Appraisers generally expect office building values to keep slipping over the course of 2023. When Altus Group recently surveyed its Canadian valuation staff for their opinions, more than two-thirds of respondents projected a further 5 to 15 per cent decline, while just 1 per cent judged that values have hit bottom and will remain flat in the coming months.
Presenting those findings during a recent webinar, a panel of the firm’s analysts tallied a range of factors that are undermining cash flow, pushing up cap rates and making investors skittish. That’s evidenced in an 11 per cent decline in office values between the first quarters of 2022 and 2023 across 214 institutional-grade income properties contributing to the Altus benchmark.
“It’s more and more difficult all the time to see a situation where the appetite for office going forward matches what it was in the past,” said Jonas Locke, vice president of Altus business advisory services in Canada.
Challenges arise both from the COVID-19 pandemic’s destabilizing impact on user demand and financial dynamics that investors are now confronting for the first time in several years. The spread between cap rates and the Bank of Canada 10-year bond rate has narrowed to a range last seen during the global financial crisis in 2007-2008. Concurrently, the conventional five-year mortgage rate has climbed to nearly on par with cap rates.
“It has virtually eliminated leverage as a tool to enhance your yield,” Locke observed. “If you’re buying real estate today and paying those types of interest rates, the idea of a leveraged deal being in excess of a cap rate is not there.”
Looking at the past year, Mike Helm, Altus Group’s senior director of national portfolio management, parsed some of the details in the benchmark data, which is drawn from clients that have adopted the firm’s valuation management software and have agreed to contribute. That enables quarter-over-quarter and year-over-year comparisons of the valuations of 693 real estate assets located Canada-wide, of which about 31 per cent are office properties. (Industrial accounts for 39 per cent, retail makes up 16 per cent and multifamily represents 14 per cent.)
“Unsurprisingly, we’ve seen the largest value declines, quarter-over-quarter and year-over-year, in the office sector,” Helm noted. “The direction we all know, but the magnitude amongst the different markets is interesting.”
Toronto and Montreal experience steepest fallout with Vancouver yet to follow
The steepest drops typically occurred in Toronto and Montreal with less erosion registered in Vancouver and Calgary. In Calgary, that’s largely due to a lower starting point and less distance to slide, whereas Helm suggests Vancouver’s trajectory is still unclear. He attributes the fallout in Toronto and Montreal to a larger share of trophy assets.
“Our lowest yields and our highest values are typically in those major markets. For those large-scale, relatively low-yield assets, a 25-point move is going to be more significant in terms of impact to value, both dollar-wise and percentage-wise,” Helm affirmed. “Vancouver has been notably lagging in terms of the value declines witnessed in Toronto and Montreal. So we can potentially argue the strength or uniqueness of the Vancouver market or, alternatively, the possibility of a higher downside and more significant relative value declines moving forward.”
Trends in the United States may offer a hint.
“We’ve seen debt markets significantly impact U.S. valuations,” Helm reported. “We’ve seen larger value declines on U.S. office assets so I think it’s reasonable to suggest that value declines are likely to continue in the Canadian office market.”
The well-documented surge of the hybrid work model, which now sees many employees splitting their on-the-job hours between home and formal offices, increasingly causes strain for landlords as leases come up for renewal. As well, the tech sector, which emerged as an engine of jobs and office absorption in several Canadian markets in recent years, appears to be in a lull. While all property types in the Altus valuation benchmark experienced a year-over-year negative impact on yield in the 12 months between Q1 2022 and 2023, office was alone in also recording a downtrend in cash flow projections.
Locke drew parallels with upheaval in the retail sector, arguing that there will be continuing demand for both bricks-and-mortar shopping venues and office buildings, but that some “reinvention” will be needed. He cited the city of Calgary’s incentive program for office-to-residential conversions as one example. Climate risk and investors’ ESG imperatives are also expected to prompt some culling.
“With the goal of net zero and the amount of money that will have to be put into some of these office buildings, there’s a question of whether or not that is justifiable, especially with the softening of the rents with the high availability rates,” mused Raymond Wong, vice president of the Altus research and data division.
Drop in deal volume complicates valuation
Altus panellists listed rising interest rates, difficulties in securing financing and discordance in buyers’ and sellers’ expectations as key reasons for unusually low transaction volume across all property types. Colliers Canada’s recently released snapshot of Q1 capital markets reports a 49 per cent year-over-year drop in investment value between Q1 2022 and 2023, and webinar participants acknowledged that a slowdown in transactions affects appraisal.
“Sales really drive yield rates, but there is a whole other piece of the puzzle — the cash flow. The value of real estate is driven by cash flow projection and an appropriate yield, and there is a lot of work you can do inside the cash flow projection to reflect current markets, fundamentals and circumstances,” Locke submitted. “When it comes to yield rates, in the absence of sales, I think we survey the market a lot more than we ever have. We talk to brokers and investors and fund managers, and we try to build consensus and consistency. We look to the financial markets for clues as well.”
“We have a well-defined methodology that’s consistent across valuations in a given sector, save for market- or asset-specific nuances. What’s happening is just a lot more conversations with clients, brokers, investors, anyone involved in underwriting assets,” Helm concurred. “Something really important to clients right now is the performance of their assets versus their peers.”
For Q1, Colliers reports a quarter-over-quarter increase in office transactions with $786 million worth of deals, up from $452 million in October, November and December. Wrapping up 2022, Colliers analysts remarked on the diminished REIT and institutional activity that accounted for just 49 per cent of office acquisitions for the year. For the start of 2023, they characterize office transactions as “on the smaller end of the market” primarily in the $20- to $25-million range.
“I am not hearing the same conversations around distressed assets or sales that we’ve heard in the U.S. So I wonder if that will continue to be the case over the balance of 2023,” Helm reflected.
Locke foresees more deal activity with stable interest rates and some initial sales to reset the market.
“The gap between purchaser expectations and vendor expectations, that’s the key hurdle to kind of get over,” he maintained. “There’s lots of capital out there that’s looking to be deployed; it’s getting an understanding around pricing. I think there could be a situation where you see one or two benchmark transactions and a bunch to follow.”
Barbara Carss is editor-in-chief of Canadian Property Management.
