Investors avidly pursuing industrial properties

Investors avidly pursuing industrial properties

Vacancy tightens, rental rates climb and cap rates compress during Q2 2021
Tuesday, August 3, 2021
By Barbara Carss

Investors pursuing industrial properties can typically expect returns of 2 to 3 per cent in the current environment of scarce supply, climbing sales values and escalating land prices. CBRE reports continuing cap rate compression during the second quarter of 2021, with the national Class A rate nudging below 4.8 per cent and bottoming out at 3.25 to 3.75 per cent in Vancouver, Toronto and Montreal.

Market analysts anticipate more capital flowing into the sector as vacancies tighten and rental rates rise. Nationally, CBRE’s second quarter statistics peg the average industrial availability rate at 2.3 per cent, the average net rent at $9.82 per square foot, and the average sales price at $184.73 per square foot. Metrics for Vancouver and Toronto outperform the national benchmarks on all those fronts, with the average sales price hitting a chart-topping $400 per square foot in Vancouver. Ottawa surpasses the national average for rental rates and sales value, while Montreal, Waterloo Region and London, Ontario record below-average availability rates.

“We’ve never really seen lease rates and land move in such a quick accelerated manner on the industrial side, especially what we’ve seen over the last 12 to 15 months,” Werner Dietl, CBRE president and chief executive officer, observed during a recent webinar examining commercial real estate market dynamics. “In all of our major markets across the country we have a supply and demand imbalance. We’ve started creating some new models looking at where industrial leasing rates could go and we’re well into the ($) mid-teens per square foot net. If you factor that with where we see land going right now, we’re in uncharted territory. But we do think there is additional depth of demand just given how low our vacancies are.”

Quarter-over-quarter availability shrank 60 basis points (bps) in Vancouver, 50 bps in Montreal and 40 bps in Toronto to sub-1.5 per cent levels in all three markets. Halifax and Calgary registered even sharper quarter-over-quarter dips, as Halifax’s availability rate fell 130 bps to hit 3 per cent and Calgary’s dropped 120 bps down to 6.6 per cent. More than four million square feet of industrial space was absorbed in Calgary during the first half of this year, surpassing the combined total for 2019 and 2020, and representing the most uptake in two consecutive quarters since 2005.

About 27.1 million square feet of new industrial space is currently under construction Canada-wide, equivalent to about 1.4 per cent of the existing national inventory. Roughly one third of that space is slated for the Greater Toronto Area, where it will add negligibly to the 802 million square feet now comprising the industrial market. The rest is largely concentrated in Vancouver (5.5 million square feet), Montreal (4.5 million square feet), Ottawa (2.8 million square feet), Calgary (2 million square feet) and Edmonton (1.6 million square feet).

Earlier this summer, analysts warned that available space is nearing depletion in Vancouver, Toronto and Montreal if leasing activity continues at the recent pace. Diminishing supplies of zoned land and soaring construction costs further complicate delivery of new product and fuel foreboding about inflation.

“We don’t have enough space to accommodate business demand and can’t build new space fast enough,” Paul Morassutti, vice chair of CBRE’s valuation and advisory services, noted upon the release of Q2 2021 stats. “We’re at the beginning of a new cycle. What will businesses do and what will happen to prices for consumers when the supply of industrial space dwindles? We’re about to find out.”

Inflationary pressures apparent, but not necessarily lasting

Continuing that discussion during CBRE’s recent webinar, Benjamin Tal, deputy chief economist with CIBC World Markets, outlined potential precursors to an inflationary era. Those include: a looming post-pandemic spending surge as Canadian households and businesses find avenues for an estimated $230 billion in accumulated cash; rising costs for raw materials; supply chain disruptions that create extra costs; and rising wages as many service sector employers compete for labour. Already, inflation has surpassed Bank of Canada and U.S. Federal Reserve Board projections.

“On a month-over-month basis, prices are rising faster than expected,” Tal said. “That could be short-lived. Within six months it could have eased again. But there is a risk that it will last longer, and that’s the key risk facing the commercial real estate industry.”

Among factors favouring stability, he predicts commodity costs will moderate as world trade reopens and the supply chain smooths out, and that wage escalation may flag with the termination of the government’s COVID-19 relief programs. Tal also sees the Bank of Canada’s hints that it will begin to phase out pandemic-prompted quantitative easing in the second half of 2022 as a timely step to head off inflationary momentum. The greater threat, he suggests, is that more severe interventions could be necessitated at a later date, catching consumers and borrowers off guard.

“The issue is not inflation; the issue is high interest rates. To me, the number one risk is to what extent inflation will be sticky and not go down,” Tal asserted. “The focus should really be on the sensitivity of the consumer to high interest rates and the recessionary risk due to that.”

For now, Morassutti characterizes real estate market trends as upbeat, citing the 25 per cent gain for the TSX REIT index thus far in 2021, net asset values that are “absolutely going in the right direction” and strong activity in the capital markets. “If you look at the property level, fundamentals in virtually every sector in Canada are improving,” he said.

E-commerce is tagged as a continued driver for the warehouse/distribution and logistics sector, as CBRE projects about 100 million square feet of additional space will be needed globally within the next four to five years to accommodate online retailing needs. In Canada, Dietl speculated that developers will have to at least double their typical annual output to keep pace with demand. He also drew parallels with mounting pressures for housing supply.

“It feels like we have similar trends on industrial and residential now. We have a supply and demand imbalance across the whole country,” Dietl mused. “We can’t build it fast enough. We can’t seem to find ways to deal with the pricing on construction and land, and this is putting extraordinary pressure on lease rates and negotiations and how we’re going to solve for that in the short term.”

Meanwhile, as forecasted even in the most sluggish quarters of 2020, investors are now deploying capital with zeal — targeting both the obvious performers and emergent specialized asset classes.

“Every fund out there wants high-quality logistics and multifamily, but there’s not enough of it in the world to buy, and if you are buying in those sectors, you’re buying 2 and 3 per cent returns, which are not high enough for most funds,” Morassutti submitted. “That’s why we think, first of all, capital will go back into the office market, and why we think momentum in the alternatives will continue. The yields are better.”

Barbara Carss is editor-in-chief of Canadian Property Management.

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