While Canada’s office real estate sector stands to benefit from certain tailwinds, one research director says it faces a reckoning regarding its risk profile and status as a core asset.
Adam Jacobs, senior national director of research at Colliers Canada, said in an interview with BNNBloomberg.ca Wednesday that office real estate was previously viewed as a “core asset” with a low-risk profile over the longer term. With hybrid working arrangements staying in place beyond the COVID-19 pandemic, he said the market is grappling “with the fact that office clearly does have some risk now.”
“We're seeing that technology can disrupt office also, and it has a lot more risk as a long-term investment. So that's part of the reckoning happening in the market, trying to figure out what's the price of this?” he said.
“What's the value of it? How risky is it compared to a warehouse or a hotel or the other things I can own? We haven't gone through that disruption for office (real estate) the way we have a retail and some other assets.”
Collier’s National Investment Report, released last week, said the industry has continued to experience rising vacancy rates over the past four years. According to data from Altus Group, released in January, Canada’s office availability rate came in at 17.6 per cent in the fourth quarter of 2023.
According to Jacobs, there was speculation as recently as a year ago that employees would broadly return to the office five days per week. But this doesn’t appear to have taken place, he noted, and negotiations in the industry are now commonly based on the assumption that hybrid working arrangements are “not just for the next six months, but the next 10 years.”
“So I think there's still some reckoning on the tenant and landlord side of ‘we didn't realize that hybrid work is like completely permanent.’ I don’t want to say permanent, but I feel more confident than I did maybe a year ago that this is just kind of the status quo for a while,” he said.
As of November 2023, data from Altus Group indicated the proportion of workers in a hybrid environment has tripled since January 2022, rising from 3.6 per cent to 11.7 per cent. During that period, entirely remote working arrangements fell from 24.3 per cent to 12.6 per cent.
Tailwinds from immigration, top assets
Despite the various challenges facing the sector, Jacobs says it stands to benefit from some tailwinds.
Firstly, he said there is a significant divide between the top and bottom of the market. According to Jacobs, buildings at the top of the market face far fewer vacancies and are performing as well as ever.
“They're still growing, the rent is still way up from where it was four or five years ago. So what we call triple A, the top of the market, is still very resilient,” he said.
In comparison, the bottom of the market faces markedly less demand as “tenants can just work from home anyway,” he said. As a result, there is now uncertainty surrounding what will happen to office buildings in the bottom 10 per cent of the market.
“They're going to get converted to apartments, (or) they’re going to get knocked down and something else is going to get built there instead… (or) they're going to get sold off for pennies on the dollar,” Jacobs said.
He said it is “not clear” what will happen to assets at the bottom of the market, but the data supports relative strength at the top of the market, with rent growth and demand for leasing.
In December of last year, Keith Reading, senior director of research at Morguard, said in an interview with BNNBloomberg.ca that a key trend to monitor in the office real estate industry is a “flight to quality.”
“What we have seen recently is that a lot of companies also have taken the opportunity to move up the quality ladder,” Reading said.
The other tailwind regarding the office market is Canada’s demographic situation, Jacobs said. He added that record immigration is seen as a positive tailwind for other sectors like single-family homes, apartments and others.
“We never say ‘Is (immigration) a good thing for the office market?’ and my question is always ‘Why not?’ If five million people are going to move to Canada over the next couple of years, did they all come here to work from home?”
“I assume some of them would like to get a job, get their career started, network, work downtown and make connections. So I think we might be somewhat underestimating that immigration…might also benefit office.”
‘Big players’ on the sidelines
Other big changes in the office real estate market have included the fact that big market players have largely “stepped aside in the last couple of years,” Jacobs said, including pension funds like OMERS and the Ontario Teachers Pension Plan. He said he predicts this trend to continue, as many “big players” may feel more comfortable allocating capital into areas like infrastructure or private equity bonds.
“That's really changed, a lot of the buyers now, they're foreign buyers maybe from Europe or Asia. Or they're local, but it's like a private investor,” Jacobs said.
The Colliers report noted that institutional investors have been “sellers of office,” and buying activity has been increasingly done by private investors.
“Institutions have been willing to sell signature downtown assets, or pursue one in, one out strategies: developing a new office asset and then selling an older one,” the report said.
Development cycle ‘to zero’?
The report from Colliers also highlighted that a large development cycle for the office market is ending, where “mega projects launched or planned pre-pandemic were delivered over the past three years.” This spurred some atypical market conditions, the report noted, with increasing inventories and rising vacancies occurring at the same time.
Jacobs said that the office market has experienced a “crazy development cycle” with new units being built in downtown Vancouver and Toronto. He said the market has faced an “impossible situation” with hybrid working arrangements amid “millions and millions of square feet” of office space coming online.
In this instance, he said all the space can’t be leased.
“So we've had years of rising vacancies for downtown office. The development side is going to come to an end, it's already way on the downswing. It's already down more than 50 per cent from where it was a couple of years ago,” Jacobs said.
“And I think the way things are now it might go to zero. Between working from home and interest rates, I'm not sure who's going to be building new office towers these days, at least for a couple of years. So that's going to bring a little bit more balance back to this.”