Two years into the most intense campaign of interest-rate hikes in decades, commercial real estate’s last bastions of support are faltering, with industrial and storage property owners succumbing to oversupply and slowing demand.
Until recently, these two sectors were considered immune from the downturn spurred by higher interest rates because their demand remained so strong. In the second half of 2022, when rates were already rising, Canada’s national vacancy rate for industrial properties fell to 1.5 per cent, and distribution warehouses in and around cities such as Toronto and Montreal commanded some of the fastest-rising prices in the world.
But just like the owners of office towers and rental apartment buildings before them, industrial and storage landlords are struggling with weaker valuations, darkening the cloud that has hung over the industry.
In commercial real estate, property values are measured by a metric known as the capitalization rate, which is a percentage of annual rents relative to a building’s value; the lower the rate, the better, because it means a building is worth a lot. At the height of the e-commerce craze during the COVID-19 pandemic, industrial warehouses in the Greater Toronto Area could sell at 3-per-cent cap rates. Today, they average around 5.5 per cent, according to real estate brokerage CBRE.
Storage facilities, meanwhile, thrived during the pandemic because home sales are a huge driver of their demand – and Canada’s housing market was on fire. But their values are coming back down to earth, too. StorageVault Canada Inc., a publicly-traded storage company, has lost its premium valuation and now trades at a discount to its net asset value, just like the rest of the industry.
The correction is jarring because some of the world’s most sophisticated real estate investors were adamant that Canadian properties, particularly industrial warehouses, would withstand the rate shock.
Two years ago, the supply of warehouse space in Canada was so tight that some landlords were able to raise rents more than 100 per cent during tenant turnovers and lease renewals. And in June, 2022, Prologis Inc., a major industrial property owner based in San Francisco, bought land in the Greater Toronto Area for $2.5-million per acre, more than double the going rate five years prior.
Higher rates did take some air out of this market, because they raise mortgage costs, but industrial and storage properties could endure the early pain. What’s really doing damage now is too much development, coupled with softer demand.
“We’re seeing that this sector is not immune to oversupply,” said Fraser McKenna, an industrial real estate broker at CBRE.
The Canadian economy has also cooled, and on top of that, e-commerce in North America isn’t growing nearly as fast as it once was. In the decade starting 2010, U.S. e-commerce sales grew at an average rate of 14.6 per cent annually, according to Juozas Kaziukėnas, an industry consultant. Since 2022, that rate has nearly halved to 7.8 per cent.
Because of these dual forces, the national availability rate for industrial properties hit 3.7 per cent in the first quarter, the highest level in six years. Average rents in Canada also fell for the second straight quarter, though they are still slightly up year-over-year. Across the sector, “large bay” properties, or giant warehouses, are the most affected, partly because major companies that normally occupy larger spaces are taking longer to make decisions amid the economic uncertainty.
Within the storage sector, Steven Scott, StorageVault’s chief executive officer, described the recent pain as a normalization in an interview, rather than carnage.
During the pandemic, he said, demand was through the roof because of unusual trends such as university and college students keeping their items in storage while campuses were locked down. Restaurants also needed space to store outdoor furniture, because they could only open intermittently.
“A four-month tenant became a two-year tenant,” Mr. Scott said. Plus, the housing market was booming.
Still, the sector’s recent cooling is significant. In Canada, storage property owners have averaged net operating income growth of 13 per cent each quarter since 2017, according to analysts at RBC Dominion Securities. Last quarter, it was 5.2 per cent.
The saving grace is that Canada’s reset is much less severe than what is playing out in the United States. In metros such as Los Angeles, Phoenix and Atlanta, there is a massive oversupply of these properties. Canada has been building industrial warehouses, for instance, at a rate of between 1 and 2 per cent of total supply each year, according to CBRE. In metro areas such as Los Angeles and Dallas-Fort Worth, they are adding between 5 and 9 per cent of total supply annually.
Sun Life Financial Inc., which owns a large real estate portfolio, took a writedown this month on industrial properties it owns outside of Los Angeles, attributing it to an “oversupply bubble that’s putting downward pressure on rents.”
Canada should also benefit from strong immigration in the long run. Prologis, the industrial giant, has estimated that for every new person added, a metro area needs 30 sq ft. of more industrial space. Last year, Canada added 1.3 million people, and over the first four months of 2024 the population aged 15 and older rose by roughly 411,000 people.
Landlords hope this growth will help fill existing property vacancies – and estimate that Canada could even face a shortage of available space in a few years’ time because hardly anything is getting built now. Construction financing is tied to the prime lending rate, which has soared, and it now costs around 9 per cent annually to borrow money to build.
As for storage, Mr. Scott said his sector is still driven by the “D’s”: death, divorce, downsizing, density, dislocation (such as moving cities for a job) and disaster (such as flooding). All of these are still relevant, just less so at the moment.
While the recent corrections have hurt, industrial and storage property owners aren’t reeling like office landlords. In Canada, the average national vacancy for office buildings is now 18.4 per cent.
“The confidence is still there in the industrial market,” said Brad Dykeman, executive managing director at brokerage Cushman & Wakefield. Although there’s been a slowdown, rents are still up 86 per cent and 125 per cent in Toronto and Montreal since mid-2020.
But landlords must accept a different mindset, as prospective tenants aren’t as desperate to scoop up space any more. And when they want to rent, there are lots of properties to choose from.
“The difference is, people have choices,” Mr. Dykeman said.