April 30, 2021 | 12:48
Commercial Real Estate Outlook
Commercial Real Estate Outlook
While the industrial and multi-family sectors were largely immune to the virus, retail and offices were much more vulnerable, though less than feared due to palliative government programs. Boosted by a rebounding economy, 2021 will be a year of healing for both segments.
The pandemic has pushed more economic activity online, some of it permanently, including shopping, working and meetings. Part of the shift toward remote work will stick, with many employees possibly working from home one or two days a week . The shift will leave a lasting mark on office demand, office-adjacent retailers, housing markets, and urban regions, though it may not radically transform them.
Government support programs to subsidize wages and rents, along with loan forbearance programs by lenders, allowed many businesses to survive the pandemic. In Canada, business insolvencies fell last year, though they have turned up recently. After plunging initially, the number of active businesses in Canada has rebounded sharply, though it is still down 20,348 (or 2.2%) in the 11 months to January. Total business failures in Canada and the U.S. have stayed low during the pandemic. U.S. commercial and industrial default rates edged up to 1.3% in late 2020, though this pales next to the 4.4% peak in 2009 (Chart 1). It’s unknown how many businesses will default when support programs end.
Commercial property prices did not suffer as much as many feared at the start of the pandemic and fell much less than in the Great Recession (Chart 2). U.S. prices have since turned higher, trimming the initial 10% loss to 5.7% as of March. The sectoral differences are glaring. Industrial prices are up 14% from pre-virus levels and apartment values are down only 4%, while mall values have plunged 20% and offices 9%. In Canada, commercial rents fell a moderate 1.8% y/y in December. A 5.9% drop in retail rents was partly offset by modest increases for offices and industrial.
Industrial—Taking Home the Oscar
A thriving industrial segment benefited from strong demand for goods and increased warehousing needs to support last-mile logistics for e-commerce. The sector is seeing low vacancy rates and steady rent increases. It should strengthen in 2021 as the recovery accelerates and supply-chain disruptions abate. More fulfillment centres and delivery terminals are needed to accommodate the rapid growth in online sales and some shift of teleworkers to more rural locations.
Industrial rents in Canada’s major cities rose modestly in 2020 and should speed up in 2021 amid low availability. At under 3% in 2021Q1, the national availability rate is the lowest on record, with rates dipping below 2% in Vancouver, Toronto and Montreal. While Calgary’s rate is near 8%, it is starting to fall. Higher resource prices and a still relatively low-valued Canadian dollar should support Canada’s industrial space in 2021.
Multi-family Residential—Standing Tall
Apart from some big cities, multi-family residential held up well during the pandemic. The segment was challenged by sharply lower international migration (including foreign students) and the concentration of job losses among lower-income workers. But it was supported by a hot housing market and generous income-support and forbearance programs. Occupancy rates and rental payments mostly held up well, despite some deterioration in large urban cores, though rent growth (CPI basis) slowed sharply during the pandemic in both countries. Rents plunged in some major cities (San Francisco, New York, Toronto) as teleworkers sought larger properties in less-expensive areas, immigration fell, and lower-paying jobs evaporated. However, rents held steady or even rose in many smaller, lower-cost regions that were less impacted by telework and out-migration. The multi-family segment of large cities should benefit as immigration and lower-paying jobs rebound, and as higher house prices and borrowing costs shift some demand back to rentals. In fact, some teleworkers could return to big cities if they have overestimated the persistence of telework and, hence, underestimated the toll of a multi-hour commute even a couple days a week.
The strong fundamental forces and low vacancy rate supporting the rental market before the pandemic will continue to do so in the years ahead, with Canada also looking to benefit from a strong rebound in international migration. In fact, Toronto condo demand is now bouncing back as more buyers get priced out of detached homes and investors take advantage of the 12% y/y decline in downtown Toronto resale condo prices to February 2021. According to the CMHC, the national apartment rental vacancy rate rose more than 1 ppt to 3.2% in 2020, but rents were steady. The U.S. rental vacancy rate for all types of units rose just slightly to 6.5% y/y in 2020 Q4, with a modest upturn in large cities offset by a decline outside metropolitan regions. With a third of 18-to-34 year-olds living with their parents, finds the Census Bureau, demand for rental units should remain strong, especially given the surge in home prices in the past year.
Retail—Online Push Was the Last Thing it Needed
The retail sector felt the brunt of the pandemic, though store vacancies were limited by supportive government programs. The pandemic damage was not evenly spread among retailers. It was muted for stores deemed essential, such as groceries, pharmacies, and hardware, and concentrated among stores deemed non-essential, including many smaller shops. In-person service providers suffered more than goods sellers given the greater ability to transact online and use curb-side pickup. Some small retailers have piled on debt to stay afloat and, with retailers closed to in-person shopping in some Canadian provinces, many won’t survive without continued government aid. The shift to online sales will also lead to a decline in retail square footage and further pressure rents in the near term.
In Canada, retail vacancy rates remained surprisingly low in Vancouver and Toronto in 2020, though they rose in Montreal and Calgary. However, the data likely undercount the true increase as they are skewed toward large retailers as opposed to small shops that were hit much harder. There were 2,930 (3.4%) fewer active retail businesses in January than at the start of the pandemic. Restaurants Canada says that more than 10,000 locations have closed for good since the pandemic started. Across the country, retail rents fell 5.9% y/y in December, according to Statistics Canada. Shopping malls remain in distress, with the U.S. vacancy rate the highest in at least two decades.
Amid restrictions on in-store purchases, online shopping has been a lifesaver for many retailers with strong digital platforms. The online share of U.S. retail sales jumped 3 ppts in the four quarters of 2020 to 15.7%, while Canadian retail e-commerce nearly doubled in the year to February. New converts to online shopping mean that in-store sales will likely remain lower than before the virus. CBRE sees a 20% decline in U.S. retail square footage by 2025. Suburban retailers will benefit from increased telework, at the expense of retailers that cater mainly to office workers in big cities. Still, given massive pent-up demand and household savings, and easing restrictions in the U.S. currently and later for Canada, the retail segment should have a better year in 2021. Store closures are likely to slow and survivors will initially face less competition. Stronger household finances in the U.S., including near record low debt-service costs compared with near record highs in Canada, suggest firmer support for American shops.
Office—Remote Work To Leave a Mark
Office landlords were largely shielded from missed rent payments due to long-term leases and government aid for tenants. In Canada, despite sharply higher vacancy rates, office rents held up well in 2020, though landlords needed to provide concessions to retain tenants, according to CBRE. After falling to five-year lows before the pandemic, Canada’s office vacancy rate rose to 14.6% in 2021 Q1, up from 10.0% a year ago and the highest in a quarter century (Chart 3). Metro Vancouver’s rate rose about 2 ppts to 6.3%, still the lowest among large cities in the nation, but Greater Toronto’s rate nearly doubled to 12.4%, the highest since 2005. The U.S. office vacancy rate rose to 11.9% in 2021 Q1 from 9.7% in late 2019, according to CoStar. With some tech workers fleeing to less expensive areas, San Francisco’s office vacancy rate reached 16.7% in late 2020, and vacancies have also leaped in other major cities. CBRE Group found that 137 million square feet of office space was available for sublease in the U.S. in late 2020, which is up 40% y/y and the most in 17 years. According to data firm VTS, including concessions such as free rent, U.S. office owners are currently offering long-term leases at discounts of up to 13% below 2020 Q1 rents, and firms are signing up for about 10% less space on average than before the pandemic.
As companies re-evaluate their work-from-home needs, some downsizing, repurposing, and repricing is expected. A hybrid telework model implies less demand for office space, which could raise vacancy rates further. However, even if many workers spend a day or two each week at home, companies will likely need to keep a buffer for when the staff is in the office at the same time. This could limit the decline in office space, perhaps to less than 20% from pre-pandemic levels. Lower rents and larger concessions may be needed to entice companies to sign long-term leases. Some office space will be converted to multi-unit housing and warehousing to support online logistics. The likely shift in office needs will favour buildings in regions with lower rents, easier commutes, and affordable housing. This will curb demand for in-person services in urban areas, as even a small change in the office/commuter crowd could have a meaningful impact. Still, large cities aren’t going away. Young people are drawn to urban amenities, while firms benefit from clustering effects from access to skilled workers and diverse suppliers and customers.
Bottom Line: 2021 will be a year of healing for the retail and office segments, while multi-family should strengthen and industrial continue to thrive. Repricing of rent and reuse of space will help markets return to balance and allow retail and office owners to eventually generate positive returns. Until then, continued government support should provide a vital link for owners and firms struggling with the pandemic and needing a bridge to the other side.
 This tentative conclusion is based partly on recent surveys of workers and employers. For more details, see: “Will Remote Work Stick”, BMO Economics Department, Focus, April 9, 2021. https://economics.bmo.com/en/publications/detail/1c7c8381-901c-40b1-a523-412f7c72331f/ [^]