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Raymond Wong is joined by special guests, Wendy Waters, VP or Research Services at GWL Realty Advisors and Phil Stone, Principal and Head of Canadian Research at BentallGreenOak, to review the 2022 Canadian CRE market and take a look ahead to what is potentially in store for the market in 2023.
Welcome to Altus Insights Podcast Series. This podcast brings together some of our leading brainiacs at Altus Group to discuss, debate, and on occasion complain about the evolving state of Canada's residential and commercial real estate. Join Ray Wong, Marlon Bray, and Avi Zelver for monthly podcasts covering the latest market and construction cost trends across major markets in Canada.
Welcome to Altus insights podcast series with Ray and Marlon hosted by me Avi. This podcast will cover monthly market updates and construction cost impacts across major markets in Canada.
Raymond Wong: I Thank you for joining our monthly Altus insights podcast. Marlin couldn't join us for today's episode. This session, we're going to talk about 2022 in review. And what we sort of anticipate for 2023 and 2022 was sort of a turbulent, turbulent but interesting year with we were still seeing a 9% increase of investment to activity over 2021 from 55.8 billion last year to about 60.8 billion by activity is definitely tapering off the office. Vacancy rates continue to climb with slow return to the office. Industrial multifamily residential continues to experience very low vacancy rates and continue to increase and rents. And of course retail continues to evolve. And to join me in today's discussion of two very steam and well-respected guests combine, I guess with the three of us. The scary part is over 60 years of experience inside. And we have Wendy waters, who's vice president, research services and strategy at GW Realty advisors and as well as Phil stone, principal head of Canadian research at mentor Reno. So let's give you each a few minutes before we get into the questions to talk a little bit about yourself and bit of an introduction as well as a little bit something about your company. Wendy, you want to start?
Wendy Waters: Sure so, yeah, so I've been at GW well for 16 years, leading the research group and with various titles within that. My background, I was prior to this, I was young leading research there and prior to that I was actually in the. And then before that I did a PhD in economic history specializing in 20th century economic growth and development. So it's a reasonably good background for what I'm doing now, which is, you know, understanding what drives real estate performance is a lot to back to the economy, demography. It's all about how people experience life, use real estate as part of that. And GW Realty advisors, for those of you who don't know, we manage the real estate assets of institutions and pensions. We have approximately $17 billion under management in Canada, another $1.2 billion in the United States. So the office industrial, retail and multi family residential, we do development, we do property management, asset management, portfolio management. So fully vertically integrated. I think that's primarily about it unless you have any further questions, right?
Raymond Wong: No, Phil?
Phil Stone: Great thanks, ray. Thanks for having me on the podcast. This'll be a fun discussion. Yeah, as I mentioned, I'm principal and head of research at Bentley GreenOak. So GreenOak is a global real estate investment manager, deploying strategies across the risk spectrum and both the debt and the equity side of the business. We are now a little over $80 billion US in assets under management. And I've been in this role for about five or six years now. Coming on six, I've been at battle GreenOak and previously Sunday Life now owns a majority share of mantle GreenOak for about 10 years now. I come at it from a little bit of a different perspective research that is in that I've been, I would say more of a real estate practitioner in my prior roles across various investment management roles through both some private organizations and publicly traded arete as well prior to joining Sunday Life. So that's a little bit about me and looking forward to the ensuing discussion right now.
Raymond Wong: I hope for a little bit debate discussion. So we're going to start off with the capital markets. So we're going to talk about intertwined the market fundamentals as we go through about. We're seeing investment activity starting to come down a little bit. Can we go through that? Some of your perspectives are what do you think is happening with the market right now? Why are we seeing this bit of a slowdown? What are your thoughts with interest rates or inflation? So thought up from there Wendy you want to start with your perspective on the capital markets?
Wendy Waters: Well, I think our perspective right now, you know, it's slowing down. There's a lot of price discovery going on. So there's know, the bid asked spread is a little bit wide in some cases. So it's figuring out what the right return on the cash flow should be that in most of the real estate asset classes. We're going to talk about office in a minute. That might be the slight outlier. The market fundamentals are still really strong, especially industrial and multifamily, but we also do grocery and retail that is a strong acid class. And so the rent the rent the NOI is still is holding up, in fact, in many cases growing. So the question is, what are investors prepared to pay for that income stream? And that's the price discovery on the cap rates that we're noticing. And it's probably know, as long as there's a lot of volatility and interest rates and inflation, you know, you're going to take a little while for that to sort itself out.
Phil Stone: Yeah, I don't know, 100% I mean, it's really been a cost of funds question combined with uncertainty. So those two factors, I think investors are on pause for the moment. And I think until there's further clarity on both inflation, which is going to lead where interest rates go, you know, I think it's going to be pretty tepid for the next, you know, call it six, six to nine months. I won't get into too many specifics on frame because, again, there's a lot of uncertainty out there, both from an economic perspective and an interest rate perspective. I think it's know, this past year is really a tale of two markets. Ray, you mentioned those transaction volumes off the top, I think. Yeah, we're going to be we're going to end up 2022 will go down probably is the second largest year in terms of transaction volume on record. But it's really been basically since the second half of the year. Transaction activity has really ground to a halt. And that's really across all buyer profiles. Institutional investors really hung hamstrung by the denominator effect, as you've had both bond and equity prices really come off. I mean, this will, you know, when you look at a 60/40 portfolio, this is on pace now for the second worst performing year in the last 100 years. And so, you know, real estate's actually been a pretty good place to be when you look at the performance of real estate, look at the MSCI index and how well it's performed to date. But of course, real estate is lagging. Right and so you get the combination of that price Discovery Plus plus appraisal valuation leg to a certain extent. And we're going to start to see that repricing continue into next year. And I think we have to kind of go through that. And I think it's, you know, to Wendy's point, operating fundamentals have been exceptionally strong. You know, again, we'll talk about it. But for someone to be secular changes in office and retail, but all else, things are in pretty good shape. And so it's really a repricing exercise based on cost of funds.
Raymond Wong: You know, the earlier comment that we're only up 9% and. Compared to a year ago. And 2021 is an anomaly because it's sort of like one half years of investor activity, one just because of a lot of deals that were pushed off in 2020. And to a certain extent, the first quarter, 2022 was reflective of that overlap of 2021 activity though that bled into this year and up until midyear, we're up 45% compared to a year ago. We're definitely starting to see some of the deals and some of the complexities just to get some of these deals over the finish line. Now, with the interest rates. And I think we all sort of predicted that we're going to see increase in interest rates this year. And with inflation being that sort of obstacle or that they're got to bring in line to a certain extent now has any of those sort of factors of what's happening with the market fundamentals adjusted or impacted any of your recommendations to the well with respect to where are the market's going to look at the beginning of the year to where we are now? Have you changed your thoughts about where the market is moving toward?
Wendy Water: I can start, I think because market fundamentals are so strong in certain asset types, I would say not in a big way. Obviously, we're always taking a look at what the structural and if there's any structural changes happening. What are the cyclical factors affecting our real estate markets? And certainly we've kicked into some cyclical changes with higher interest rates, higher inflation, and we're figuring out what is structural and what is cyclical from that. And then some rec maybe some recommendations on that. But generally, I would say that it doesn't affect that it affects maybe ability to execute or it affects timing as opposed to, you know, what our outlook is.
Phil Stone: Yeah, I would say I mean, I don't think much has changed since the beginning. I think not that we. You know, I think what I would say is I think you want to stick with when you looking at property sectors, you want to be in those sectors where you've got rent growth and high growth to offset those inflationary pressures. And I think it's been quite evident in some of the market activity that we've seen where, you know, those more inflation sensitive sectors are getting hit. But even in, let's say, for example, industrial, where pricing has been quite strong, rent growth has been quite strong. You know, we've seen some what limited transactions have transpired. There's a clear dichotomy between those with rent roles, a longer term weighted average lease term that our call it 5 to 10 years that don't have significant annual inflation bumps where they're below inflation. We've seen more repricing on those assets than we have for shorter lease terms. And the folks in my transactions team put together a fantastic slide just the other day actually looking at pricing for and they look at more or less same as same store. As you can get in this market where there is limited transactions. But when we look at pre interest rate hike and post interest rate hike, even for those high quality, you know, large box, big box distribution centres, you're in the low 3 cap rate for some of those assets. We now see kind of trading in the mid 4. So some significant price correction and that's largely vault driven. And so you've got to be able to get at an income stream that will provide you protection against rising costs.
Raymond Wong: Wendy you did an article with National Post back in July end of the office, not so fast. Gw Realty advisors so you're a strong proponent of where the office market office product is and how we interact with the care to sort of comment on some of the highlights of that article and your stance?
Wendy Waters: Yeah well, in terms of office, you know, we see if in somewhat of just another cycle of office where, you know, typically a lot of new construction. New construction happened towards the end of a growth cycle. And then when it opens, we tend to be in a bit of a downturn. And whatever causes the downturn is different every time. This time it was more of a virus and then global geopolitical events, but it's the same effect. So there's a bit of a downturn, but we still see office as having a strong future. You know, employees are coming back. We're seeing back to 3 to 3 or four days a week, which means people need desks, they need space to work. We've seen tremendous growth in office oriented employment over the last five years and including right through the pandemic. And there's been a little bit of a pullback with some of the tech companies more recently. But that is not even taking them back in most cases, to their 2019 employment levels. It's setting. Some people added in anticipation of growth during the pandemic. So so we're optimistic on office for, you know, the long term future of office generally for these reasons that we have growth. We have a need for people to connect, to collaborate. There's a lot of companies now talking about how they feel. Productivity, broadly defined, has been impacted by people working remotely. It's not just about how many spreadsheets you fill out in the day, but it's how you get mentored or you provide mentoring formally and informally. It's those quick collisions where you learn something in the hallway. It's the quick connections with your team to say, hey, who's got this file or who? Does anyone know where this is? Is anyone know the answer to this question? And, you know, if you had to do four teams calls to find the answer that it would waste two hours of your day. And you can solve or sometimes solve it in the office in five minutes. So so we're optimistic on office medium term. Longer term, we are in a part from a down part of the cycle in some of the markets, you know, from mostly from New supply, but also companies experimenting with what the future office space they need us. You know, Toronto obviously is in a new supply cycle with a lot of companies looking at consolidating, changing of how they used office space pre-pandemic. And it's being implemented through. And now as they moving into new office space and the bigger the company, the more consolidation potential there is smaller office markets, a little bit less because you still need your kitchen and your meeting rooms. And, you know, if you're only a one floor tenant, if you, you know, 10% of your workforce goes home or 20% goes home, you can't really hard to shed 2000 square feet. It's easy to shed 20,000 square feet. So depending on the market, we're seeing a little bit more impacts in Toronto than in Vancouver. Calgary pleasantly surprised that there's going to be some modest activity in absorption there, and certainly not modest compared to what it's been quite strong compared to what it's been. But, you know, modest maybe compared to some longer term averages across the country.
Phil Stone: Yeah No, I look, I think, you know, over the longer term, I think just given the nature of the investors, the developers here in the Canadian markets who are very prudent, I think we have some supply challenges in the near term. Certainly, I think, you know, Vancouver and Toronto most prominently in downtown markets. But I think over the longer term, things are going to be, you know, just fine in office. But I think over the near to medium term, there's going to be some real challenges. You know, if you look at Canadian office markets in comparison to North American markets, you know, Vancouver, Toronto, still some of the lowest vacancy rates in all of North America. Despite the fact that they've increased and are continuing to rise. I think Vancouver fared much better than Toronto has over it over the past year and a half or so. But I think there's going to be some challenges. I think it'll be interesting to see how many of the big tech layoffs are impacted are impacting Canadian jobs. I think it's been difficult to read through the headlines and sort through just how much. But, you know, we're getting from our tenant base, we're actually getting contrasting, I guess, comments and actually some tech tenants actually looking for more space despite some of these headwinds, which you would not think would be the case at this moment in time. But it is. So it's not a one size fits all. And certainly, you know, as Wendy mentioned, when it comes to occupiers and how they want to utilize their space, it's definitely not a one size fits all and it varies even within a firm and departments. You know, there were some encouraging news article last week from the federal government. Nothing concrete yet, but it sounds like they're about to make an announcement on the Treasury Board coming out with some guidance. We'll see how prescriptive it is on federal employees getting back to the office. You know, whether it will specify how many days that is, in what days potentially. But I think there's been a bit of a shift there in sentiment. And, you know, for a lot of the reasons Wendy mentioned, there's benefits to being back in the office. But yeah, I think, you know, that sector, just from a pricing perspective, I think has been mispriced for a long time, particularly with respect to the CapEx that's required to actually position a building and maintain its competitiveness over time. And so I think, you know, both equity participants, but importantly on the debt side of things, Lenders are really looking at how their underwriting office going forward. And I think that's going to have an impact on both the liquidity of assets and the pricing ultimately over the next couple of years.
Raymond Wong: Well, what do you mean by mispriced is too high or too low to high?
Phil Stone: Too high, I think a lot of again, it's a large function of cheap capital. But I think the operating and capital requirements that need to go into a building to make it competitive against a growing new supply of product, I think was, I guess under underwritten in the buying process and in valuations. I don't think there was enough capital carried. And so therefore, I think those values, you know, and this is a market phenomenon, this isn't specific to any one country, even for example. But so I think there is some repricing to happening to happen in office. And we've seen it already. I mean, you can see it in the public markets in both Canada, in the us, obviously a little bit more leveraged than, say, the institutional market. When you look at the price declines that we've seen in office and say, for example, if you look at the MSCI property index as a proxy for private market assets, values are maybe off 10 to 12%, but kind of slowly trickling down. And I expect that they'll come off a little bit further in 2023 as well.
Wendy Waters: Yeah, the there's been a lot of research on whether office has been know, to Phil's point, it's under underwritten or maybe slightly overpriced compared to what the CapEx is going to be required. And this was being talked about before the pandemic. So it's something another one of those situations where the pandemic put a magnifying glass on a trend that was already there or an issue that was already there. And, you know, the other thing I was going to say is I think we've got some office buildings well, amenities generally newer, but they could be a very nicely refurbished older product, have been doing well and where the employees are. I think Gensler had some data last week or two weeks ago at the real estate forum that something like in some of the buildings they're actively involved with, 90% are back and well amenitized office I mean the only 10% to 15% back in some of the older product. So that tells you where the demand is and so that repricing may be less of an impact on the amenities buildings and maybe, you know, it's more on some of the buildings that are a little bit more challenged in that way in terms of attracting tenants.
Raymond Wong: That question regards to with ESG and we have to talk about ESG, do you think that's going to add more to this? And as well as the metals themselves, the argument that is a little bit more targeted, especially with the younger workforce that are looking for that interaction, looking for that great coffee shop. Do you think that sort of plays into possibly higher rents? But on the ESG component, do you think that's going to contribute to sort of more costly changes with some of those particular, older products?
Wendy Waters: Well, I think we've got you know, everyone's got both climate resilience and a push towards carbon neutrality that we have to manage over, let's say, the next decade plus or next few years as you plan capital on building. So it does play in there's problems there. So far, I think we're not getting that many tenants that are coming right out saying, you know, growing numbers saying we have to be in a green building, but it's definitely out there as a key consideration. Or maybe they don't want to be in a green building, but does need to be a net zero building industry. I think they should rephrase that. But it's definitely I think it's coming. You think some of our major tenancies tech companies have made net zero pledges. So I suspect know, I do anticipate that we are going to see that and that is just part of the capital plans that our teams work on for any building include climate and carbon considerations going forward. Yeah, for sure. And I think I think that flight to quality story is just going to become more and more pronounced and it's both an occupier and an investor flight to quality. And, you know, we've seen it today. We've looked like when you look at absorption data and you stratify it by year of construction and we've looked at it even breaking up the last decade from 2015 onward. You it's positive by a lot in that and 2015 and newer category and it's negative absorption for basically all us. And so yeah, I think that's probably going to continue for some time.
Raymond Wong: What do you guys consider well-amenitized building? What do you think are the basic needs to meet that would attract a certain company?
Phil Stone: Well I mean I would look to see if CBRE had a good occupier survey out I think it was call it mid-year. But I think among the few things that they noted as top of the list were like shared meeting spaces, flexible open space, flexible office space. So thinking about, you know, co-working and that as an amenity within your building. To a certain extent, I think connected tech and building apps, you know, touchless technology, things like that. But also just, you know, again, with the pandemic really shone a light on indoor air quality, for example. But it's as much about in the building itself as it is the locational amenities and the surrounding retail and service amenities as well.
Wendy Waters: Yeah Yeah. My that you know, certainly indoor air, but also the light come out of light. So some of the older buildings sometimes don't have as great a light. So employees really want to have access to daylight. That was a trend before the pandemic. So those tend to be fewer perimeter offices by the window and more access to that natural light for everyone. Outdoor space is definitely a key one for any new. New construction tends to have outdoor spaces for the tenants to use. Dog and pet friendly is another one that's it's relatively new, but it's, you know, you get tenants who say that that's a requirement to come into the building. So Thank you or to which are new office building in Vancouver is pet friendly the anchor tenant that was a condition and we were quite happy to give that a try. And we think we've tried it in some other buildings as well, more on the multi road side. But once we had some experience with that. And the other one is fitness and end of trip are the other big ones that a lot of tenants are asking for across the country. So end of trip for people who want to cycle, commute or jog or whatever. Also for people who might want to go for a run at lunchtime, that's very popular places, safe places to park bikes is big. And then, of course, a fitness center that's, you know, a nice, high quality fitness center. It's no longer that dark, dingy room and, you know, off the parking garage or in the basement, if the trend is now brighter above ground and a much higher quality fitness centre.
Raymond Wong: Wendy, for your building, is there a maximum number of dogs or cats you can have within that space or is it unlimited?
Wendy Waters: Good question. I do not know the answer to that. Some of that may be from the tenants themselves as to figuring out how many dogs they want in their spaces. But yeah, there are some rules around that. But also the tenants tend to make their own rules in terms of behaviour, how many and so forth.
Phil Stone: Ray, Altus is now pet friendly aren't they?
Raymond Wong: Well that's another reason why I was asking because I think we were, we were restricted by the they were they, they, they allow us for the one day unlimited dogs. So we very much appreciated that one day and we're hoping to squeeze a few more days.
Phil Stone: So I was going to say, is there an app you have to log your dog into to reserve a space?
Raymond Wong: You're going to give Wendy some idea and she's going to put in some recommendations here. So I'm a little bit afraid at this point. I love having our dogs in. Thank you for joining us for part one of our 2022 CRT market and review mini series. In our next episode, we'll continue the conversation Wendy and Bell by reviewing Canada's industrial and multi residential market.