Did the pandemic crush commercial real estate? We asked a market expert

Saturday, July 4, 2020   /   by Sergey Korostensky

Did the pandemic crush commercial real estate? We asked a market expert

As the city slowly reopens, the streets remain eerily quiet and the office buildings unsettlingly empty. It seems the short-term shift to working from home has proved that employees can be productive from their home offices. Which presents an important question: do companies still need commercial office space? We asked Roelof (Roo-lof) van Dijk, a real estate analytics expert, to offer his insights on the present—and future—of Toronto’s market.


Tell us about your job. 
I’m the head Canadian analyst at CoStar, a real estate analytics company. Basically, we do research to figure out the state of the country’s commercial real estate supply. I’ve been watching Toronto’s market for the past 15 years. We look at what’s out there, how many square feet, the age of the building, number of tenants, what type of building is being listed. We collect all that information for real estate brokers and investors, who use it to help their clients find offices and make investment decisions.


What was Toronto’s commercial real estate market like in the before times?
It was tight, meaning a large chunk of properties were leased, which drove rents up. At the end of 2019, we had a commercial vacancy rate of 2.9 per cent. That’s ridiculously low, both historically and in comparison to other cities in North America. In a balanced market—one where neither landlords nor tenants have a major advantage—the vacancy rate is usually between six and 10 per cent. At 2.9 per cent, landlords have a big advantage because tenants don’t have a lot of other places to go. With so little space available, there’s a huge need for more office space, which is why there’s about 10 million square feet of office space under construction downtown. Because of that, we were expecting vacancy rates to rise to six per cent by 2021-2022. Then Covid happened.





And what impact did the pandemic have? 
It’s hard to tell. Commercial real estate is slow to react because leases are relatively long term, usually around five years. Right now, we’re watching the sublet market, which is up five to 10 per cent since the beginning of the pandemic. That isn’t much, but I think as we proceed, we’re going to see more space being subleased. More people are working from home, and some companies are experiencing financial hardship, so they’re going to evaluate their needs and put some of their excess space on the market. But even with subleasing, it takes time for companies to put plans in motion. It’s a big decision to vacate your space and put it on the sublet market, especially when there’s so much uncertainty. If a company gives up their space, then in three months’ time there’s a vaccine and everyone can go back to work, that company is not going to be happy. Especially since vacancy rates are relatively low and it’s going to be tough to find new space.


That must make it difficult to predict the future. 
Absolutely. There are a lot of unknown variables, whether it’s a vaccine or a second wave of the virus. In the base scenario, in which a vaccine is discovered in about six months and things slowly return to normal, we expect the downtown Toronto vacancy rate to go up to seven per cent by 2021-22.


If that’s the base scenario, what’s the worst case?
If we have a second wave of the pandemic later this year and people are afraid to go out shopping or go into the office, vacancy rates will rise as companies sublet their existing offices and decide not to renew their leases. But even then, we predict a downtown vacancy rate of eight to 10 per cent. For context, that’s half the current vacancy rate in Calgary, which was already suffering from the downturn in the oil and gas industry.


What if our whole attitude toward work changes? Some people have discovered they really like working from home.
According to a recent survey, employees enjoy working from home, and high-profile companies like Twitter and Shopify are talking about making it permanent. But at the same time, there are lots of other firms that aren’t handling the shift to working from home so well, especially companies that aren’t digital native. They’re looking forward to the day they can get their employees back in the office for data security, network reliability and other reasons. I think it’s more likely that companies will continue to lease commercial real estate and find a way to space out their employees within the office, as opposed to a widespread transition to working from home.


Does that mean office life is going to look different?
Definitely. You’ve basically got two options for spacing your employees out. One is doubling the amount of real estate you have, which comes at double the cost. That’s a hard pill to swallow for most companies. The other option is to have groups rotate between working from home and coming into the office. So, perhaps half of the employees come into the office from Monday to Wednesday, then the others come in on Thursday and Friday. You also install plexiglass screens and add space between the desks. Generally, newer buildings—and those currently under construction—will be more desirable in the post-pandemic work environment.


Why?
One of the big selling points for new buildings is that they tend to be more efficient, meaning they’re bigger and have room for more people. Newer buildings also have the fastest elevators, which is good, considering there will be restrictions on how many people can enter at once. And the new buildings also have the best ventilation systems, which is especially important now. The better the air quality, the healthier the employee. You don’t want to circulate poor air in general, but especially when there’s some evidence that coronavirus can spread via air conditioning.


Is work from home going to change the residential market, too?
I think a lot of people who’ve been spending more time at home have realized that their place has some drawbacks. Maybe it’s too small or they don’t have enough office space. I’ve looked at some of the data from Apartments.com, which is part of CoStar, and there’s increased demand for two-bedroom apartments. Some people are probably sharing with a friend to save money, but I’d say it’s also about finding home office space. The other thing you might see—which has happened in other cities—is some older, smaller office buildings being converted to residential.


How are things looking in the retail sector?
It’s not looking good. A lot of business owners were already struggling, operating on thin margins with high rents. E-commerce had been chipping away at brick-and-mortar retail for years, and now people have become more reliant on it than ever. They’re not keen on being inside with other people and touching things other people have touched. Right now, businesses are receiving a lot of government support. But once those programs are wound back, we’re probably going to see a wave of bankruptcies and closures, lots of shopfronts sitting empty. High-end mall and experiential retail were bright spots for the industry before the pandemic, but they’ve been hit the hardest. Old-fashioned street-front shops will have an advantage because you don’t have to go through a crowded indoor mall to access them.


Is there anything good coming out of this?
Industrial real estate is still in super high demand. The vacancy rate was below one per cent pre-Covid, and now, because e-commerce is booming, there’s even more need for warehouse space. We may see some manufacturing return to Canada from overseas, and many companies are looking to build extra slack into their supply chains after this year’s shocks. That will be a boon to areas like Oshawa on the fringes of the GTA.