Scott Bowden, the managing director of valuation and advisory services for Colliers. The pandemic is likely to raise cap rates, he said. (Courtesy Colliers)

The severity of COVID-19’s impact on the Canadian commercial real estate market is not yet known as the situation continues to unfold and forecasts are adjusted. As an industry benchmark, one of the most pressing questions is what the pandemic will mean for cap rates.

Scott Bowden, the managing director of valuation and advisory services for Colliers International, told RENX people are looking for as much information as possible to help them make decisions. So, when firms such as Colliers release reports such as the Canada Cap Rate Report for Q1 2020, there is heightened interest.

“We’ve been hosting more webinars where, man, we’ve had attendance that would rival any real estate forum in terms of people listening to what we have to say,” Bowden told RENX.

“They just want to gather as much information as they can and try and apply it to themselves.”

While the report offers a snapshot of what was happening, Bowden said looking ahead he expects a rise in cap rates for most asset classes.

Why cap rates are likely to go up

The capitalization rate of a real estate investment is calculated by dividing the property’s net operating income by the current market value. It’s the most popular measure for how real estate investments are assessed for profitability and rate of return.

“When we see greater risk due to businesses being impacted, due to tenants or property owners having their businesses impacted, capitalization rates as a reflection of that risk are impacted by COVID-19 because they are that reflection of risk,” Bowden said.

“Our expectation is that they will start to go up, because people are going to start to see more risks. The days of looking at an asset and painting it with a broad brush . . . are evaporating.

“It’s really about digging deeper into what’s going on in a specific property that’s going to matter.

“What people want is something that can be digested and what they don’t want to hear is ‘it depends’.”

However, he said the greatest factor for cap rates universally is the strength of a landlord’s tenants to pay their rent.

He cautioned people not to adopt a sky-is-falling mentality to the COVID crisis because real estate is a marathon, not a sprint. Looking at something over a longer horizon tends to tell a clearer story about the real estate asset.

Bowden said in the last 10 years the capitalization rate of almost every asset class has compressed dramatically.

“Back when I started, people would look at a 6.5 per cent capitalization rate for a shopping centre and say, ‘You’re nuts, that’s way too low.’ And now people in the industry are saying, ‘You’re nuts, that’s way too high’,” he observed.

“As the capitalization rate gets lower – so your perceived risk gets lower and lower – if there is a change to the capitalization rate, the impact on value becomes that much more pronounced.”

Some key CRE sectors

It’s apparent assets such as retail and hotels have been immediately impacted more than any other asset class, the report states, and it’s possible the recovery for these asset types could drag out longer depending on the duration and severity of the pandemic.   

“Conversely, while there may be some disruption to localized assets within the industrial sector it is widely believed that this particular asset type will flourish in most parts of the country once life returns to normal.

“Multifamily apartment assets should continue to be highly sought after as they’re generally less risky, but there may be some short-term cash flow issues as some tenants struggle to make rental payment,” said the report.

“Lastly, the widespread work-from-home circumstances we’re all currently experiencing will likely change the office sector to some degree in the future, but it’s not certain to what extent at this point.

“Government aid packages may act as mitigating factors for some asset classes, but their success will not be known for some time.

“Certainly, the longer social distancing remains in force, the higher the likelihood that more and more asset types will become adversely affected.”

The report also said shifting and volatile markets have historically led to a gap between vendor and purchaser expectations.

This typically results in diminished sales activity. Colliers expects that situation to unfold in the second quarter, with a reduced level of conventional arms-length transactions.

“Most investors are currently taking a wait-and-see approach as it relates to new acquisitions and potential dispositions.

“However, the volatility of the stock market may also drive capital to commercial real estate as investors look for a more stable, risk-weighted return for their money,” said the report.

“We have never found ourselves within such an unprecedented situation. . . . The impacts on asset valuation could vary greatly from one property to the next depending on a combination of factors.”

A sampling of Q1 Canadian cap rates

The cap rates quoted in the Colliers report reflect investor sentiment prior to the COVID-19 pandemic in March.

Here are some of the Q1 2020 cap rates for select Canadian major markets and asset classes, from low to high ranges:

Downtown office class-A

* Vancouver – 3.5 per cent to 4.50 per cent;

* Calgary – 6.0 per cent to 6.75 per cent;

* Toronto – 3.75 per cent to 4.75 per cent;

* Montreal – 4.50 per cent to 5.50 per cent.

Suburban office class-A

* Vancouver – 4.75 per cent to 5.75 per cent;

* Calgary – 6.25 per cent to 6.75 per cent;

* Toronto – 5.50 per cent to 6.25 per cent;

* Montreal – 6.00 per cent to 7.00 per cent.

Industrial single-tenant class-A

* Vancouver – 3.50 per cent to 4.75 per cent;

* Calgary – 5.25 per cent to 6.00 per cent;

* Toronto – 3.75 per cent to 4.75 per cent;

* Montreal – 5.00 per cent to 5.75 per cent.

Industrial multi-tenant class-B

* Vancouver – 3.75 per cent to 5.00 per cent;

* Calgary – 5.50 per cent to 6.75 per cent;

* Toronto – 4.50 per cent to 5.50 per cent;

* Montreal – 5.50 per cent to 6.50 per cent.

Multifamily high-rise

* Vancouver – 2.75 per cent to 3.25 per cent;

* Calgary – 4.00 per cent to 4.75 per cent;

* Toronto – 3.50 per cent to 4.50 per cent;

* Montreal – 3.00 per cent to 4.25 per cent.

Multifamily low-rise

* Vancouver – 2.75 per cent to 4.25 per cent;

* Calgary – 4.25 per cent to 5.25 per cent;

* Toronto – 3.00 per cent to 4.00 per cent;

* Montreal – 4.00 per cent to 5.00 per cent.

Retail regional/power

* Vancouver – 4.00 per cent to 5.50 per cent;

* Calgary – 5.25 per cent to 6.00 per cent;

* Toronto – 4.25 per cent to 5.00 per cent;

* Montreal – 4.75 per cent to 6.50 per cent;

Retail community

* Vancouver – 4.00 per cent to 5.75 per cent;

* Calgary – 5.25 per cent to 6.00 per cent;

* Toronto – 5.25 per cent to 6.00 per cent;

* Montreal – 6.25 per cent to 7.00 per cent.

Retail strip mall

* Vancouver – 3.50 per cent to 5.50 per cent;

* Calgary – 5.50 per cent to 6.50 per cent;

* Toronto – 4.75 per cent to 5.75 per cent;

* Montreal – 6.50 per cent to 7.50 per cent.