Rebuilding after the shock

Few industries in the modern economy have faced as sudden a demand shock as the commercial real estate sector in 2020. As workers were directed to stay out of public spaces, an estimated 40% of Canadians ended up working from home. Since then, many workers have returned to the office, but the number of Canadians working from home remains nearly three times what it was in 2016. That massive shift in work habits has had an immense effect on the commercial real estate industry, especially in office space. 

At the same time demand shifted, the Bank of Canada raised interest rates to combat inflation. Seeing potential weakness in the commercial real estate sector, banks and other major lenders have tightened their lending policies, which together with increased vacancy and higher costs, has created a perfect storm for property owners. 

Finding an equilibrium

Today, the national vacancy rates are significantly higher than prior to the pandemic.  According to CBRE, the national downtown vacancy rate has risen from 10.2% in 2019 to 19.5% in Q1 2024. The suburban rate has seen a similar trajectory, rising from 12.8% in 2019 to 17.2% in Q1 2024. And though rates have risen across the board, they vary significantly based on the class of property. High-grade buildings (A-class or above) remain in demand in most major markets—the national vacancy rate for premium downtown assets stands at 11.2% vs. 24.4% for Class B/C properties. The trend is clear: tenants favour high quality properties.

Additionally, the market is currently absorbing new property—large blocks of former WeWork property have been added to supply recently, as have new builds in most major markets. More than 1.7 million sq. ft. were added to new supply in Q1 2024, equivalent to 70% of the new supply added in all of 2023. On a positive note, it appears we are at the tail end of a major office development cycle. According to Colliers, office construction has declined more than 50% since 2020, which means less new space will be coming to market in coming years. Unfortunately, while that provide some long-term relief, it doesn’t help with the current situation.

The reality is that property owners with a higher proportion of sub-A commercial properties are likely to see lower demand for their offerings for the foreseeable future. Office real estate companies with strong balance sheets and access to capital may be able to manage their cash flow, but those with high debt will find it more difficult to weather the storm. 

Higher vacancies or tenant renegotiations can lead to substantially reduced cash flow and operating losses, which in turn can place the company in danger of violating financial covenants.  This situation is exacerbated by an inability to find lenders or, when they can be found, to be subject to higher financing costs. Higher interest rates, and the compound effect of the high cost of capital, place pressure on the bottom line and can lead to a vicious cycle of reduced profits and higher costs. 

Where are the good options?

Companies with less desirable portfolios of commercial properties generally have a few options available to them, none of which are particularly desirable: lower rent, conversion, retrofit or rebuild. 

Lowering rent to entice new tenants to their properties (or keep existing tenants in place) can be a temporary fix, but in current conditions is unlikely to help with long-term problems. With so much new supply coming to market, the discounts need to be substantial to keep vacancies low, which can create significant cash flow issues and may make the investment untenable. However, this may be a viable option if the property is well capitalized and there is a longer-term strategy for redevelopment.  

Conversion to a different property type has increased in recent years. However, conversion requires a significant upfront investment and, only certain properties are ideal conversion candidates. Some markets have incentive programs to help defray costs, but the overall investment remains high. Additionally, more than half of conversions have been office-to-residential, and the strength of the condo market varies depending on location—this may be more risk than a company may be willing to take on.

Retrofitting a property into a higher asset class can help to bolster demand, but, as with conversion, the upfront costs are high. The ability to successfully retrofit a building is often driven by location and cost. Just upgrading a property does not automatically increase its desirability. Commercial tenants are looking for good locations with access to transit options and parking, and services such as food courts and health clubs. Unfortunately, many Class B/C buildings don’t meet those criteria and no level of retrofit can compensate for a poor location. The second consideration is cost.  The cost of retrofitting can be significant or impractical given a building’s footprint.  Finally, there is the option to tear down and rebuild from scratch or consider a change of use for the site. This eliminates the complexities of retrofitting and conversion and allows a site to be redeveloped to its highest and best use.  The cost of doing so is significant, and in most cases, the property is sold to a developer or is rebuilt in a joint venture arrangement.  

Unlike many other industries, restructuring an under performing asset in real estate is costly. Most other businesses can spin off assets or shut down divisions that aren’t performing.  However, other than an outright sale to a developer, any permutation for improvement in commercial real estate involves a significant investment.

Moving forward

While the challenges of the moment are great, there is no existential crisis at play. What we are likely to see is some consolidation in the industry. Smaller companies and those that have overextended will sell off some of their assets to retrench and improve their best holdings through retrofits. Larger players with access to capital will likely be able to acquire distressed assets for future redevelopment.

Companies with challenges need to work with key stakeholders to ensure they have the opportunity to succeed. This includes meeting the demands and expectations of their tenants who want continuous improvement and a great place to work, and working with their lenders to ensure they have access to the funds that will help them maintain their properties and carry them until a solution can be implemented. 

Whether you need advice on a path forward or support in managing your stakeholders, our experienced advisors can help—contact your local advisor or reach out to us here.