Breaking down underlying segments in Canadian CRE and what risks are still out there as investor confidence grows
Canadian commercial real estate started to show some real positive signs in Q2 of this year. Transaction volumes across asset classes ticked up slightly. Even beleaguered asset classes like office showed some glimmers of hope. Q2 offered us a glimpse into how the ongoing rate cutting cycle might restart the wider commercial real estate sector. Despite all the hope, though, investors are only cautiously optimistic.
Keith Reading, senior director of research at Morguard, explained why transaction volumes are increasing and confidence is growing. He also explained why that confidence remains tempered by caution. He broke down the drivers underlining each major commercial real estate asset class and outlined how asset managers should be viewing this space going forward.
“Everybody’s watching interest rates and we’ve now seen a 75 basis point reduction in the Bank of Canada rate, so the big question on everybody’s minds is what’s going to happen and when,” Reading says. “When will activity levels pick up? The short answer is not yet, I think you still need at least two more 25 basis point cuts, which I think the [BoC] is looking at doing…So in my estimation I think we’ll probably see some point in the first half of next year where we’ll get stability in the lending market. That’s when you’ll start to see activity pick up.”
While Canadian rate cuts to date have helped contribute a little bit to investor confidence, Reading sees plenty of players and buyers still sitting on the sidelines. Those players know that more cuts are coming, and are therefore still waiting to meaningfully begin their buying activity because while rates are more attractive now, they should be even more attractive when the BoC hits its so-called ‘neutral’ interest rate.
Another area of concern for investors, Reading says, is the strength of the underlying economy. Weak performance over the past six months and an uptick in unemployment may introduce some new volatility into the market. Reading believes, though, that rate cuts should be enough to prompt enough of a rebound which, combined with an eventual stabilization in lending, should be enough to bring investor confidence up from its current cautious state.
Looking at multifamily housing, which was long a bright spot in CRE thanks to low supply and high demand, Reading notes that rent growth has slowed. Rent has hit such a high point as to be unaffordable in cities like Toronto and Vancouver, where rents are now slowing quite a bit. Interestingly, more affordable markets like Calgary and Edmonton are now seeing increased rents as people continue to migrate there from cities like Toronto and Vancouver. While rent growth has slowed, the fundamental drivers of population growth and low supply remain in place.
Industrial is another area where rental growth has slowed. After enjoying record pace of rental growth, Reading says there has been a plateauing. That said, the market continues to perform relatively well and managers are still finding opportunities in industrial. The same could also be daid for retail which Reading describes as ‘fairly healthy’ despite concerns about the job market, inflation, and interest rates.
Office has long been the black sheep of the CRE family but Reading points to some signs of renewal there. Vacancy rates are continuing to rise, but they are rising more slowly than they had in previous quarters. Class A offices are holding in better and Vancouver and Ottawa are currently outperforming. Toronto, Calgary, and Edmonton post less attractive vacancy rates. The hope, Reading says, emerges from the fact that office construction has slowed to a crawl. Some buildings are even being purchased for conversion to residential. That plus some bargain purchases may be enough to bring life back into the office market.
While CRE appears full of green shoots, Reading still sees risks out there on the market. First and foremost is the risk that rates don’t keep falling. If the BoC holds up its cuts for whatever reason, it could cause a serious issue. On the other side, if the economy ends up in recession and a full-blown hard landing — as opposed to the soft landing we appear headed towards — then Reading says there could be more difficult implications for commercial real estate. The US economy, too, should hold some weight for Canadian investors due simply to the deeply interconnected nature of our two economies.
Fundamentally, though, Reading believes that if asset managers own quality properties, they should be able to weather today’s trepidation and be ready to grow with an improvement in overall market sentiment.
“It's times like this, when things are a little rocky, a little challenging, when it pays to own good real estate,” Reading says. “When you come out of a down economic period, good real estate tends to carry you through those challenges and you come out the other side in a little better condition.”
