When the current building cycle ends, the office sectors in both Toronto (shown) and Vancouver should return to a more balanced state, according to CoStar. (Google Maps image)

Booming office building construction cycles in Toronto and Vancouver will force landlords of older buildings to make some tough decisions in the coming years, according to data from CoStar Group Canada.

CoStar’s Roelof van Dijk, market economist, Canada, said the office market sector is facing significant changes across Canada. With every construction cycle, the market is the recipient of more efficient, better buildings which are leading tenant demand.

“That’s a big impact right now in Toronto and Vancouver because we’re undergoing huge construction cycles, a ton of space in both markets. About 11 million or 12 million (square feet) in Toronto and about four million in Vancouver,” van Dijk told RENX in an interview. “The question is what happens to the older buildings?

“You’ve probably seen some of that already occurring in Alberta. Specifically you look at Calgary and what happened with the last construction cycle that unfortunately occurred during the downturn, and similarly in Edmonton.

“Now, those older buildings – the really old ones – those are the ones that are suffering. You’re starting to see some conversions of those buildings in Calgary and Edmonton.”

van Dijk said newer buildings in both markets should continue to fare “a little bit better” in leasing rates and attracting tenants, despite continued high vacancy and a glut of sub-let space on the market in Calgary. The same effect will apply to a lesser extent in Vancouver and Toronto, he predicts.

Strong fundamentals in Toronto, Vancouver

“We (probably) have a little bit of that to look forward to in a Toronto and Vancouver scenario when you have all this new supply coming online,” van Dijk said.

“Yes, the fundamentals in those two markets are very good right now; exceptionally low vacancy rates, strong rental rate growth, but building a ton of new space and when that new space comes online over the next three, four years, that new space will be met with strong demand.

“It already is. Pre-leasing in those buildings averages like 80 per cent and that’s great. But what happens to the older class-A buildings?”

This happens through every construction cycle and landlords of those older buildings must decide what they do with their properties. Do they initiate another round of renovations? Can they be renovated? Or will those buildings end up being demolished to pave the way for new development?

CoStar forecasts Toronto’s downtown office vacancy rate moving from about three to about six per cent, putting the market into a more balanced state at the end of the current construction cycle. The story is the same for Vancouver.

“I think there’s some changes coming structurally in Vancouver and Toronto as a result of all this new supply and the older buildings are going to have to react,” van Dijk said.

“Strangely enough, the landlords that are building the new stuff also own a lot of those older buildings, so they know what’s down the road. They’re trying to keep the tenants in their portfolios and this is the way to do it and figure out what to do with the old stuff later.”

Roelof van Dijk, is market economist, Canada, with CoStar Group Canada. (Courtesy CoStar)

High-tech, co-working demand drivers

He said high-tech companies continue driving demand for office space in Canada in Vancouver and Toronto, as well as in Montreal, Ottawa, Edmonton and Calgary.

Continued growth in co-working spaces provided by companies such as Regus and WeWork is also a key source of demand.

“We’re seeing a huge demand for space from those types of tenants as a result of these smaller companies that are growing and need smaller space but still want to be in a central location in a nice, big building,” said van Dijk.

However, while the trend to flexible and co-working spaces continues, van Dijk pointed to an interesting recent development in the commercial real estate industry.

“I think we’ve probably hit a certain point where the pendulum may have swung a little too far,” van Dijk said. Some workers arriving at their flex offices can’t find workspaces, or they arrive early to “park their stuff there all day” and lock up a valuable position.

“More and more employees are starting to complain about that. When you talk about square footage of space per employee, that came down dramatically over the last 10 years and it probably swung a little too far on minimizing that space. Companies are going to start pushing back a bit on that, or employees are going to start pushing back a bit on that.

“Everybody’s talking about this to retain or attract talent. At the end of the day, the employees are now the ones that are saying they’re uncomfortable with this.”

Flexible space up 25% in 2018

CoStar isn’t the only firm keeping a close eye on co-working. A CBRE report says news of a WeWork (We Company) IPO is placing the sector front and centre of the office conversation.

“While questions have been raised about the profitability of these operators in a recession, it is unquestionable that the meteoric growth of the flexible-space sector is unprecedented in commercial real estate,” said CBRE.

The report looked at the top 10 markets in the United States and found they account for more than 70 per cent of the nation’s flexible-office inventory (25 per cent in Manhattan alone). With nearly four billion square feet of traditional office space in the 54 major metros tracked by CBRE, continued growth of flexible space is inevitable even under conservative estimates, it said.

In 2018, flexible space grew by 25 per cent in the Top-10 markets. Flexible space as a percentage of total office inventory is about two per cent, with San Francisco and Manhattan the most saturated with over three per cent each.

CBRE said the top-five operators by square footage are WeWork, Regus, Spaces, Knotel and Industrious. The We Company (WeWork) and IWG (Regus and Spaces) hold 50 per cent of the U.S. flexible-office inventory. Knotel and Industrious have another 10 per cent.

About CoStar

CoStar is an American-based company formed 32 years ago. It currently has about 4,200 employees. Mark Ibbotson, managing director, of CoStar Group Canada, said research began in this country in Toronto in 2011.

“We are a research company first but in the last, I’ll say, 10 years we’ve really married with the technology platform that we’re innovating on an annual basis. So we consider ourselves a research and technology company married together,” he said.

“Just under half of our 4,200 employees are researchers.”

About 100 of those employees are in Canada.