Commercial Real Estate: Canada’s Other Hot Sector
Canada ended 2016 with a record $34.7 billion in commercial property sales. The country witnessed a record influx of foreign capital, especially in three of the four major offices markets in the country and in particular Vancouver and Toronto, so much so that domestic investors took a slight pause in the market. Cap rates for trophy office product were on par with those seen in New York, Paris, London and Shanghai. Investors in office buildings justified their purchases by forecasting strong rental performance of these assets in the future. These forecasts are about to come true.
Toronto entered 2017 as a star performer, a trend that is expected to continue as the city boasts one of the lowest downtown office vacancy rates among major North American markets. The trend is similar for Vancouver, Montréal and even Calgary. “I predict that rental rates of offices in the major markets will grow significantly over the next three years and by perhaps as much as 50 per cent in the most desirable well-located trophy office buildings” says Brett Miller, Chief Executive Officer of JLL Canada.
The industrial sector too will see a rise in rental rates to the tune of high double digit growth. Industrial availability has steadily decreased since the financial crisis, providing upward pressure on rental rates. A strongly improving manufacturing outlook along with a weaker Loonie should support an increased demand for manufacturing space ahead. Three favorable factors are influencing rental rates: a limited supply in the market and a conservative and risk averse ownership profile; immigration and the on-going demographic change throughout Canada will result in higher levels of office space demand over the next three to five years and; yield preservation tactics as the cost of long term money begins to climb.
As of the first quarter 2017, Class A average direct asking gross rents for office space in downtown Toronto stand at $59.17 per square foot. Given Toronto’s attractive value propositions — livability, highly-skilled workforce, growing economy — rents can be expected to increase by up to 50 per cent over the next three years. The current environment is the perfect breeding ground for rental growth, and allows Toronto to catch-up with major U.S. cities. To a lesser extent a similar model holds true for Montréal and Vancouver and even Calgary whose rates over-corrected due to sub-leasing activity after the drop in oil prices. Even though the Alberta market is witnessing historically low rents, an expected improvement in industrial activity in the oil and gas sector combined with recovering oil prices will provide a path for significant rent increases.
Limited supply boosting rental growth
Vancouver and Toronto have led demand from investors, landlords and tenants alike, and this trend is expected to continue. Low office supply is noticeable in Vancouver as two major projects — Solo District and Containers Phase II — have been pre-leased 85 and 100 per cent respectively. With only one significant development expected to be delivered this year in downtown Vancouver, rents will push upwards strongly as demand outstrips supply.
Toronto’s office CRE market is facing the lowest downtown office availability rate in 10 years and has the lowest vacancy rate among major North American cities. Cadillac Fairview and Ivanhoe Cambridge recently announced two office projects spanning a combined 3.7 million square feet. To no one’s surprise, approximately 46 per cent of which is pre-leased for delivery in mid-2020. Apart from the two projects, no other sizable projects are currently under construction. Approximately 75 per cent of Canada’s Class AAA office inventory is held by 10 institutions that are conservative in nature and will not build without large anchor tenants. Furthermore, any new large projects downtown will likely not be ready until 2021-2022.
Changing demographics will support demand ahead
According to Statistics Canada, Canada’s population has increased by 1.3 per cent on a year-on-year basis. Highly-skilled immigrants constitute a major portion of new entrants in the market as Canada looks to attract talent across the world. In the same period, Canada has seen the addition of approximately 287,200 people in the job market. Highly skilled workers occupy office space at an average of 150 square feet per worker and every 1,000 new jobs create demand for a small suburban office building.
After President Trump’s immigration ban, Canada recently introduced new visa measures that make it even easier for tech companies to recruit foreign talent. With U.S. technology firms looking to further expand their presence in the country, Canada will see a flux of highly skilled immigrants enter the workforce.
Demographics will change not only because of highly skilled workers but also because of international students. The University of Toronto recently saw an 82 per cent increase in applications from the United States alone, with 1,425 undergraduate applicants compared with 784 last year. More workers and jobs will increase demand for space across asset classes and will pressure rents upwards in a tight market. Since the U.S. election, Canadian tech firms say far more U.S. coders are showing a serious interest in migrating north just as the Canadian government has put out the welcome mat.
An improved manufacturing outlook and a weaker Loonie should incentivize manufacturers to grow their operations and take advantage of new trade relations that Canada has penned with the European Union and China. Progressive trade policies translate to billions of dollars in bilateral trade and investment. As new markets open, Canadian exporters will seek to add skilled workers and expand operations which will increase demand for industrial space and push rents upwards.
The future shines bright
A strengthening U.S. economy, newly signed bilateral trade agreements with the European Union and China, improved competitiveness of the Canadian dollar, stabilization of oil prices and a highly stimulative fiscal and monetary policy should translate into better growth prospects not only for Canada but also for Canadian commercial real estate. Investors, landlords and tenants will pursue attractive product with the same fervor that was seen in 2016 and significant rental growth won’t be far behind.
Gaurav Mathur is Research Manager, Capital Markets at JLL. For more information visit www.jll.com