Office Demand Outlook: New construction adds

UNCONVENTIONAL

RECESSION

Projected Rapid Recovery Comes With New Context for Office Demand

By Barbara Carss

AN INFLUX of new office supply was always expected to shake up the status quo in Toronto’s downtown commercial real estate market given that approximately two-thirds of the more than 8 million square feet of space currently under construction is already preleased. However, prospects for backfilling were perhaps viewed with less trepidation entering 2020 when the downtown Class A vacancy rate floated around 2%.

A year of pandemic-related upheaval, which saw a fourfold increase in sublet space and the Class A vacancy rate climb to 7.3% by spring of 2021 now has commercial landlords more nervously contemplating demand trends as many tenants look to retrench or at least reassess their future space needs. Although the source of this uncertainty may be extraordinary, industry veterans note the scenario itself is far from novel.

“Too much new supply coming at the wrong time has always been the office sector’s Achilles heel,” Paul Morassutti, Vice Chair, Valuation and Advisory Services, with CBRE Canada, reflected during a recent online presentation accompanying the release of the firm’s 2021 market forecast.

CBRE’s 2020 fourth quarter statistics for 10 major Canadian markets show that the vast proportion of in-progress office space is slated for Toronto, Vancouver and Montreal, with Toronto host to 9.1 million square feet or slightly more than half of what’s under construction. Toronto’s share of new downtown office space is even higher, representing more than 67% of downtown construction nationwide and equivalent to about 10% of the city’s existing downtown office inventory.

Vancouver has 61% less space under construction, but it’s set to make a bigger dent in the city’s smaller inventory. The approximately 3.5 million square feet of new office supply in progress is equivalent to 14.5% of the current net rentable area downtown. CBRE pegged the downtown Class A vacancy rate at 4.4% as of Q1 2021, up 20 basis points from Q4 2020 and 260 basis points from Q1 last year.

With most informed analysis indicating that a portion of the pre-pandemic workforce will permanently vacate formal office accommodations, Morassutti warned there is likely to be a larger and longer-lasting glut than investors envisioned 12 to 18 months ago. Even with no new supply pending and complete employment recovery, economic growth and job creation would be needed to attain pre-pandemic occupancy levels. CBRE’s modelling concludes the dual impact of off-site work and new supply

could give rise to as much as a 4% jump in Toronto’s downtown office vacancy rate.

“We can say without equivocation, remote work is here to stay. Virtually every tenant survey supports this. The physical office will absolutely continue to be part of the future of work, but it will be designed to support more flexibility and choice. It will have to incentivize people to come in,” Morassutti maintained. “The issue is: what impact would a 10% cent reduction in demand have on long-term vacancy? After all, the retail sector has been completely upended by the movement of just 10 to 15% of sales to online platforms.”

PREPARING FOR CHALLENGES Findings from Altus Group’s November 2020 survey of 85 commercial real estate executives verify that many asset and property managers are readying for more challenging times. About 35% of the

“Too much new supply coming at the wrong time has always been the office sector’s Achilles heel.”

CALGARY REQUIRES MORE COMPLICATED CURE

Reflecting on a year in which a global pandemic unsettled commercial real estate fundamentals to the east and to the west, Calgary-based analysts focus more on tangential circumstances than the COVID-19 outbreak itself. During a recent online market review and forecast, executives with CBRE Calgary’s investment and advisory services fingered an economy tied to oil and gas for sinking the hesitant recovery that had appeared underway as 2020 began.

They’re now projecting that more than a third of the downtown office inventory will be vacant by the time 2021 comes to a close. Angus Fraser, Executive Vice President of office leasing, noted the departure of three foreign firms — Devon Energy, Murphy Oil and Equinor — over the past 12 months along with an uptick in mergers and acquisitions (M&A), such as Cenovus Energy’s recent takeover of Husky Energy. That further aggravates a five-year trend of downsizing in the sector’s office footprint.

“Our first quarter results are going to show a vacancy rate of 32.3% and that’s on the back of negative absorption of 1.25 million square feet,” Fraser revealed. “Negative absorption was driven primarily by that M&A activity in the energy sector. In almost all cases, all of the office space of the acquired entity was put back on the market. The Cenovus acquisition of Husky Energy was certainly a large contributor to that number with the expected redundancy of all of Western Canadian Place.”

Similar trends plague the suburban office market, albeit due to the hollowing out of a slightly different tenant base. Stuart Watson, a Senior Vice President with CBRE Calgary, traces the construction spree that doubled suburban inventory — from 13 million to 26 million square feet — in the decade between 2005 and 2015 to flourishing demand for engineering services.

“A lot of the space that was built over that cycle was A Class space with big expansive floorplates,” he advised. “The problem that we’ve faced, really from 2015 onwards, is the disappearance of big energy projects, the consolidation of that [engineering] sector and, as we come out of this pandemic, the new embracement of new workplace strategies.”

Both Watson and Fraser see some promise in the tech sector, which has been a focus of the city of Calgary’s economic development strategy. There’s evidence of more local capital going into the sector as wary investors shift away from energy and real estate; a planned downtown SAIT (Southern Alberta Institute of Technology) campus will accommodate the new school of advanced technology; and downtown tech tenants have absorbed about 500,000 square feet of space since 2016, with much of that filled during the past two years.

“Relative to the retreat of oil and gas, this is small potatoes, but, nonetheless, this is a source of growth that previously didn’t exist here,” Fraser acknowledged.

For companies favouring a return to formal office settings after the prolonged pandemic interlude, he also suggests downtown Calgary offers an attractive combination of low rents, a paucity of dense open-plan formats that would require overhauls to accommodate social distancing, and shorter commuting times than downtown workers may encounter in other large cities.

Turning to the suburbs, Watson urges landlords to pivot to capture tech sector players that have been more inclined to build their own facilities.

“In the short-term, a lot of the activity in the market is going to be change-related not growthrelated,” he hypothesized. “There’s a new challenge for the supply side of the market. Owners are going to have to find a way to innovate their properties in order to capture demand in what’s really going to be a win-lose market.”

respondents will see lease terms expire for 5 to 20% of the office space in their portfolios during 2021, and another 2% face rollover of more than 20% of office holdings.

Upwards of 60% of respondents expect market rents will drop for high-quality office space and more than 75% predict falling rents for lower-calibre space. A majority — 57% — expect tenants will adjust their space requirements downward in the future because more staff will be working from home, but relatively few foresee shrinkage of more than 20%.

Meanwhile, 57% of respondents predicted it would take nine to 12 months to lease high-quality space. That’s a notable upward adjustment in expectations from the 34% who foresaw that timetable when questioned in June 2020. Similarly, respondents generally voiced less confidence in their tenant retention ratios.

“Overall, leasing activity in Q4 was very low in general, especially in the central business district, and not expected to pick up until workers return to the office,” accompanying Altus analysis concludes. “Lower quality assets, especially older Class B and C downtown buildings, will suffer the most from flight to quality and structural vacancy (space never being backfilled).”

Nevertheless, Morassutti offers some hopeful qualifiers.

“We added almost 5 million square feet of new supply in Toronto beginning in 2008 in the midst of the global financial crisis and another 6 million square feet beginning in 2013 and, quite frankly, the market outperformed virtually all vacancy forecasts both times,” he recalled. “Despite the many doomsday forecasts that we see, Vancouver and Toronto still have the lowest vacancy rates in North America. Montreal and Ottawa are in the top five.”

BOUNCE-BACK FORESEEN Looking to the broader economy, Benjamin Tal, Deputy Chief Economist with CIBC World Markets, joined Morassutti in the online forum to reiterate that COVID-19’s wallop is not a conventional recession. He sees the seeds of a strong and rapid recovery in its uniquely slight blow to goodsproducing sectors, the comparatively easier reactivation of the services sector and pent-up demand from consumers with higher incomes who have been stockpiling earnings over the past year.

“We are sitting on $19 billion of excess cash. This is the story of this recession. The abnormality is that there is a huge amount of money sitting, seeking, waiting for a correction,” Tal asserted. “I believe, in a relatively short period of time, we will see a significant amount of spending. The economic boost is that this spending will be going not to goods, but to services — exactly where the jobs are needed.”

That spending momentum has already been channelled to residential real estate, in particular pushing up housing prices outside of large urban centres. Tal charted the steeper rate of increases in areas peripheral to large cities, but cautioned that a post-pandemic rebalancing of work routines could rein in some more far-flung markets.

“Maybe today your current employer is fine with you working from home. What about your next one? If you move to a remote area two or three hours’ drive from Toronto, Vancouver, Montreal under the assumption that you will be working from home fulltime, that’s a big risk,” he submitted. “You will see some people will have to rent an apartment in the city because they will be back in the office at least a few days a week.”

For now, many investors, asset and property managers are grappling with the challenge of differentiating temporary routines from lasting trends, especially while daily life is still largely in the grips of the pandemic interlude. Few commercial real estate insiders realistically await a full reversion to the 2019 way of working, but it is equally unlikely that the vast majority of workers and consumers have fully embraced a life bereft of social interaction.

Some people may move to locales where they can live more affordably and upgrade their housing options, but, once there, look to replicate other aspects of the lives they’ve left behind. That could mean demand for pedestrian-oriented development, experiential retail and other functions and amenities associated with urban downtowns.

“Increasingly, the office will become less of a commodity and more of a consumer product, and like every consumer product, the office will have to continue to fight for its customers and meet their needs because those customers have options,” Morassutti speculated. “One uncomfortable question that we should be asking ourselves is: Who said the old office was that great to begin with?” zz

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