Trophy office towers could be anchored atop the market for the long term as the past decade’s wave of new building subsides and little further development is anticipated. Speaking during a recent online presentation, Nick Axford, chief economist with Avison Young, reiterated the office sector’s dual woes of retrenching tenancies and uncertain financials, and maintained that winners are already emerging from the unfolding upheaval.
“Now, more than ever, this is a real estate market that is hugely differentiated, not along conventional geographic or sector boundaries, but along quality lines,” he asserted. “I can absolutely see rents continuing to push ahead pretty strongly at the top end of the market, but, below that, vacancy rates moving up more significantly with potentially some quite significant rental declines.”
Axford and his colleague, Richard Chilcott, a Toronto-based principal and sales representative with Avison Young, sketched out a second-quarter Canadian market picture that’s showing signs of a pickup in transactions after several months of lull. However, they noted that vendors and purchasers are still coming to an understanding of asset pricing in an environment with rising cap rates, aloof lenders and general nervousness about trends in office demand.
That’s in contrast to the momentum of 2021 and into the early part of 2022. Chilcott hypothesized that “pent-up energy” coming out of a record-breaking year kept deals flowing even after interest rates spiked upward in March 2022, until a new reality eventually set in.
“Things started to slow. That was really driven, I think, from the debt perspective. People were starting to look at: What is happening with occupancy? And what is happening with construction costs? And where are my returns going? And do I need to do this transaction?” he recounted. “Then, into Q4, there were very, very few transactions. It was just: We’ve had enough. We don’t know where things are going. We’ll just sort of sit on our hands.”
Eight months later, he reports that transactions are occurring in all property sectors, but typically with painstaking and prolonged due diligence. Looking to the future, the analysts foresee a return to more active deal-making when interest rates stabilize, there’s more clarity around pricing and refinancing pressures prompt more vendors to move.
“There is capital awash to invest,” Chilcott said. “It does come down to what’s a quality location and what’s a quality building. ”
He drew parallels with the tail-end of the global financial crisis period when some investors proactively acquired assets with an eye to long-term returns, and suggested that purchasers with private equity backing are well positioned to do that again. Meanwhile, Axford heralded the return of old-school savvy.
“People who are in the market simply playing that spread between what you can borrow at and the cap rate on the building, hoping to benefit from continued cap rate compression or financial engineering — a lot of those players are going to be taken out of the market. Understanding what to pay for a building is going to be so asset-specific,” he submitted. “People who’ve got those traditional real estate skills of understanding the qualitative and quantitative aspects, who’ve got the capital to deploy and can take advantage of the current market are going to find it a really, really productive market.”
Perhaps counterintuitively, he suggests a slowdown in job growth, demonstrated in recent cuts in the tech sector, could bode well for office occupancy levels. That’s in combination with humans’ basic need to interact with others and employers’ continued priorities to attract talent and replenish an aging workforce.
“We’re seeing this huge structural change coming through in the way that people are currently thinking about working and whether or not to go into the office to do it,” Axford mused. “Weakening of the labour market will mean that people will not just want to be working, but will want to be seen to be working.”
Data from Avison Young’s proprietary urban analytics platform, which uses mobile phone data to track building users, shows a steady incremental rise in attendance in urban downtown locations. Although a larger number of people initially returned to suburban locations as the COVID-19 pandemic ran its course, those attendance levels have now stagnated or even slipped slightly. Axford concludes that people are once again looking for the attributes that conventionally drew them downtown.
“Quality of environment and quality of location are going to be key differentiators in pricing. Great assets, particularly in high-quality locations — that’s sustainable buildings and attractive amenity-rich parts of cities — will end up thriving and will perform better,” he hypothesized. “Poorer quality commodity office space in poorer locations that doesn’t offer those benefits will actually see quite a material decline.”
“Office will work its way through in terms of what is in demand and what isn’t,” Chilcott concurred. “Transactions right now are very slow to get done, but that doesn’t mean it doesn’t get done. We’ve done some extremely low cap rates on office with little or no vacancy because it was a rare opportunity for the investors to get their hands on it.”
Barbara Carss is editor-in-chief of Canadian Property Management.
