New office supply poses backfill challenges

New office supply poses backfill challenges

Toronto and Vancouver await downtown influx as tenants reassess space needs
Tuesday, March 16, 2021
By Barbara Carss

An influx of new office supply was always expected to shake up the status quo in Toronto’s downtown commercial real estate market given that approximately two-thirds of the 8+ million square feet of space currently under construction is already preleased. However, prospects for backfilling were perhaps viewed with less trepidation entering 2020 when the downtown Class A vacancy rate floated around 2 per cent.

A year of pandemic-related upheaval, which saw a fourfold increase in sublet space and the Class A vacancy rate climb to 5.5 per cent, now has commercial landlords more nervously contemplating demand trends as many tenants look to retrench or at least reassess their future space needs. Although the source of this uncertainty may be extraordinary, industry veterans note the scenario itself is far from novel.

“Too much new supply coming at the wrong time has always been the office sector’s Achilles heel,” Paul Morassutti, vice chair, valuation and advisory services, with CBRE Canada, reflected during a recent online presentation accompanying the release of the firm’s 2021 market forecast.

CBRE’s 2020 fourth quarter statistics for 10 major Canadian markets show that the vast proportion of in-progress office space is slated for Toronto, Vancouver and Montreal with Toronto host to 9.1 million square feet or slightly more than half of what’s under construction. Toronto’s share of new downtown office space is even higher, representing more than 67 per cent of downtown construction nationwide and equivalent to about 10 per cent of the city’s existing downtown office inventory.

Vancouver has 61 per cent less space under construction, but it’s set to make a bigger dent in the city’s smaller inventory. The approximately 3.5 million square feet of new office supply in progress is equivalent to 14.5 per cent of the current net rentable area downtown. CBRE pegged the downtown Class A vacancy rate at 4.2 per cent as of Q4 2020, up 100 basis points from Q3 and 210 basis points from Q4 2019.

With most informed determination indicating that a portion of the pre-pandemic workforce will permanently vacate formal office accommodations, Morassutti warned there is likely to be a larger and longer-lasting glut than investors envisioned 12 to 18 months ago. Even with no new supply pending and complete employment recovery, economic growth and job creation would be needed to attain pre-pandemic occupancy levels. CBRE’s modelling concludes the dual impact of off-site work and new supply could give rise to as much as a 4 per cent jump in Toronto’s downtown office vacancy rate.

“We can say without equivocation, remote work is here to stay. Virtually every tenant survey supports this. The physical office will absolutely continue to be part of the future of work, but it will be designed to support more flexibility and choice. It will have to incentivize people to come in,” Morassutti maintained. “The issue is: what impact would a 10 per cent reduction in demand have on long-term vacancy? After all, the retail sector has been completely upended by the movement of just 10 to 15 per cent of sales to online platforms.”

Smaller deals, longer lease-up schedules, lower rents anticipated

Findings from Altus Group’s November 2020 survey of 85 commercial real estate executives verify that many asset and property managers are readying for more challenging times. About 35 per cent of the respondents will see lease terms expire for 5 to 20 per cent of the office space in their portfolios during 2021, and another 2 per cent face rollover of more than 20 per cent of office holdings. Upwards of 60 per cent of respondents expect market rents will drop for high-quality office space and more than 75 per cent predict falling rents for lower-calibre space.

A majority — 57 per cent — expect tenants will adjust their space requirements downward in the future because more staff will be working from home, but relatively few foresee shrinkage of more than 20 per cent. Meanwhile, 57 per cent of respondents predicted it would take nine to 12 months to lease high-quality space — a notable upward adjustment in expectations from the 34 per cent who foresaw that timetable when questioned in June 2020. Similarly, respondents generally voiced less confidence in their tenant retention ratios.

“Overall, leasing activity in Q4 was very low in general, especially in the central business district, and not expected to pick up until workers return to the office,” accompanying Altus analysis concludes. “Lower quality assets, especially older Class B and C downtown buildings, will suffer the most from flight to quality and structural vacancy (space never being backfilled).”

Nevertheless, Morassutti offers some hopeful qualifiers.

“We added almost 5 million square feet of new supply in Toronto beginning in 2008 in the midst of the global financial crisis and another 6 million square feet beginning in 2013 and, quite frankly, the market outperformed virtually all vacancy forecasts both times,” he recalled. “Despite the many doomsday forecasts that we see, Vancouver and Toronto still have the lowest vacancy rates in North America. Montreal and Ottawa are in the top five.”

Pre-pandemic trends to be retained, discarded or modified in the recovery

Looking to the broader economy, Benjamin Tal, deputy chief economist with CIBC world markets, joined Morassutti in the online forum to reiterate that COVID-19’s wallop is not a conventional recession. He sees the seeds of a strong and rapid recovery in its uniquely slight blow to goods-producing sectors, the comparatively easier reactivation of the services sector and pent-up demand from consumers with higher incomes who have been stockpiling earnings over the past year.

“We are sitting on $19 billion of excess cash. This is the story of this recession. The abnormality is that there is a huge amount of money sitting, seeking, waiting for a correction,” Tal asserted. “I believe, in a relatively short period of time, we will see a significant amount of spending. The economic boost is that this spending will be going not to goods, but to services — exactly where the jobs are needed.”

That spending momentum has already been channelled to residential real estate, in particular pushing up housing prices outside of large urban centres. Tal charted the steeper rate of increases in areas peripheral to large cities, but cautioned that a post-pandemic rebalancing of work routines could rein in some more far-flung markets.

“Maybe today your current employer is fine with you working from home. What about your next one? If you move to a remote area two or three hours’ drive from Toronto, Vancouver, Montreal under the assumption that you will be working from home fulltime, that’s a big risk,” he submitted. “You will see some people will have to rent an apartment in the city because they will be back in the office at least a few days a week.”

For now, many investors, asset and property managers are grappling with the challenge of differentiating temporary routines and lasting trends, especially while daily life is still largely in the grips of the pandemic interlude. Few commercial real estate insiders realistically await a full reversion to the 2019 way of working, but it is equally unlikely that the vast majority of workers and consumers have fully embraced a life bereft of social interaction.

Some people may move to locales where they can live more affordably and upgrade their housing options, but, once there, look to replicate other aspects of the lives they’ve left behind. That could mean demand for pedestrian-oriented development, experiential retail and other functions and amenities associated with urban downtowns.

“Increasingly, the office will become less of a commodity and more of a consumer product, and like every consumer product, the office will have to continue to fight for its customers and meet their needs because those customers have options,” Morassutti speculated. “One uncomfortable question that we should be asking ourselves is: Who said the old office was that great to begin with?”

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

1 thought on “New office supply poses backfill challenges

  1. Hang onto your hats, this will be an interesting ride as both Landlords and Tenants grapple with a ” New Normal”.
    It should be interesting and this article helps bring it into perspective.
    Real estate ownership has always involved risk to some extent.
    The only saving grace is we didn’t cause it, we just have to deal with it.

Leave a Reply

Your email address will not be published. Required fields are marked *