Stricken asset classes shaking off COVID

Stricken asset classes now shaking off COVID

Office and retail stake out relevance for work culture and social interaction
Monday, November 29, 2021
By Barbara Carss

Office and retail were diagnosed as stricken asset classes early in the COVID-19 pandemic. With some properties already suffering from pre-existing conditions, fears of looming work-from-home and e-commerce conquests abounded. However, after 20 months on the disabled list, conventional venues for labour and shopping are rallying to fight for market share.

Speaking at an online event earlier this fall, in conjunction with the release of the 2022 Emerging Trends in Real Estate report from PwC and the Urban Land Institute (ULI), commercial real estate insiders advised that investors are engaged and most tenants aren’t going anywhere. In the Greater Toronto Area and farther afield, there’s general optimism that health-related uncertainties are abating, along with recognition that today’s challenges are instead tied to the economic and cultural upheaval the pandemic either unleashed or accelerated.

“It’s more apparent in the U.S. where you see 150,000 people going to a college football game, but they won’t go back to the office,” reflected Ashley Lawrence, managing director and head of Canadian real estate with Brookfield Property Group.

It’s become the de facto premise that, given the option, many people will choose to continue working outside formal office settings, and that employers bent on attracting and retaining talented staff will accommodate those wishes. Yet, it’s also assumed that many people who adapted to working from home over the course of the pandemic could be open to readapting to an office workplace, at least some of the time.

What’s been termed “the great resignation” to describe a recent escalation in career moves in some sectors could bolster the latter likelihood, as new hires are introduced into and seek to forge relationships within organizations. Lawrence predicts it will also place a priority on enticing valued employees to stay, ultimately reorienting the purpose of the office.

“If they work for Company A in their offices at home, they have the exact same environment as if they work for Company B in their offices at home. Those two or three days when they’re in the (formal) office, that’s where you’re going to set the culture,” he maintained. “If you have employees who are only in the office two days a week, those 8-hour or 9-hour days become much more vitally important to engagement with the company.”

Employers still readying for workforce return

It’s expected that many office buildings, particularly in downtown locations, will be sparsely occupied for the remainder of 2021, but increasing numbers of corporate tenants will bring their workforces back in-house in the new year. Lawrence hypothesizes employers have been using the third and fourth quarters of this year to suss out staff needs and demands, and plan for new arrangements.

“Some of the delays we’re seeing in return-to-office are about figuring out how and when and who is going to be back in the office, and for what purpose,” he said. “It’s not easy to switch up an office configuration if you’re a bank. It’s a lot of money and a lot of time.”

Players in the suburban space, such as Jaime McKenna, managing director and group head of real estate with Fengate Asset Management, suggest the low-density, car-friendly characteristics of office parks gained stature with employers and employees over the course of the pandemic. Companies with satellite hubs outside the downtown could provide a less congested office environment and — noteworthy for those who shunned public transportation in pre-vaccine days — minimized driving frustrations.

“We’ve already seen activity pick up substantially in 2021 and that’s because of satellite office,” she reported.

The next challenge is holding that interest when downtown locations regain their attractiveness — one that Fengate has tackled with the introduction of a food delivery service and by working to identify other opportunities to bring urban conveniences within easier reach.

“If we’re going to get people out of their homes and into the office again, it’s got to be a little bit less disruptive than what we were used to pre-pandemic,” McKenna said. “I’m very bullish on the suburban office market if you can combine that convenience with the availability of satellite office space to reduce commute times.”

Investment sentiment positive with no signs of tumbling values

Canadian executives surveyed for the Emerging Trends in Real Estate study have a similar outlook on downtown and suburban office assets. Both property types rank as “fair” investment and development prospects — at below 3.5, above 2, on a scale of 1 to 5 — with suburban office nudging slightly ahead. As well, the niche sub-class of medical office, which is not differentiated by location, garners a “good” assessment — above 3.8; below 4 — from prospective investors and developers.

Opinion is somewhat more split on acquisition and disposition with just 15 per cent of respondents agreeing that it’s a good time to sell centrally located office, versus 24 per cent expressing that opinion about suburban stock. Additionally, 55 per cent favour buying medical office and just 9 per cent endorse selling it.

Colin Johnston, president, research, valuation and advisory, for Altus Group in Canada, pointed to the number of office building deals in Toronto, Montreal and Vancouver this year with no sign of discounted values. In Toronto, 10 million square feet of new office space currently under construction is about 65 per cent pre-leased, and the city was one of North America’s tightest office markets prior to the pandemic. He pegs today’s higher vacancies — with a downtown Class A rate of 9.9 per cent as of the third quarter — as within an acceptable range.

“Lease availability did rise, but we saw rental rates not really eroding much. We saw TIAs (tenant improvement allowances) and landlord packages. With a lot of institutional ownership of office buildings in all the major markets, these owners can ride out the storm pretty well. As long as you’ve got term and you’ve got covenant, values will continue to hold,” Johnston maintained. “A lot of people are continuing to bet on office. People still believe there is a need for office in the future and that’s why people are stepping up with investment dollars.”

Investors have shown robust renewed interest in almost all asset classes. Johnston cited the 56 per cent uptick in activity for first six months of 2021 compared to 2020 and, perhaps more tellingly, the 30 per cent increase over the first six months of 2019. That’s a trend that Canadian respondents to the Emerging Trends survey project will continue, with 62 per cent of them foreseeing an oversupply of equity capital for investing in 2022.

Retail assets aren’t expected to capture the bulk of that, as outlet centres, power centres and regional malls were the three lowest ranked investment prospects among 24 asset sub-classes. However, only regional malls were actually rated “poor”, with a score of 2 on the scale of 1 to 5, and neighbourhood/community malls cracked the “good” rankings, with a score of 3.77.

“I’m a big fan of our opportunities in grocery-anchored retail going forward. It’s an asset class that’s really weathered the storm through the pandemic,” concurred Andrew Duncan, chief investment officer with RioCan Real Estate Investment Trust.

Retail regroups from dire days of 2020

RioCan REIT’s move into the multifamily rental sector in the years prior to the pandemic now looks particularly well-timed. Within its retail base, pandemic-related business curtailments had varying repercussions. As of Q3 2021, Duncan confirmed those assets were 60 per cent occupied with tenants proffering 95 per cent of owed rents, which was on par with pre-pandemic trends.

“What the pandemic’s done is created further bifurcation of retail in terms of sub asset classes, like grocery-anchored strips versus enclosed versus unenclosed,” he said. “They’re all very different assets and are underwritten in value very differently. We’ve got all of that, and we’re responding to each of those asset classes differently.”

“The owners of retail need to reimagine their retail assets to stay relevant and, more importantly, to really just preserve value,” asserted Frank Magliocco, partner and national real estate leader with PwC Canada. “In PwC’s recent study of Canadian consumer shopping trends, it found many consumer behaviours that became entrenched during the lockdowns are really persisting. As retail landlords look to adapt in response to these changes, the focus is shifting toward repurposing spaces to stay relevant for consumers, and finding new ways that they can bring value to retailers and their customers, such as sharing data and offering more diverse experiences, shared community services and a better retail mix.”

Johnston offered the 16 per cent increase in year-over-year bricks-and-mortar retail sales for the first seven months of 2021 as evidence that it’s no longer ceding market share to e-commerce at the same spiking rate as in 2020. Nevertheless, e-commerce now accounts for an estimated 12 to 15 per cent of total Canadian retail sales compared to 7 to 8 per cent two years ago.

“What’s nice to see is that clothing has bounced back in a significant way,” he observed. “Clothing and fashion was one of the categories most hit, and most associated with enclosed shopping centres, so to see that rebound has been encouraging.”

For now, restaurants and food halls still have a lot of ground to recover, but, for the survivors, their post-pandemic allure is something of a given. “Food is one of the things we like. We like going out,” Johnston reiterated.

Abandoned sites are more of a rarity in Canada than the U.S., where he tallies 24 so-called ghost malls encompassing about 8 million square feet of space that have been wholly transformed into distribution centres. Canada’s lower ratio of retail space per capita is comparatively favourable to U.S. scenarios, but it remains a tough market for malls in need of renewal. Meanwhile, many sit in prime locations that could be highly in demand for other purposes.

“The strong have gotten stronger and the weak have gotten weaker. I think we’ll just see that acceleration toward redevelopment for some of those assets,” Johnston concluded.

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

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