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In part two of our first episode, Ray, Marlon and Avi continue their discussion on the impact of the pandemic on Canadian real estate with perspectives and insights on 2021/2022 cap rates, construction cost impacts across asset types, the accelerated evolution of retail, and a deeper dive on office market values.
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 the 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. In part two of our first episode, we'll be discussing cap rates, construction cost impacts on all assets, the accelerated evolution of retail and a deeper dive on office market values. Let's rejoin the conversation. As we spoke a bit about residential sorry, I'm going to switch it over to commercial a little bit sorry, I know, you know, of a few years back, cap rates were sitting at around 5% to 8% and then we saw them kind of dropped that 2% to 3% range. Are they expected to stay in that range or are there certain assets that we're going to see stronger cap rates or is it going to continue trending down? What are what's your perspective on the asset types and the cap rates, if you could kind of break it down by asset? Well, well, the easy one is apartments or multifamily that we've always seen very low cap rates in that area. In Vancouver, we've seen them close to about less than 2% But now we're starting to see a similar phenomenon in industrial. So for certain tenants, you're seeing some corporate transaction. And again, this is unheard of five years ago of less than 3% And a lot of the changes that we've seen on the retail side and the office side for cap rates, sort of the big chunks happened in the last 18 months, especially on the retail side. So now we're seeing more of a flattening, but is interesting now with some of the transactions is not what it appears that we've seen a couple of downtown office sales that sold at a very low cap rate, but it wasn't really indicative of the current office. Use is more indicative of the new use or the proposed use three to five years down the road on either condo or a multifamily. So anything you find with a little bit of hair on it with increased developable land or increase upside in rental based on renovation or increase sort of mixed use, adding a residential commercial used to it that those potential opportunities will fetch sort of a premium, knowing that the property will be repositioned for higher returns down the road. So definitely, you know, for multifamily and industrial, we still will see continued low cap rates. It'll be interesting to see some of the transactions on the other type going forward and not to mention so your specialty sort of investment, a lot of discussions right now about life sciences and data centers. You know, the challenge with them is that they have slightly higher operating costs and the cap operates a little bit higher. But again, it represents increased yields for investors. So there's a lot more interest in those other sort of niche property sectors and be interesting to watch and see how their values perform. Because definitely there's a higher yield as reflected over the risk for some of those the niche players, even the Public Storage area. And we saw a lot more sort of activity in that area, especially with the growth in condominium sales and the need for storage in not just in the suburban area, but in urban areas. Mm-hmm and stay on the topic of industrial Marlin. Do you feel like industrial was impacted more than the other asset classes? Were they impacted equally on the construction cost side? What kind of trends are you seeing across the different asset types? Well, I think industrial traditionally would be the lowest cost asset to build on a square foot. If you looked in terms of how much it cost, the industrial would be the lowest. And then we'd start moving into stuff like storage specialist use, then sort of office residential. And obviously, the government goes at the far end because when you print money and you're not driven by a profit and loss, it's different economics. And industrial was hit, particularly with certain trades, mainly around steel. It's highly sensitive to steel, obviously. In essence, I mean, the Aussies call them a shed. So in essence, it's the steel shed. So it was hit significantly, but it was hit significantly relative to what people used to play in for industrial versus their escalation being more or less than the other asset types. It would still be at the lower range. And, like I say, it's more material specific on industrial. And the other thing we've industrial is you can no longer look at industrial, all those one market. As ray touched on some unique aspects in the industrial market, a 40 foot clear, which is the typical industrial building, would be influenced by a certain degree of escalation. Once we, if we look at a two story or we start looking at 70 foot clear automated ones and specialist of that, some of the larger retailers are looking at that stuff would have been hit much harder than a more basic warehouse just because of the level of complexity, the level of steel required and sort of the processes around it, cold storage, et cetera. That is high volume of equipment, but generally residential is probably the highest with the. And again, if the government renovation projects in terms of escalation, and I would say that is similar across all of the geographical locations in terms of who is hit the most. And who will probably bear the brunt going forward as well, just because of the sheer volumes on the high rise and the low rise again until we catch up to the market. Mm-hmm And just add Bartlett's comments on the industrials, we're sort of struggling there with some of the reposition of some of those assets, and we're already seeing two story industrial in Vancouver. And you would think that based on some of the rents that is justifiable in the GTA as well, but we just haven't seen it. I think partly is due to sort of municipalities and governments that are keeping up with that sort of different type of use or different type of industrial. So I think that's going to delay some of that process that some of those things that can address the shortage. Similar to the residential, there's not enough supply to keep in demand for industrial, and the GTA typically builds between 10 and 12 million square feet a year, and 90 and 95% of that is leased up before for completion, right? So it'll be going forward. It'll be interesting to see about the pivot with industrial developers, how to accommodate some of those costs and increase densities for some of those projects that we've already seen in the rest of the world, such as Asia with multistory industrial, we just don't have that here. Mm-hmm That's interesting. And you know, even before the pandemic, we spoke about how industrial was becoming the hardest asset type. And, you know, retail is kind of transitioning from boring retail to experiential retail. I'm wondering, during the pandemic, did we see an acceleration of that? Is that trend still happening? Is it stronger than ever or our tenants able to still maintain their regular retail uses even during the pandemic? Well, you know, you saw that pivot, right? With the pandemic, the big concern was safety with consumers and people just going into real estate, period. So there's a lot of investment by owners with HVAC system improvement and filters to provide that assurances and sort of social distancing within the malls. And you know, one way traffic one. One side of the mall compared to the others. So there's an evolution on the safety in dealing with the pandemic, and the stores have continued that evolution before the pandemic increase in more experienced retail. And unfortunately, in the last couple of years, especially with some of the lesser national brands that we've seen sort of transition out or have gone bankrupt. But we're finding new retailers come in to the marketplace, especially if you are on the foreign side. So we're seeing sort of a continued evolution and as well as upgrade of malls and regional centers and as well as the increase, especially a mall like yorkdale increase in luxury brands. But again, it's not all the malls that are going to survive this. Some of the malls and some of the retail and the tertiary markets were not in position or in the tennis weren't well positioned to be able to cover some of that the drop in business. So some there will be some demolition and as well as the change in uses, perhaps more mixed uses, which we saw before the pandemic, with some of the retail malls adding the residential component of it and maximizing the return on those properties. So I think retail is here to stay just because people need to as that social interaction with restaurants and being out and asking questions and you can't do online. And for retailers, they really need the brick and mortar, because the percentage, if you're shopping online and I think we all experience this, you're looking for one or two items. But this classic example with Costco, we go in there for a bag of milk and we end up spending $300 on things that we never planned for. So those are the things that retailers are betting on, that when you're in the store, you're picking up more than one item, and it's very strategic in how the position with the products are. So I think we're still going to see a continue evolution and change. And, you know, especially on the service aspect for from retailers, maybe we need a survey. Has anyone ever actually left Costco spending less than $300, no matter what you go in for? It always is $300, no matter what you go in for. We've tried and I think this one time we got it down to about $25 but that's even picking up three items. So even just trying to go in for a bag of milk doesn't work. And Costco, it's they've gone into those express checkouts as well for the smaller items. So I think some people are doing that and it moves a lot quicker. But even Costco is starting to pivot their model based on what their needs are. But it's you're right, it's a big challenge for us with Costco. Yeah and I think to raise point around intensification of malls, I think that's going to be the had already started pre-pandemic. I think that's going to be the story of the next 10 years. You're going to see that real evolution of the secondary malls, in particular for intensification. And then the primary malls have spent a lot of money renovating improving the experience, and we'll start to see intensification of them as well. It's very logical mixed use development. If you think about I want to build a 300,000 square foot retail and I add 3,000 departments, all of a sudden I've got built in customers, so there's a definite logic to it. And I think that transit orientated projects and developments. I know that's the buzzword of this year, but I mean, that's been going on for a long time. I mean, building by building by transit vertical. But I think we're going to see those get bigger, larger scale. And that's where you're going to see stuff like office. Stuff like retail do very well because they're going to be the anchor point of the project and the residential is going to be there. But the anchor will be something different that really brings in people to the site, connects them to transit. The challenge with those is they tend to be a bit more expensive, but we've seen some fun stuff now. It used to be mixed. Use is all horizontal mixed use, so the usage change as you move horizontally now you see a mix, the vertical and horizontal, and you've seen some extremely large projects by a number of clients across Canada, really. And I think you're going to see that trend is carry on. And some of these projects are going to get huge, but they're the ones where you can make office, retail all kind of make sense when you can. It's again with in a mixed use bag in a fantastic location. Absolutely And you know what, we've seen a lot of development applications like promenade mall, Scarborough town centre, golden mile, center point. Now we're seeing a lot of those development applications come into, you know, add retail, but also intend to find out a lot of that residential space and kind of create these master communities. So there's definitely evidence of that. And I agree. So going back to office that I know we touched upon it a little bit, but I know everyone always asks about the office market and how things are going to be impacted from COVID. So now that workers are slowly going back and we're expecting things to open up a little bit more over time. How is this going to affect the office values in terms of costs? Or are we going to see them go up? Are they going to stay consistent? What are we expecting to see on the office side once workers start really going back to the office? Well, you know, let me start from an investment standpoint, especially the last few months, and we see quite a bit of downtown, you know, a office building and in Montreal and Toronto and as well as Calgary and the most recent being the World Bank Plaza. So one from investment standpoint, there is still demand for those type of assets at record prices. And I'm a big believer of going back to the office from that social interaction, the way to brainstorm, to have those accidental meetings and as well as for people to be seen by senior management and having that level of interaction, as well as the coaching, mentoring. So I think that's been missed, especially the last couple of years saying that. I also think that this hybrid model of a balancing of three to five days between 3 and 5 days in the office and then working from home and having that flexibility, I think that's still needed. And plus that's not going away and the realization for some companies that the actual some departments actually they actually work better and more productive not being in the office, especially with that commute. And so that concern with the pandemic, with getting on public transit. So I think eventually that we're going to see a return to the office, maybe not in the same way and definitely what owners and companies have done to reposition their offices. It's as different, more of collaboration, more of interaction and to come in for a reason and not just to work at your desk 9:00 to 5:00. So I think we're still going to see a continuation of that and we're definitely saw the increase in lease activity last year and thus continue this year. So we know that people are still leasing spaces and it's different configuration. They're being a lot more smart with their space and outlining what the real needs are. I think eventually that office demand will come back to not almost to the same level of occupancy, but from a price standpoint, we haven't really seen that sort of decrease. If anything, what we saw in the suburbs, some of the office campuses are being reconvert or converted to industrial type uses. And again, that's just because of the higher value or the highest and best use for that site. So I think we're going to see some of that demolition and Calgary as well. We see we're seeing some conversions there to sort of affordable housing or apartment. So I think we're going to see continue evolution how we use and interact office. But again, from a social standpoint, I think is still very much needed to have that interaction, as well as to be able to retain top talent. Yeah and people are still looking at New construction office and people there's still a lot under construction in Vancouver and Toronto still have significant amounts of office and construction, and you don't have to go back too far to lose. There's a fairly significant period when nothing was built, and I think also the newer products being built, a very, very high standard. It's a different type of product. A lot of it has a lot more money in it and whatnot. And again, it's that different way of working where there's more common space, more amenity space and those changes are going to carry on. I think part of the challenge on the office is going to be it's like all the other assets. The rates have to stay up there because the cost of construction is so high. The cost of land is so high. You still have to make money. So it's going to be the same challenge. I think the office give it a couple of years. See how it plays out. I think to Ray's point, we're going to see a lot of the panic vanish and a return to some form of normality, even if that looks very slightly different to where it is now. Yeah, it's not that long ago pre-pandemic that there is a need for it to be in the urban areas and in Vancouver and Toronto, you have less than 4% vacancy rates on these buildings and there is a pent up demand for people wanting to come downtown, but not enough space. So and when you saw that you know, 10 to 20 million square feet of buildings are now under construction, there was a bit of a concern that we knew that the vacancy rate was going to go up when these buildings were going to be complete. But there was also that pent up demand that was just not enough. Space and now what we're seeing is to marlyn, your point that pre-release activity has not dropped off with the buildings under construction. But the challenge now is that backfill space that they're leaving and there could be slightly higher order B or C building and how they're going to pivot and reposition themselves to address some of those concerns with better HVAC systems and others that the newer buildings are offering, especially with space layout and how they're going to compete in the space and whether or not they're going to be converted into a mixed use or something else. But there's definitely a demand for that new space, allowing for better social distancing, as well as to deal with some of the the, you know, the air filter or the concerns with how the space is ventilated. Yeah and I think going back to if you go back 3 or four years ago, even before the pandemic, a lot of people were talking about potential conversion of these class C marginal class B offices into alternate uses. I think for that to work, there's they'd have to be some sort of agreement with the municipalities where this tradition you have to replace the office in the new development in some of these areas where that doesn't really make sense, having that flexibility, where that work use can be changed just to pure residential or again industrial, but with a lower density of workers. And we can sort of again be a bit more flexible in the approvals recognizing realistically the class A office needs to be on transit, needs to be in the right location. And some of these secondary office areas where we do have these old class C buildings that need a lot of work, just tear them down, replace them with higher density, but all use the continual need to then shove 100,000 square feet of office back into the building for no apparent need whatsoever. I mean, if you couldn't lease the building up before and it was a questionable office area, it's probably still a questionable office area. So why folks want to do it just for the sake of it. So again, it's that a little bit out of the box imagination you've seen in Calgary of affordable housing going into some office space and getting away from rigid rules. And I think, you know, I say more flexibility, more nimble, a little bit more entrepreneurial, again, the favorite word of the podcast, but trying to change things a little bit. There's we have to do everything the same way we've always been doing it. Mentality has really got to change at some point. Are we to be in that whole world of trouble? I think, you know? Altus group released its Canadian construction cost guide, which is free to the public and has some really wonderful information. Marlin will spend a couple of minutes just explaining some of the insights that are available in the cost guide. Yeah, so I think with the cost guide, as soon as we issue it, it's extremely popular both in the volume of downloads and the number of questions I get. So I'd like to do is just talk a little bit about some of the questions we've been discussing with clients that are in the cost guide. And there's a couple of key things from it. One there's no two projects the same. That's why you're starting to see the large range between certain asset types and especially now the way that you geographically is starting to change in terms like development. We spoke about earlier in the podcast about stuff moving out. So the GTA now is much broader than it was, say, 10 years ago. The same would apply if you were in Vancouver now, where Fraser valley, Burnaby and whatnot. So there's different project types within that. The other thing is the guy, there's going to be lows, there's going to be highs. It's an average needs get less obsessed with the number. It's based on thousands of thousands of projects. There's going to be some aggregation in there. And then the other thing that's really interesting from this year's cascade is you start to see the GTA costs separate a little bit of the low end from the other locations, and that's partly due to the extreme levels of escalation in the GTA. So some of those, some of those have increased by 20 14% On the low side, the top side hasn't gone up quite as much. And again, that's part of that discussion. We cannot early whether the lower end of the market is evolving a little bit. If you're charging $1,100 per square foot, there's a certain quality expectation. There may have differed from the good old plastic laminate countertops, you know, 10 years ago. And then the other thing from the cost side is when you read the parking sector and parking is terrific, try to build as little as humanly possible. And only what you need. Thank you, Marlon. And we'll post a link for how to download and how to get access to that construction cost guide. Just to close it off, though, I know both of you don't sleep much at night, so maybe share with us what keeps you up at night or any final thoughts or points or anything that you think is worth mentioning. We'll start with you, Marlon. Oh, OK. So obviously pre-christmas there was the big Warning at the LCBO that was going to be a shortages of wine and scotch. So that kept me up for a while until I filled my wine fridge up with Australian wine. And I have way too many bottles of scotch, which might be an indicator that the pandemic is still going on as well. And there seems to be a direct link between number of bottles of scotch and lockdowns. But aside from the human side of things, I think there's a couple of things that I worry about a little bit. One of the biggest ones we've touched on today is affordability. And where is that top point for affordability? And again, I mentioned it earlier, so it was in Midtown and it's $660 per square foot in 2016. Just in the middle of the pandemic, you were probably starting to get to 11.50 square foot. Now it's $1300 per square foot. Where does that top end go? Recognizing, as I mentioned, developers not really making any more money either. So it's not that this is funding profit. This is just keeping up. So that affordability and where do we end up with the top end? And that would be the same as you move across to Montreal, you move across to Vancouver. They all have the challenges in terms of how high can revenue go at the top end. I think the bottoms are always going to carry on creeping up, and the same would apply to the rent, which I think Ray touched on earlier on the industrial. It would apply to the purpose built rental as well. It's not just uniquely a residential challenge. I think just residential is a lot more in the news because people can't buy homes, so it's more newsworthy and easy to pose as a headline as well. The obvious sort of challenge was starting to see now is stuff like interest rates is a little bit of nervousness. How far are they going to go up? That impacts the person buying impacts. The person developing it impacts the person acquiring sites, impacts the entire development industry across the board. So how long can we print money before interest rates have to go up? Then how high do those interest rates need to go up? Recognizing the economy's in a little bit of a unique situation. And then the final thing that tends to keep me up, we won't jump on inclusionary zoning again, but I think we did that one to death. But is it's this volume of work in the Canadian market. And although there's been some peaks and troughs in some other areas, Vancouver in particular has had a spike up and down, and Montreal and Toronto in particular have been extremely hot since 2016. 2017 so. And I usually make the joke. I get PTSD from delivering these estimates, developers now because every time you see it, the cost is up, you know, and you wait a year or two, you update your numbers and you're seeing a 20% escalation on an estimate or you seen a pro forma construct and you start to wonder how long can this last? And it's the exhaustion you see in the market and in the COVID lockdowns and in the continual cost escalation, the unknowns where the government policies are going to be. I genuinely feel that there's quite a lot of exhaustion, as well as the enthusiasm, which I'm hoping that sort of starts to level itself out, especially volumes of work in that. The scary thing is we're not building enough homes, so we actually have to ramp up. So how is it we ramp up? How is it we address those needs of increased workforces, increased site speed and the whole process up, and it kind of still ties into that affordability. We're seeing there's a lack of supply, but we're going to see we're going to struggle to increase supply. So how do you get that balance? I think it's a unique challenge. And again, I think the construction industry and the development industry can deal with it. They just need to be, let alone to actually deal with it and solve the problems. This is having a bunch of people aren't necessarily in the industry. All reactionary policies put in place that are a detriment. They're not pushing us forward. It's just doing the same thing over and over again. Which definition of insanity? Mm-hmm You know, and now, Marlow, of course, I agree with all those points. The big thing that we're going to see over the next number of months is sort of the noise in the marketplace, right? And from geopolitical to national, there's plenty of issues with affordability and especially with interest rates and how we deal with inflation and especially when what we're seeing with gas prices and how that impacts the cost of goods and whether or not that itself will slow down the slow down the economy. So it's the noise in the marketplace that we have to learn that is similar to you. With this with this pandemic, we have to deal with it. Overall, I think we were going into a positive direction, both economic growth and where we're heading. And especially the employment numbers are better than compared to a year ago. But is that noise that we hear on sort of daily, weekly basis that causes minor disruptions or jitters in the marketplace that we have to try to get through? And I think so far that we've seen in the past 20 months that companies and people have pivoted and they've adjusted and we just that sort of just has to continue as we sort of get closer and closer to whatever we're defining now level of normalcy going forward. Yeah and I think Avi, because it sounds like a negative and I think generally myself, I'm very, very positive on the market going forward. We just think there's going to be there's going to be challenges and like, say, there's some exceptionally good developers in Canada and North America. We they tend to figure stuff out and get stuff done. And I think that's going to carry on. And I think there's going be a few interesting bumps in the road, but overall very, very positive. Just don't look at your next estimate. It probably increased in value. Well, I love that you ended it on a positive note, and I appreciate both your opinions, and I just want to thank you both so much for this insightful discussion and for the great perspectives you both provided. I know I'm particularly grateful to have you both. I know how on demand both of you are speakers and you have so much knowledge to share. So I'm really excited to do these podcasts with you guys moving forward. So thank you so much to both of you. And special Thanks to our audience. Thank you for taking the time to listen to our very first podcast. We'll be releasing new podcasts on a monthly basis. And we will have special guests join us along the way. If you would like to nominate someone or yourself or you have any specific questions or subjects you'd like us to cover, please email us at the link below. We will post a link under the video and we hope to hear from you. And hopefully you join us on the journey and watch our future podcasts. Thank you all so much and have a wonderful week ahead.