What’s driving commercial real estate values?
Canadian commercial real estate has been a great investment over the last decade. Although the sector is changing due to technology and demographics, industrial and office space are set to continue to do well. Retail, on the other hand, will be under more pressure to re-invent spaces to maximize value.
A relatively low Canadian dollar, a stable financial system and a growing economy have made Canadian real estate an attractive investment for foreigners who have helped to drive up property values in recent years.
Today’s low vacancy rates for office and industrial buildings in most of Canada’s major cities are allowing landlords to raise rents and obtain longer leases from commercial clients.
This means that capitalization rates (cap rates)—the ratio of a property’s annual net operating income over its market value—have trended lower over the last decade, creating more value for owners.
Cap rates currently range between 4% and 10% depending on the type of asset (office, industrial, retail, or hotel) and the city in which the property is located.
At the high-value end of the range are sought after offices in Vancouver, Montreal and Toronto, while shopping malls in Edmonton and Calgary, where the economy has not been doing as well, are at the lower-value end.
Tech companies re-inventing demand for office space
Despite an increase in commercial construction—up 11% on an annualized basis in real terms in the first quarter—a lack of office space remains a problem in some of Canada’s biggest cities. The lack of supply keeps property values high and has pushed up rental rates—great for property owners. Tenants, however, are faced with renewing their lease often on longer terms or paying considerably more at a new location.
In response to these market dynamics, shared workspaces are becoming more popular to maximize a space’s use. Many companies are encouraging more remote work, or implementing seat-sharing—where employees no longer have a permanent desk.
Elsewhere, the rising trend in shared workspace, promoted by companies, like WeWork and ShareDesk, is driven by the growth of the gig economy—freelancers, consultants, part-time and contract workers who do not require a fixed place of work.
Given low vacancy rates, the supply of office space should pick up. However, according to CBRE, part of the reason it’s unlikely to grow significantly is due to rising development costs. Land, materials and labour have all become more expensive. As well, municipalities have added more development charges and created long planning and approval processes.
Overall, continued low cap rates for office space are likely to prevail, especially as hiring increases in sectors such as technology, professional services and education.
Retail hit by technology and slower consumer spending
Consumer spending slowed from a pace of 3.6% in 2017 to 2.1% in 2018, as higher interest rates forced up debt-servicing costs, resulting in less household disposable income. This is bad news for owners of retail properties. Retail vacancy rates have risen, according to Morgard, as companies such as Sears, Gap, HBC’s Home Outfitters and Payless Shoes have closed up shop.
Another factor affecting retailers is e-commerce, which represented 3% of Canadian retailers’ sales last year. As more people purchase items from the comfort of their home, shops are becoming showrooms, and malls are transforming themselves into experiential places for food and entertainment. Retail properties that can be transformed to maximize the space’s value in these ways will benefit in this changing marketplace.
e-commerce supporting industrial property values
While still a small share of total sales, e-commerce is having a significant impact on industrial real estate. The logistics industry is growing as companies focus on moving inventory quickly from manufacturing plants, to warehouses and distribution centres, and ultimately to the customer.
Indeed, the value that warehousing added to the Canadian economy more than doubled over the last 20 years.
While 1.7 million square metres (18.5 million square feet) of industrial space will be constructed this year, this represents only 1% of existing inventory, according to CBRE. Hence, new construction is unlikely to be sufficient to satisfy growing demand, especially in cities like Vancouver, Toronto, Montreal and Halifax.
A low Canadian dollar will continue to make commercial real estate attractive to foreign investors, underpinning prices in major markets. As with many areas of our economy, technology and demographics are having a profound impact on this sector. Property owners will have to harness these trends to their advantage to create value in the coming years.
What does it mean for entrepreneurs?
- With interest rates expected to stay relatively low, it can be a good time to invest in a property provided it fits your business’s needs.
- Retail properties will be under pressure as consumer spending slows. Entrepreneurs will need to assess how to maximize value from their space, which may include re-inventing it.
- Think about how technology can help you make better use of your existing space.
BDC has a wealth of tips and tools on commercial real estate for entrepreneurs. Whether you need help to assess your needs, decide between buying or leasing or need financing, check out our free eBook and other resources.
Canadian economy at a glance
Canada’s economy improves as household spending rebounds
While falling exports weighed on growth in the first quarter, households and businesses provided a counterbalance by increasing their spending. Overall, Canada’s economy grew a modest 0.4% annualized in the quarter.
Household spending increased at an annualized pace of 3.5% in the first quarter—a surprisingly strong pick up from 2018. Higher purchases of services led the way, but consumers also spent more on goods, including furniture and building supplies.
A rise in disposable income—up 3.2% compared to a year ago—helped households feel more confident about spending, but they also dipped into savings to pay for their purchases, lowering the national savings rate to 1.1% of disposable income.
Prospects seem good for continued steady consumer spending ahead with the Conference Board of Canada’s consumer confidence index rising in May to a level last seen in October and strength continuing in the labour market.
Business investment also picked up
Investment in machinery and equipment rebounded in the first quarter, largely attributable to aerospace firms, and some other businesses may have taken advantage of tax changes that allow for immediate and accelerated expensing of these outlays.
Elsewhere, investment in commercial real estate rose, but other types of property investment declined, including on institutional and residential buildings.
Residential investment fell 6% annualized in the first quarter, continuing the contraction that began last year. A decline in investment on single-family homes—down 23% annualized—is largely driving this trend. The rise in interest rates since 2017 and stress test rules for most mortgages have pushed up debt-servicing costs, making single-family homes less affordable for many buyers.
As sales of single-family homes slowed, builders have cut back on construction, limiting the supply and further reducing affordability. New incentives announced in the federal budget may help alleviate some of the affordability constraints, but it will likely take some time before we see an improvement in this sector.
Canada’s goods exports declined by 5.7% on an annualized basis last quarter, and the slowdown in global trade played a role. Exports of agricultural products, minerals and metals products, motor vehicles, forestry products and consumer goods all contracted.
However, the biggest factor lowering Canada’s exports was self-imposed. Energy exports, which represent a quarter of total goods exports, dropped 24% on an annualized basis as Alberta’s curtailment order forced a reduction in oil production and a subsequent drop in exports. As curtailment lessens, production will pick up, and already March data showed an improvement in exports.
With the elimination of import tariffs on aluminum and steel, and the likely ratification of Canada-U.S.-Mexico Free Trade Agreement, Canada’s exports should improve over the coming year.
President Trump’s tariff threat on Mexican imports created uncertainty related to ratification of the free trade deal in early June. However, these tariffs have been suspended indefinitely after the signing of an agreement on border security between the two countries. Should these threatened tariffs be imposed, it would be very damaging to all three countries, given the supply chain linkages, especially in the automotive sector.
Interest rates expected to remain stable
Inflation remains low. Consumer price inflation hit 2.0% in April, and the average of the Bank of Canada’s core measures of inflation was 1.9%. The Bank of Canada kept its policy rate at 1.75% again last month.
Although households seem to be managing with higher interest rates, it seems unlikely the bank will begin hiking rates again soon, given rising trade tensions and slower global growth.
What does it mean for entrepreneurs?
- The recent stability in interest rates appears to have allowed consumers time to adjust to higher debt-service costs and boost their spending, especially on services. Firms focused on this market segment should see revenue growth.
- Improving growth in Canada would ordinarily signal higher interest rates to come, but global trade tensions are keeping rates subdued, meaning it remains a good time to invest.
- Sectors purchasing steel and aluminum from the U.S. should see improved pricing with the elimination of import tariffs.
U.S. economy at a glance
Growth still strong despite trade turbulence
Despite trade conflicts with China, the U.S. economy remains strong with first quarter annualized growth revised down just a notch to 3.1% from last month’s estimate of 3.2%.
Trade tensions did weigh on business investment where growth was revised to 2.3% from 2.7%. Businesses built up inventories in anticipation of higher tariffs on Chinese imports, and they were wise to do so. Tariffs on US$200 billion worth of Chinese goods went up from 10% to 25% on June 1.
Consultations on tariffs on the remaining US$325 billion of imports from China began this month and should a trade deal between the two countries not be reached, it seems likely the new tariffs will be imposed in July.
Meanwhile, trade relations in North America had seemed to be headed in a positive direction until May 30. That’s when President Donald Trump threatened to impose a 5% tariff on all Mexican goods coming into the U.S., effective June 10. Trump said the tariffs would escalate by 5% each month to a maximum of 25% until the two countries reached a deal on what the President called a migrant crisis at the border.
The threat put a potential wrench into the ratification process of the United States-Canada-Mexico Free Trade Agreement. It had been on more solid ground after the U.S. agreed to eliminate import tariffs on steel and aluminum from Canada and Mexico.
The U.S. imports US$350 billion from Mexico, nearly a third of which is in the automotive sector. Tariffs of 25% would be very damaging to the economy given the linkages between the two economies and there would be spillover effects for the Canadian economy.
Trump’s threat received harsh criticism from both parties in the Congress and business, including the Republican-leaning U.S. Chamber of Commerce.
Negotiations between the two countries were swift and an agreement on border security was reached on June 7, following which Trump suspended indefinitely these tariffs.
Consumers continue to be positive
After declining in March, consumer confidence picked up 10 points over April and May, according to the Conference Board Consumer Confidence Index.
Consumers’ assessment of their current situation was at the highest level since 2000. While their expectations for the future also improved, the increase was not as significant.
Consumer spending was revised up slightly in the GDP estimates. Whether higher household spending will materialize remains to be seen. U.S. real retail sales were up only 1.3% in May compared to a year ago.
Slowing job market
The labour market is showing some signs of slowing. Employment increased by only 75,000 in May, much less than anticipated. Job gains have averaged 164,000 per month in 2019, compared with 223,000 in 2018. This may be due to fewer people being available to work at this stage of the business cycle, as seen in the low unemployment rate of 3.6%. Average hourly wages continue their slow upward climb, rising 3.1% compared to a year ago.
Inflation stays put
Despite a tight labour market, wage growth has not been significant enough to translate into higher prices, keeping inflation at 1.5%, which is below the Fed’s target of 2%. Trade tensions and low inflation led the Fed to keep the funds rate unchanged at 2.5%.
Housing market reacting to higher interest rates
Elsewhere, first-quarter growth in residential investment was also revised lower. It fell 3.5% in the first quarter, a bigger drop than the initial estimate of -2.8%.
Residential investment began to slow in mid-2017 when interest rates started rising. Throughout 2018, it contracted each quarter and housing starts have been falling each month since October, compared to their level the previous year.
With interest rates expected to remain where they are in 2019, housing investment may begin to stabilize, though at a lower level than in the past. One positive sign is that housing starts picked up in April compared to March.
What does it mean for entrepreneurs?
- Stable interest rates in the U.S. and a stronger Canadian economy could see the Canadian dollar appreciate.
- Despite heightened trade turbulence, the U.S. economy remains strong and offers many opportunities for Canadian exporters, especially in the consumer goods sector.
- Exporters of building supplies, including lumber, may find tough going in the U.S., given the current slowdown in the residential market.
Oil market update
Global oil prices are volatile as traders react to conflicting developments
Global prices are volatile and are likely to remain so over the coming months as opposing forces play out in the market.
On the supply side, the OPEC-plus group has curbed production to raise prices from the lows of last autumn, but the U.S. has ramped up production, pushing inventories of light crude oil higher. At the same time, U.S. sanctions on Iranian and Venezuelan exports are reducing global supply of heavier crude oil. These dynamics on the supply side are creating price volatility.
Adding to the lack of clarity is uncertainty over whether OPEC+ will raise production to fill the supply gap created by U.S. sanctions. The group is meeting at the end of June to decide on its course of action.
Whether an increase in production is necessary is an open question, given that global demand weakened in the first quarter. A key reason for this downturn was a contraction in global trade by 2% between October and March. As well, a strong U.S. dollar is keeping oil expensive in local currency for oil importers. Furthermore, unresolved trade tensions between China and the U.S. are weighing on investment decisions.
All of this has resulted in more oil supply than earlier estimated. The International Energy Agency (IEA), however, expects demand will pick up over the course of the year as accommodative monetary policy and fiscal stimulus support the global economy.
WCS discount widens as Canadian production picks up
Canadian producers have enjoyed a better price for their product—Western Canadian Select (WCS)—in recent months, amid falling supply of heavier crude from Venezuela and Iran and limits on Canadian production. Now, this scenario is beginning to change.
Canadian production has picked up as an Alberta government curtailment order eased over the past few months. The government-ordered reduction is falling to 175,000 barrels a day in June from 325,000 in January.
While a progressive easing in the curtailment had been planned, it has happened a little faster than originally anticipated, as inventories quickly fell and the gap between West Texas Intermediate (WTI) and WCS, narrowed quickly from a low of US$40 a barrel in October to US$10 in January.
However, as production picked up in March, the spread between WTI and WCS has again widened, to US$13.50 a barrel as of June 10. Prices for WCS futures contracts over the rest of the year are trading with discounts to WTI of US$18 a barrel in July and up to US$22 in December. At these discounts, refiners are willing to pay to ship crude from Canadian producers by rail, which is more expensive than by pipeline.
Over the next year, rail exports are likely to rise to meet U.S. refiners’ demand for heavy crude oil. While the news on June 18 that the federal government will build the Trans Mountain Expansion pipeline is excellent for the industry, its construction and that of Enbridge’s Line 3, are at least two years away.
This means that at current production levels, rail will have to carry the excess production above pipeline capacity, keeping downward pressure on the WCS discount.
Global oil prices will remain very volatile over the coming months and are likely to trade in a wider range of US$55 to US$75 a barrel until there is clarity over whether demand has picked up sufficiently to warrant the OPEC+ group increasing production. The WCS price gap with WTI will continue to widen as Canadian production increases.
Other economic indicators
The key rate remains unchanged
On May 29, the Bank of Canada held its key rate at 1.75% as expected. The oil sector is beginning to improve, and job growth remains strong, however the Canadian economy is facing increasing trade risks such as Chinese restrictions on Canadian goods. The key rate should remain unchanged until the end of the year.
Loonie still weak
The loonie remains weak, with a fourth consecutive month of decline, and an average monthly exchange rate of $0.74 US in May. Since May 30, the Canadian dollar has been impacted by Donald Trump’s announcement of potential tariff hikes on Mexican goods which threaten the effectiveness of the Canada-United States-Mexico Agreement (CUSMA).
Business confidence improves
In May, SME owner confidence rose slightly. The Business Barometer Index of the Canadian Federation of Independent Business rose 3 points to a year-high of 59.7 points, slightly beating its four-year average (59.5 points). Seven out of ten provinces saw an improvement in confidence, led by Alberta with a 7.7-point gain, and followed by the other Western provinces (Manitoba, British Columbia and Saskatchewan). Despite a slight drop in May (-0.6), Health Care remains the most promising sector according to SME owners, followed by Professional and Enterprise Services (60.5) and Hospitality (59.3).
Business credit conditions are stable
At the end of May, the effective business rate was 3.54%, the same as at the close of April, showing stability in price conditions. Credit conditions loosened for households, with the effective rate decreasing to 3.8% today from 3.9% at the end of April.