Is there a reason to be (cautiously) optimistic about the office market?

Colliers' national head of research explains why he thinks the Canadian office real estate market isn't in the 'apocalyptic' place that many perceive it to be

Is there a reason to be (cautiously) optimistic about the office market?

Adam Jacobs hears more panic in anecdotes than he sees in data. Jacobs is the national head of research for Canada at Colliers and when he talks to colleagues or clients about the Canadian office real estate market he says the tone comes off like investment volume is down over 90 per cent. He says that, in reality, the market is simply where it was before the onset of the COVID-19 pandemic. The highs hit in between then and now, however, make the current state look worse than it is.

Jacobs outlined a case for some optimism in Canadian office real estate. He does not pretend that the asset class doesn’t have problems, and that some owners or lenders are in a tight spot. However, he highlights the nature of the market and who owns what to emphasized that pension funds and the institutional owners of class A office real estate are in a stronger position than many might think, especially considering their time horizon.

“I think there are some apocalyptic stories, but I think it’s always a little dangerous to take the outlier stories from the US and apply them here,” Jacobs says. “I don’t think we have as many extreme stories here for a variety of reasons, including the boring stuff like how our mortgages are structured, making it harder to walk away from a deal. Part of that is that most of downtown Toronto, Calgary and a lot of markets are owned by CPPIB and the Ontario Teachers’ Pension Plan, AIMCO, and QuadReal. These investors have a lot of money and a long time horizon. Often they’re part of funds where real estate isn’t even their main investment. They don’t have to panic.”

Jacobs accepts that there is some risk in office right now. He notes that there are buyers with money and will to purchase, but who aren’t buying because they want the price to reflect the risks inherent in office real estate right now. Even well-tenanted buildings are still subject to longer-term risks around the nature of work in the future.

The Canadian office market is also a victim of bad timing. Driven by a dearth of supply and fast-growing demand in the late 2010s, markets like Toronto embarked on an office building spree. Then COVID hit. Many of these offices are now coming online at a time when vacancy rates are rising, adding modern, high-quality supply to a market with lower than expected demand. This is immediately impacting other office landlords whose tenants may be tempted by newer spaces. This new supply needs to be worked through the market, a cyclical process that Jacobs estimates will take longer given the rise of hybrid and remote work.

Despite those risks and cyclical issues, Jacobs also believes that the office story takes up more mental real estate among investors and analysts than it’s worth. He highlights the very visible nature of office buildings and downtown cores, which can make people assume the worst. What they don’t see are the nature of the leases or the quality of the remaining tenants.

Canadian offices are also looking stronger compared to their US counterparts. Jacobs cites a recent meeting with office landlords in California who were happy that their vacancy rates had stabilized at 37 per cent. Toronto is at around 12 per cent. That isn’t a good vacancy rate, but it shows Canada is not experiencing the same severe crisis in office real estate as many US markets are.

Two deals may illustrate the state of opportunity and risk in the office real estate market. In February the CPPIB and Oxford Properties sold two offices in downtown Vancouver for around $300 million. Later in the month, the CPPIB sold its interest in a Manhattan officetower for $1.

The New York office was in need of repair and refitting. CPPIB’s co-owning partner on the property, Jacobs says, wanted to pour tens of millions into the building to fix it up. The CPPIB did not want to make that investment, and walked away from the property. That is something a landlord can do much more easily in the US than in Canada, where lenders are empowered to go after other assets. The Manhattan office market, too, has so much supply and competition as to be very challenging for any investor.  The deal was “shocking” but Jacobs does not believe it reflects the state of office real estate in Canada.

Jacobs notes that the Vancouver offices are more reflective of the top-quality assets that still command value in Canada. He notes that one core tenant was Amazon, who don’t come with the risk of defaulting. It highlights that the office properties on the more expensive end of the market are holding their value well. As plan sponsors and members look at the office assets their pension plans own, Jacobs believes they should look closely at the exact nature of those offices to ascertain their current level of risk.     

“I think we’re really seeing a divergence between the best of the best offices, where there are fewer challenges and lower vacancy rates, and the rest of the market overall,” Jacobs says. “Generally, the pension plans own these triple A office properties. They’re largely in an area of the market that is much safer right now.”