Changing Opportunities

The story of Canadian real estate this year is one of shifting economic fortunes and changing real estate trends. The decline in oil prices has caused a sharp slowdown in the Calgary economy, the Edmonton economy also is trending downward, and the long-term impact on the local real estate market remains to be seen. At the time of writing, the Canadian economy has had a second quarter of minor decline—largely a result of the impact of oil in Alberta. Yet these low energy prices—and the low Canadian dollar—are improving the prospects for manufacturing, transportation, warehousing, and other sectors across the country, especially in eastern Canada.

As economic power returns to the east, investors and developers are turning their attention to new opportunities in faster-growing Toronto and some parts of Montréal. Vancouver is the exception in the west, as it retains the top real estate investment spot.

This year’s top-ranked property subsectors reflect the changing nature of Canada’s real estate market. Warehouses, fulfillment centers, and neighborhood shopping centers are among the top-ranked this year. Each is a classic defensive play in times of slower economic growth, and even minor negative economic growth—yet each of these sectors is also ideally positioned to capitalize on periods of stable domestic consumer demand and increased exports, especially to the United States. In our view, to interpret this as a sign of firms “battening down the hatches” in preparation for an economic storm would be to miss the larger point—which is that opportunities are changing, but they still exist.

We see other signs of real estate players responding positively to changes in their markets and identifying new growth opportunities. Investor interest in medical office and health care properties is perking up as an aging baby boomer generation makes increasing demands on the health care sector. As the rise in housing prices continues to outpace Canadians’ income growth, especially in markets like Toronto and Vancouver, more and more people are choosing to rent—permanently, in some cases. Even some retirees are opting to rent after they sell their homes, rather than buy a smaller home. Developers are keen to meet this growing demand with new purpose-built rental units. However, some of our interviewees expressed concern with the number of purpose-built rental projects announced in Toronto, citing concerns with whether the numbers really do work yet. Mixed-use developments with residential and retail real estate space have also grown beyond a trend and have become a requirement in and around Toronto and Vancouver.

Caution and prudence characterize today’s Canadian real estate players. Many of our survey respondents suspect that Canada’s real estate markets are due for a breather after so many years of economic and real estate expansion—and they’re acting accordingly. Some are slowing their acquisition efforts in Canada, and focusing their attention on existing holdings and opportunities in the United States and other foreign markets. Landlords are concentrating on bringing in new tenants—and extending the leases of existing ones. In Calgary, industry players are settling into a holding pattern as they wait out the current downturn, avoiding rash action.

Calgary and Edmonton—and, to a lesser extent, Saskatoon—aside, the outlook for Canadian real estate remains generally stable. Condominium sales remain solid, and single-family homes continue to do well despite affordability worries. The boom in office construction in recent years is giving rise to some oversupply concerns, at least in the near term. And industrial property across much of the country is poised for growth in the current export-friendly environment.

Without a doubt, Canada’s real estate market is undergoing important shifts—but it would be wrong to take a pessimistic view of the current environment. Opportunities may be changing, but Canadian real estate players should remain confident that good opportunities exist across the country.

Emerging Trends in Canadian Real Estate

“The real estate market in Canada has nine lives. Every time a correction should have happened, something else goes wrong locally or worldwide and causes a distraction.”

Caution Rules as Firms Position Themselves for the Next Business Cycle

How long can Canada’s real estate market continue to grow? It’s a question many in the industry are asking these days. The Canadian economy and real estate market have grown consistently or stayed stable in the seven years since the global economic downturn, and the 13 years leading up to it. Some respondents suspect a downturn is coming—sooner rather than later.

It’s a line of thinking that is convincing real estate companies to adopt a more prudent, defensive position. With competition for high-quality properties intensifying, large real estate players are slowing their pace of acquisitions in Canada; while they opt to wait and see where the Canadian market is heading, they are looking to the United States and elsewhere for opportunities.

Some companies, including real estate investment trusts (REITs), are culling non-core property holdings to capitalize on high valuations and raise capital for redevelopment or intensification projects. Landlords are working to sign tenants to longer-term leases. And most companies are taking the long view when it comes to their business strategy.

However, this heightened level of caution appears to be driven by pragmatism, not pessimism. True, respondents are concerned about the impact of low energy prices on western Canada’s markets. While many feel that U.S. and European economic performance is less than ideal, others see opportunities in those markets as well as in South America. Few seem to believe that these wider economic factors will cause significant problems for their business. More than anything else, it seems that respondents believe that the Canadian market is due for a breather.

Liquidity Everywhere, but Nothing to Buy

While there’s a lot of liquidity in the Canadian market, there isn’t much to invest it in. Respondents talk about the severe lack of high-quality product available for purchase right now, given the current cost of capital. Prized, top-tier Canadian properties are increasingly in the hands of pension funds, institutional investors, and REITs, which in some cases are selling their Tier 2 assets to help fund the purchases. As a result, transaction volumes have picked up for secondary assets and value-added plays. While this creates a steady supply of product, respondents point out that the properties often are older and require investment to suit current market needs.

Office Leasing: Yield Is King, but the Rules Are Changing

With so little top-tier product available, respondents are maximizing their existing holdings. Yield is king, and companies are focused on attracting new tenants to existing office properties—and extending the leases of existing tenants—in order to generate stable income. Yet respondents say that leasing itself is changing, in part as a response to tenants’ own business challenges. Instead of 10- to 15-year leases, respondents say that tenants want leases of ten years or less. Tenants are also reducing space per employee, and some tenants are sharing offices, or opting for value over high-end, luxury amenities. Respondents report that it is becoming increasingly critical to engage the tenants’ human resources groups and others in organizations to secure new leasing. Some tenants are declining traditional property management services like cleaning, choosing to engage their own, often less costly, suppliers.

Stronger U.S. Dollar a Source of Mild Optimism

Economic uncertainties in China and Europe have Canadian firms once again looking to the United States to drive growth. It’s not without risk, of course: the U.S. recovery is not especially strong, and many U.S. trading partners are not growing. The U.S. dollar’s relative strength could well benefit Canadian real estate markets, particularly in eastern Canada. Respondents believe that Toronto-area industrial development, especially distribution centers, may be boosted by the U.S. dollar. Should U.S. firms choose to capitalize on the stronger U.S. dollar to hire skilled Canadian staff, the office sector, especially suburban office properties located near or on transportation hubs, may also benefit.

Lower Oil Prices Have Mixed Impact on Canadian Real Estate

The sharp drop in oil prices has led some to speculate that eastern Canada will regain its position as Canada’s economic engine. However, the impact of the energy sector downturn on Canadian real estate—in Alberta and elsewhere—is just starting to be felt.

Oxford Economics’ May 2015 report, Canada: The Negative Impact of Lower Oil Prices, forecast a 20 per cent drop in energy sector investment this year, and indeed Canadian energy companies have postponed or shelved many projects in light of business conditions. Yet on the real estate side, investors appear to be biding their time. There are little to no large real estate purchases or sales taking place in Alberta, although firms are putting space up for sublet. Alberta’s experience with boom-and-bust cycles has taught companies that sometimes the best strategy is to simply hold.

Elsewhere, low energy prices may prove a boon to certain sectors and their related real estate markets. Canada’s weaker currency should make the country’s non-energy exports more competitive. If gas pump savings should materialize, this too could boost business and consumer spending, potentially benefiting retailers, among others. This could, in turn, drive activity in industrial, office, and commercial real estate, especially in the east.

Foreign Investment: Canada Retains Its Allure

Global investors continue to see Canada as a safe haven for their capital, and the lower Canadian dollar only adds to the allure. Many respondents expect foreign investment to continue to flow into Canadian real estate—not only into traditional markets like Vancouver, Calgary, and Toronto, but also into Montréal and even Saskatoon, where interest in farmland and development land is rising.

Foreign investors face numerous hurdles in entering the Canadian market. As a result, they are determined to ensure that they realize a good return on their investments. Interest in hotel and office properties is rising, and observers expect that foreign investors will soon turn to Canadian health care real estate, especially as the U.S. health care real estate market matures.

However, like their institutional counterparts, foreign investors are also finding that premium opportunities are expensive and in short supply, and it remains to be seen whether this will cool their interest in the Canadian market. It is equally unclear what impact the slowdown in Canada’s energy sector will have on foreign investment.

Housing Affordability Concerns on the Rise

While developers are building condominiums and mid-density products like stacked townhouses to meet municipal and provincial urban density demands, it is getting harder for developers to build affordable housing in the urban centers that people covet—which could have consequences for Canada’s urbanization trend.

Developers and builders believe that several issues are pushing housing prices up and potentially out of reach for many prospective homebuyers. Land prices continue to rise, and many believe that provincial government policies are a key factor: greenbelt legislation in Ontario and British Columbia, for example, is limiting land supplies in an effort to promote urban densification. In addition, lengthy approval processes and significant development charges also are limiting supply and driving up costs across the country. And then there are the construction costs themselves, which continue to rise.

Affordability issues could potentially change urbanization trends, some argue. One respondent sees homeowners selling their homes, moving further out from the core to a less expensive house, and banking the remaining equity. Expansion of the regional transit systems across major urban areas may make it easier for people to buy more affordable homes further out from the core; one respondent remarked that within a few years, self-driving automobiles could have a similar impact, by making lengthy commutes less of a burden. The longer-term impact on development in the core, however, remains to be seen. Of course, a rise in interest rates could make housing even less affordable than it is currently and drive more significant changes in real estate markets.

Rise of the Renters

As concerns over housing affordability grow, a rising number of Canadian households are choosing to rent rather than buy. It’s a trend that is expected to continue and create new opportunities across the country. Attitudes about renting have changed, respondents note. Renting is no longer seen only as a temporary step on the road to homeownership, but as an alternative. Today, we are seeing the rise of permanent renters—a new demographic in many Canadian markets, especially as a growing proportion of the population cannot assemble the down-payment for a new home. This is not new in Montréal, but is relatively new in other cities.

Changes to lending rules, which have effectively doubled minimum down-payments, have not helped, and rising house prices just add to the challenge. Faced with a choice between long commutes from suburbs or renting in the urban core, more and more people are opting to rent.

But that is not the only reason that renting is on the rise. Some older homeowners are often opting to sell their homes and cash out, moving into high-end or luxury rental units and keeping the proceeds from the sale for spending. Luxury apartment units aimed at baby boomers and retirees could be increasingly popular in the years to come, noted one respondent. Offering flexibility, high quality, and low maintenance, rented luxury units will provide a comfortable bridge between homeownership and retirement homes.

With housing affordability likely to remain an issue for some time, rentals are expected to continue to be in demand. These properties offer investors steady income and stable cash flows; in the current environment, that is an attractive proposition. Respondents expect to see more condos redeveloped into rental properties; they also expect to see more purpose-built multi-unit rentals come on stream, since the current, aging stock of multi-unit residential is not well suited to the demand for high-quality rental units. Further cap-rate compression for multi-residential product in eastern Canada is making a compelling case to build rather than buy. Some observers, however, have raised concerns about new players entering the multi-residential market and competing with established players; multi-residential is a unique segment, and new players may find themselves facing greater-than-expected challenges.

Suburbs Resilient in the Face of the Urbanization Trend

The urbanization trend remains strong in Canada, but respondents dismiss suggestions that the suburbs are in decline. Every day, noted one commenter, people choose to exchange their small urban spaces for larger suburban living quarters. Suburbs around the Greater Toronto Area are also becoming more expensive due to government policies, immigration, and higher demand. Respondents believe that major investments in transit infrastructure, especially in and around the Greater Toronto Area, will make the suburbs more attractive to a wider group of people. And as demand drives housing prices higher and higher in the core, they expect to see a growing number of people choose more affordable homes in the suburbs. Moving to the suburbs does not necessarily mean resigning oneself to a lengthy commute, either: many successful suburbs enable people to live, work, and play without having to travel all the way downtown, and the growing trend of working from home also reduces commute times from the suburbs. Some people, in fact, may be choosing where they live first, based on affordability, and then choosing where they work, rather than the other way around.

In terms of commercial real estate, though, developers acknowledge that suburbs need more services, better tax incentives, and lower operating costs to compete with the downtown core.

Technology Creates New Opportunities and Challenges

E-commerce, cloud computing, mobile, and data analytics are just a few of the technologies that continue to reshape the way that people live and work each day. In the process, they are creating new opportunities—and challenges—for Canadian real estate players.

Respondents noted numerous ways that technology is changing how they do business. They’re harnessing the power of data to make better business and marketing decisions and improve their financial reporting. They’re using technology to improve how they design and build new developments and share knowledge across their enterprises. Some are using remote monitoring technology to deliver superior property management services to their tenants. And one respondent even noted that Google Maps allows potential investors, tenants, and buyers to view a building—and its surrounding neighborhood—well before making a visit in person.

Many respondents spoke of the way technology is changing the real estate needs of their retail tenants. Retail is evolving rapidly: e-commerce and a multichannel approach to engaging consumers become vital to retailers’ success, and this is changing how they think about their physical space requirements. Many are rethinking the role of the store, and finding that smaller formats are all that is needed to serve consumers who are likely to view in person and buy online later. One respondent remarked that some retail tenants aren’t looking for stores as much as storerooms—places to store their goods and package them for shipping to online purchasers.

The shift to a multichannel, e-commerce-driven retail model is about logistics more than anything, according to another respondent; as this changes how retailers move their products, it will also change how they look at real estate. Distribution facilities will become just as vital as physical shops—if they aren’t already. This will change how real estate players develop—or redevelop—their retail properties.

It’s not just retail that is changing, either. Respondents are also coming to terms with how technology is changing the office real estate segment. Office workforces are flexible, nimble, and highly mobile; workflows and document management are increasingly digital and cloud-based. As a result of these shifts, office tenants are looking for smaller spaces—not in an effort to cut costs, but rather to adopt a more modern approach to what the office should be. Traditional offices—and even cubicles—are giving way to bench-style desks that support several workers and even more screens of various shapes and sizes. File rooms are disappearing; closets, drawers, and cupboards are being replaced by lockers.

Property owners are discovering that these changes in office space needs are driving up costs for office design, construction, and infrastructure. Renovating an office to suit a tenant is no longer just a matter of moving some walls around: as office densities rise and per-worker square footage drops, big investments in air conditioning, heating, washrooms, and other facilities are often needed. Some believe the real estate sector is underestimating the cost impact of these technology-driven changes.

As well, the increasingly critical role of technology in tenants’ businesses is matched by their growing dependence on a stable supply of electricity. Outages are no longer a temporary inconvenience; they can bring a company’s business to a complete and costly halt. Landlords report that their commercial tenants are demanding that they guarantee uninterrupted power, including immediate backup supplies in case of outages. Some tenants want these promises written into their leases.

Expected Best Bets for 2016

Retail in mixed-use developments. Mixed-use projects combining condominiums, offices, and retail space are still going strong in most Canadian urban centers. And as people continue to move closer to the core (at least, those who can afford to), demand for retail and other amenities is rising. Retailers are eager to meet the demand with smaller, innovative store formats—which bodes well for developers with space to lease.

Destination retail remains a solid play. While the need for retail in the new core developments gets much of the attention, respondents also see strong opportunity in destination retail. Consumers eager for a bargain—or an outstanding shopping experience—have proved more than willing to make the trip to outlet malls and regional shopping centers.

Eastern Canada industrial property, especially distribution. The growth of e-commerce and shifting consumer behaviors is compelling companies to improve their supply chains and achieve ever-shorter delivery times. As a result, demand for industrial buildings and land that is suited for distribution centers is rising, particularly in eastern Canada. Suburban properties and industrial campus developments are attracting investor interest, since moving away from the urban center provides better transportation access.

Redevelopment of older properties. Respondents expect to see significant investment in the redevelopment of older buildings in the years to come. Companies are eager to upgrade their properties to keep pace with new developments coming on stream, to address tenant demands, and to capitalize on the trend toward multi-use building in the urban core.

In the west, bargain hunters are on the prowl. Investors will be keeping a keen eye on companies whose exposure to western Canadian real estate puts them at risk. We may see more consolidation among REITs, as well as more activity by investors keen to acquire valuable assets at a discount by targeting troubled REITs and other companies.

Condos and rental apartments are still a good bet. The market for condominiums remains solid in many parts of the country, particularly in Greater Vancouver and the Greater Toronto Area, especially as single-family home prices continue to rise. Yet it’s not all about condos any longer: as many Canadians opt to rent, demand for rental apartments also is growing.

Suburbs await an exodus from the core. As it gets harder and harder to find affordable housing in Canada’s urban cores, frustrated homebuyers will start looking further afield. Investors and developers are keen to welcome them back to the suburbs.


Andrew Warren serves as the Director of Real Estate Research for PwC. The Emerging Trends in Real Estate 2016, a joint publication between Urban Land Institute and PwC, can be found at pwc.com

 

Transit Net migration Foreign Direct investment Average home size

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