Focus
May 03, 2024 | 12:38
CRE Update: Out of Office
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Fixed Income Strategy
CRE Update: Out of OfficeHighlights
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General Trends |
CRE capitalization rates (which measure investment returns by comparing annual operating income to property prices) have risen about 1 ppt in Canada since the central bank began lifting rates in early 2022. The moderate increase relative to a sharper rise in 10-year Canada yields has kept the spread well below normal, indicating a mostly orderly downturn in the market. Cap rates rose across all four major CRE segments, though multifamily rates remain very low (Chart 1). U.S. cap rates have risen to above two-decade norms, led by a sinking office market. Investment rates of return for all four segments were negative in 2023 (Chart 2). Cap rates in both countries should rise moderately further this year, though lower interest rates will temper the increase. |
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After peaking in 2022, U.S. commercial property prices have fallen 21% to the lowest levels (outside the pandemic) since 2015 (Chart 3). Overall prices are down 7% y/y to March 2024, but, apart from offices, have steadied recently. Office property values have plunged 37% from their highs and 16% in the past year and look to fall further as owners with refinancing issues are forced to sell. Apartment building values are down 28% from peak levels, while industrial (-16%) and strip retail (-17%) have held up better, with the former still well above 2019 levels. Delinquency rates for U.S. office CMBS have more than tripled since 2019 to 7.4% in April 2024, according to Trepp. By contrast, industrial (0.4%) and multi-family residential (1.3%) rates remain very low. Retail rates, though higher at 5.9%, have fallen in the past year. While U.S. bank CRE loan delinquency rates remain low at 1.2% in 2023Q4, they are expected to rise further (Chart 4). According to data firm MSCI, U.S. office buildings worth over $38 billion face some form of loan distress, the most in 14 years. |
Although financial stress at some regional banks has subsided, CRE loan exposure remains a concern. Consequently, lenders have tightened credit standards and set aside substantial reserves to cover potential losses. CRE loans account for 17% of U.S. bank credit, with a lower ratio for large banks and higher exposure for smaller lenders. Office loans are a much smaller fraction of the total. Higher costs of borrowing and repairs have clashed with rent controls in some cities, notably Manhattan. Refinancing risks will remain elevated so long as interest rates and inflation stay high. Because of tumbling property prices, an estimated 44% of U.S. banks’ office loans were underwater in late 2023, according to a study by the National Bureau of Economic Research. IndustrialThe U.S. industrial segment is well supported by the expanding warehouse and distribution needs of online commerce, as well as increased reshoring efforts to address supply-chain risks. Further support is provided by substantial government incentives to spur construction of facilities for electric vehicles, batteries and microchip production. Surging data demand to feed AI systems is driving construction of large data centres. However, the earlier boom in warehouse construction driven by retailers stocking up in the pandemic has led to record-high sublease space. Still, industrial availability and cap rates remain below normal, and rent increases, though slowing, are positive. Canada’s industrial segment remains healthy but is settling down amid new construction and less demand. The availability rate is near six-year highs of 3.7% in 2024Q1, but remains below its 15-year mean, finds CBRE. After two years of double-digit increases, rent growth has slowed to 0.9% y/y. Although average asking prices have decelerated, they are still rising, keeping cap rates low. Industrial sector fundamentals should remain healthy in both countries as interest rates decline and economic growth picks up, with a low-valued currency also helping Canadian manufacturers. The main risk stems from a potential hard landing should interest rates stay high or wars in Ukraine and the Middle East escalate. |
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MultifamilyCanada’s multifamily residential market should remain well supported by a tight rental market, poor housing affordability, and an undersupply of purpose-built apartments. The CMHC’s annual survey finds the national vacancy rate for rental apartments reached a new low of 1.5% in October 2023. Growth in average asking rents for residential properties was 8.8% y/y in March, says Rentals.ca. However, some relief may be in sight. The federal government’s recent pledge to slash the number of non-permanent residents over three years could slow population growth from 3.2% y/y to a more normal 1%. The return of more sustainable household formation rates should allay pressure on supply, affordability, and rents. Greater Toronto is already dealing with swollen condo inventories, causing rents to decline modestly in the past year. And, more supply is on the way, as Toronto led all Canadian and U.S. cities with 221 construction cranes in 2024Q1 (versus 50 for runner-up Los Angeles). Still, strength in other regions should counter softness in the GTA. Rental markets in the U.S. are generally less tight than in Canada due to slower population growth and an earlier surge in apartment construction to half-century highs. Apartment vacancy rates rose to 6.7% in March, just above 2019 levels. Rent growth continues to moderate from dizzying heights. After soaring almost 16% y/y in early 2022, Zillow’s Observed Rent Index cooled to 3.6% in March, just below 2019 levels. Apartment List says the median rent on new apartment leases fell modestly in the past year to March. As a result, it’s cheaper to rent than own a home, with average new mortgage payments 38% above average apartment rents in late 2023, finds CBRE. High ownership costs (including insurance and repairs) and a lean supply of resale properties have supported rental demand. RetailU.S. retailers are outperforming Canadian shops as less indebted households with longer-term fixed mortgages have more than offset slower population growth. Retail availability rates are below normal, as new store openings more than counter some high-profile closures (The Body Shop, Bed Bath and Beyond). Landlords are less inclined to discount rents today than in the pandemic with fewer percentage-of-sales deals. Shopping centre vacancy rates fell to 5.3% in 2023Q4, finds Cushman & Wakefield, the lowest since at least 2007. Average asking rents are nearly 17% above 2019 levels. Canadian retail vacancy rates remain relatively low and cap rates have drifted just moderately higher. Strong population growth and continued demand for necessities have partly offset a pullback in discretionary spending. However, real consumer spending grew about half as fast in Canada as in the U.S. last year, and we expect it to grow by less than 1% in 2024. Retail insolvencies have surpassed 2019 levels and are likely to rise somewhat further as businesses repay pandemic-era government loans. While vacancy rates are still low in Toronto, Montreal, and Vancouver, they will likely rise modestly this year. Winners and Losers: Retailers that rely on office commuters or face stiff competition from online and big box stores will remain challenged. Older department-store anchored malls should continue to lag open-air suburban shopping centres with ample amenities. Bifurcation driven by the rising cost-of-living may continue to benefit high-end and discount stores at the expense of mid-tier retailers. Stores that are quick to adopt AI systems to improve efficiency and customer service will gain an edge over laggards. OfficeOffice landlords face rising defaults, distressed sales, and conversions as most companies are sticking with hybrid work patterns. In the U.S., return-to-office rates have plateaued at around half of pre-pandemic levels, finds Kastle Systems. Moreover, CBRE says that, due to vacations, sick leave and other away time, office occupancy averaged just 70% even before the pandemic, so the actual U.S. office occupancy rate today could be as low as 35%. That said, companies might still push for more in-person work out of concern for a long-term deterioration in corporate culture, collaboration and productivity. If return rates ultimately peak at say 60% of 2019 levels, office demand won’t necessarily fall by 40% because companies will need extra space for amenities to draw back workers. When the dust settles, BMO Economics expects office demand to land about 20% below 2019 levels, with downside risk. |
Office vacancy rates hit a three-decade high of 18.6% in the U.S. in 2023Q4, according to CBRE. Despite a thriving AI industry, San Francisco’s vacancy rate is at all-time highs of 36.7% versus under 4% in 2019. In Canada, vacancy rates reached record highs of 18.4% in 2024Q1 (Chart 5). However, net absorption turned positive, helped by the lowest construction since 2011 with no new office buildings breaking ground. Sublease space also fell for a third straight quarter. Greater Toronto’s vacancy rate of 19.2% is now the highest since 1995. However, the city’s office occupancy rate is up to about 60% of pre-COVID levels, according to the Strategic Regional Research Alliance, higher than nine major U.S. cities. Greater Vancouver has one of the lowest vacancy rates (9.5%) in North America, though it more than doubled since late 2019. In both countries, office vacancy rates look to rise further this year as leases turn over, before easing on less construction, more conversions and lower refinancing costs. |
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Surprisingly, office rents have held relatively firm in the past year. However, landlords are offering more perks, such as free parking, to keep tenants in place, and businesses will likely seek substantial savings when current leases expire (why pay for 5 days when you only need 3?). CoStar estimates that nearly half of current office leases were signed before the pandemic. Resigning will put increased pressure on struggling landlords to sell at distressed prices or default on loans. As new owners buy in at lower prices, they could cut rents and still earn a positive return, adding further strain on current landlords. More unused office space will be converted to mostly living and some warehouse space. Avison Young estimates that 30% of Canadian office buildings could be converted to apartments or condos. So far, conversion activity remains low due to high costs, with CBRE noting that 13 projects initiated across Canada early this year have hardly reduced vacancy rates. Conversions will get a boost from the federal government’s pledge to invest more than $1 billion to turn one-half of its office portfolio into a quarter million new housing units by 2031. The U.S. government is also supporting conversions by offering grants, loans, and tax incentives. Winners and losers: Canada’s office market should continue to outperform the U.S. given a higher level of well-capitalized institutional owners with long-run investment goals. However, a shrinking number of corporate head offices could weigh. Triple Class A buildings with modern amenities and energy efficiencies should perform better than older, lower-tier buildings in which landlords will need to retrofit and add amenities to stay competitive. Suburban office buildings may continue to outperform their downtown peers. CBRE says that the average U.S. downtown office vacancy rate surpassed that of the suburbs for the first time in decades in mid-2022. Canadian suburban office vacancy rates also remain lower than downtown rates. Office buildings in regions with weak population growth will remain vulnerable. Generative AI poses a longer-term risk should it displace workers in the financial, business services, and information sectors. |