What’s driving commercial real estate values?

Canadian commercial real estate has been a great investment over the last decade. Although the sector is changing due to technology and demographics, industrial and office space are set to continue to do well. Retail, on the other hand, will be under more pressure to re-invent spaces to maximize value.

A relatively low Canadian dollar, a stable financial system and a growing economy have made Canadian real estate an attractive investment for foreigners who have helped to drive up property values in recent years.

Today’s low vacancy rates for office and industrial buildings in most of Canada’s major cities are allowing landlords to raise rents and obtain longer leases from commercial clients.

This means that capitalization rates (cap rates)—the ratio of a property’s annual net operating income over its market value—have trended lower over the last decade, creating more value for owners.

Cap rates currently range between 4% and 10% depending on the type of asset (office, industrial, retail, or hotel) and the city in which the property is located.

At the high-value end of the range are sought after offices in Vancouver, Montreal and Toronto, while shopping malls in Edmonton and Calgary, where the economy has not been doing as well, are at the lower-value end.

Tech companies re-inventing demand for office space

Despite an increase in commercial construction—up 11% on an annualized basis in real terms in the first quarter—a lack of office space remains a problem in some of Canada’s biggest cities. The lack of supply keeps property values high and has pushed up rental rates—great for property owners. Tenants, however, are faced with renewing their lease often on longer terms or paying considerably more at a new location.

In response to these market dynamics, shared workspaces are becoming more popular to maximize a space’s use. Many companies are encouraging more remote work, or implementing seat-sharing—where employees no longer have a permanent desk.

Elsewhere, the rising trend in shared workspace, promoted by companies, like WeWork and ShareDesk, is driven by the growth of the gig economy—freelancers, consultants, part-time and contract workers who do not require a fixed place of work.

Given low vacancy rates, the supply of office space should pick up. However, according to CBRE, part of the reason it’s unlikely to grow significantly is due to rising development costs. Land, materials and labour have all become more expensive. As well, municipalities have added more development charges and created long planning and approval processes.

Overall, continued low cap rates for office space are likely to prevail, especially as hiring increases in sectors such as technology, professional services and education.

Retail hit by technology and slower consumer spending

Consumer spending slowed from a pace of 3.6% in 2017 to 2.1% in 2018, as higher interest rates forced up debt-servicing costs, resulting in less household disposable income. This is bad news for owners of retail properties. Retail vacancy rates have risen, according to Morgard, as companies such as Sears, Gap, HBC’s Home Outfitters and Payless Shoes have closed up shop.

Another factor affecting retailers is e-commerce, which represented 3% of Canadian retailers’ sales last year. As more people purchase items from the comfort of their home, shops are becoming showrooms, and malls are transforming themselves into experiential places for food and entertainment. Retail properties that can be transformed to maximize the space’s value in these ways will benefit in this changing marketplace.

e-commerce supporting industrial property values

While still a small share of total sales, e-commerce is having a significant impact on industrial real estate. The logistics industry is growing as companies focus on moving inventory quickly from manufacturing plants, to warehouses and distribution centres, and ultimately to the customer.

Indeed, the value that warehousing added to the Canadian economy more than doubled over the last 20 years.

While 1.7 million square metres (18.5 million square feet) of industrial space will be constructed this year, this represents only 1% of existing inventory, according to CBRE. Hence, new construction is unlikely to be sufficient to satisfy growing demand, especially in cities like Vancouver, Toronto, Montreal and Halifax.

Bottom line

A low Canadian dollar will continue to make commercial real estate attractive to foreign investors, underpinning prices in major markets. As with many areas of our economy, technology and demographics are having a profound impact on this sector. Property owners will have to harness these trends to their advantage to create value in the coming years.

What does it mean for entrepreneurs?

1. With interest rates expected to stay relatively low, it can be a good time to invest in a property provided it fits your business’s needs.
2. Retail properties will be under pressure as consumer spending slows. Entrepreneurs will need to assess how to maximize value from their space, which may include re-inventing it.
3. Think about how technology can help you make better use of your existing space.