Steven_Kriemadis
As Dorothy wistfully states in The Wizard of Oz, “There’s no place like home.” But what are owners, investors and tenants in commercial real estate (CRE) to make of ongoing visions of tumbleweeds blowing through our downtown cores in the fallout of an unprecedented shift to working from home?
According to a recent report commissioned by the National Association of Industrial and Office Properties (NAIOP), Canada’s leading organization for CRE developers, owners and investors, the reality is far from dire. In fact, even if the road ahead still looks a bit rough, there are numerous indicators that, well within the next decade, that yellow brick road might just be paved with gold.
Positive economic impact
Prepared for the NAIOP by Toronto-based real estate services company Altus Group, Economic Impacts of Commercial Real Estate in Canada (2022 Edition) emphasizes Canadian CRE’s positive economic impacts in 2021: the generation of $148.4-billion in net contribution to the GDP; $67.5-billion in labour income for workers; and the creation/support of one million jobs (372,710 direct).
An attractive angle, even though office-space surpluses continue to be exacerbated by the pandemic, the work-from-home trend and the green-lighting of construction for new “trophy” locations. Retail also faces great challenges as the pivot to online shopping remains strong, whereas industrial is hot but faces demand-over-availability issues.
Still, Canadian CRE’s largest hurdle is those empty offices – a short-term problem expected to be much improved within a few years, according to Peter Norman, Altus Group’s vice-president and chief economist. Pandemic-related decline in employee occupancy notwithstanding – compared to prepandemic numbers, weekly in-office attendance is currently down to between 25 and 35 per cent, though numbers on weekend-adjacent days (Monday, Friday) fall lower – Mr. Norman says “the economy is growing, and the number of office workers is growing. We are going to grow ourselves out of the issue of surplus office space.”
“The office sector will continue to transition over the next few years and 2023 will see more of what we’ve seen this year – which is that as lease rollovers come up, lots of tenants are negotiating smaller spaces but often in better buildings. The flight to quality will continue.”
— Peter Norman, vice-president and chief economist at Altus Group
When this will happen is harder to pin down. To start with, office-lease terms typically run between five and 10 years whereas the slow restart from the pandemic’s sudden stop has barely been in effect for one year – which means that the majority of leases are currently in effect but by no means guaranteed to be renewed. Exacerbating this uncertainty is the age-old truism “location, location, location”: Buildings more than a half-century old no longer cut it as tenants require modern spaces of reasonable sizes.
Flight to quality
“The office sector will continue to transition over the next few years,” says Mr. Norman. “2023 will see more of what we’ve seen this year – which is that as lease rollovers come up, lots of tenants are negotiating smaller spaces but often in better buildings. The flight to quality will continue.”
It’s ultimately a problem of linear programming, which many lease-bound bigger businesses will simply ride out; growth economics dictate that a 200-person capacity space half empty today might be full, or even too small, in less than a decade.
The needs of smaller businesses are another matter, and greater fuelers of the flight. Matthew Kingston, executive vice-president of development and construction at H&R REIT, Canada’s third-largest real estate investment trust, cites further complications for the future of older CRE spaces, particularly in Toronto, where renovations and rebuilds alike are required to conserve a minimum of 100 per cent of current office space.
H&R REIT is currently requesting permission from the City of Toronto to preserve a downtown heritage building, 69 Yonge St., by converting it from 100-per-cent office to 100-per-cent residential. “It’s too small a floorplate – one-quarter the size of what an office user would want in today’s market,” says Mr. Kingston, who puts the building’s current vacancy at around 20 per cent and calculates a whopping 87 per cent vacancy within two years.
A lack of modernity is what’s making it hard to hold on to 69 Yonge’s tenants, not just limited to issues of spatial design but also infrastructure, in terms of telecom, ESG (environmental, social and governance investing) and more. Plus, given the building’s floor plate, these tenants’ smaller businesses are most likely to adapt by simply leaving.
“For them, erasing office rent from the overhead is a massive deal,” says Mr. Kingston. “When you have a team of five, seven, 20 people, it’s much easier than a company with thousands to suddenly say, ‘We’re going to pursue a work-from-home policy.’
”The City of Toronto is in the dark ages from the conversion standpoint,” says Mr. Norman of the one-to-one office space retention requirement, citing other Canadian centres that are incentivizing change, notably Calgary with an available collective grant fund of over $20-million.
Commercial real estate remains crucial to the Canadian economy, especially because the owners of Canada’s estimated 750 million square feet of office space are, for the most part, pension funds. “What happens to commercial real estate values is very important because of pension funds alone,” Mr. Norman says.
In the near term, outmoded office CRE will remain a major issue for employers and employees alike, but says Mr. Norman, “office isn’t dead – it’s just transforming really quickly and almost everybody is altering their premises to be more amenable to the new way of working,”
”There is uncertainty for up to the next 10 years but in the end, we are probably going to need a lot of the space that we already have – and we might eventually need more,” he adds. “Many businesses will just ride out that linear programming problem. If growth isn’t quite as fast as perceived adjustment, some might opt for space reduction.”
Positive change is predicted in the next few years, though the trend might be hard to discern at first. “We see people returning to the office in 2023, but with a hybrid approach where they spend one to two days a week working from home,” says Mr. Kingston. “Businesses are looking for larger floor plates to accommodate more interaction and collaboration and offer amenities and outdoor space as incentives to entice people into the office – as well as top-of-the-line infrastructure to support increased digital usage, ESG targets and air-quality concerns.”
Prime locations that have these attributes will perform strongly, he says, but other buildings that cannot offer these demands will continue to struggle to maintain, as well as attract, office users.
”The vibrancy and economic activity that occur in a downtown core obviously have to do with the operation of CRE buildings – and the people that come to them and what they do at lunchtime, after work and all the rest of it,” says Mr. Norman. “It’s ultimately the difference between a live and a dead downtown.”