach. In a tight labour market, many companies will need to provide flexible work arrangements to stay competitive. Companies are trying to figure out the right balance that maximizes the employee’s desire for flexibility and commuter savings, and still satisfies the company’s need for in-person collaboration to enhance corporate culture and creativity. Some firms are waiting for leases to expire before making a final decision (though not tech giant Google, which is expanding its office footprint in California and London despite offering a flexible work approach). Offices will likely remain integral to workplace engagement. Even if most workers don’t go into the office five days a week, the demand for office space is unlikely to shrink commensurately, as more space will be used for common areas to enhance work experience. Assuming employees eventually spend an average of about 60% of their work time in the office, we continue to expect demand for office space to decline 10%-to-20% from pre-pandemic levels.
The main long-term risk to the office segment stems from a greater adoption of remote work. In this event, new Class A towers are likely to outperform older buildings that are ill-suited for information technologies and enhanced experiences. Unused office space (at least in newer, environmentally friendly buildings) will need to be repurposed for living and warehouse needs. In fact, last year a record number of U.S. office buildings were converted to apartments. Buildings with more windows than cement have an advantage here. Repurposing and repricing of office space will limit credit losses of office owners and lenders, though vacancy rates could stay high for a while given the lengthy time to convert buildings. As well, conversions can be difficult in some municipalities given zoning restrictions, which will make it harder to recoup loan losses. In addition, the office sector will be more vulnerable in regions with weak population trends.
Bottom Line: Repricing and repurposing of space will help the office sector navigate challenges posed by a semi-permanent shift toward remote working. The biggest immediate challenge for all sectors, including thriving industrial and multi-family, stems from rising interest rates to corral inflation, which risks sending the expansion into reverse. A recession would drive rents and property values lower, resulting in lower loan demand and higher default rates.