Nine years into a bull run for the Canadian commercial real estate industry, underlying fundamentals remain so strong the end of the market cycle still doesn’t appear to be in sight.

Paul Morassutti of CBRE. (Image courtesy CBRE)

That’s the sentiment expressed in CBRE Canada’s new “Canada Market Outlook 2018” report and reiterated by executive vice-president and executive managing director Paul Morassutti during the company’s annual Canadian CRE outlook presentation on Feb. 27 at the Metro Toronto Convention Centre.

“The commercial real estate industry is not over-leveraged,” said Morassutti. “Our fundamentals are solid.

“Our ownership base is strong and well-capitalized. Our immigration policies are attractive to global talent and our government, while at times flawed, is not . . . crazy. Other than the unpredictable, there’s no reason to believe that this run won’t be extended.

“We tend to be obsessed with where we are in the cycle, but real estate is a long game. There will be dislocation, change, obsolescence, failure and rebirth. The industry is slowly morphing from one that owns boxes that contain long-term leases that generate predictable cash flow to something that requires a higher degree of stewardship. Vision and creativity will be rewarded.”

Declining vacancy rates, accelerating rental rate growth, rising property values and increasing capital allocations for real estate have provided impetus for the sustained success of the Canadian commercial real estate market. This should be enough to offset potential hindrances, including rising interest rates and the possible collapse of the North American Free Trade Agreement.

Record-breaking CRE investment

After a record-breaking $43.1 billion in Canadian commercial real estate industry investments in 2017, surpassing 2016’s record of $34.7 billion, Canada was one of only four countries to set back-to-back investment records. CBRE forecasts 2018 could see the market set a third straight record, with investors continuing to flock to the asset class as a stable, high-yielding investment vehicle.

“Investment was broadly based in 2017, with pension funds reflecting the highest level of activity since 2008, with most of these purchases reflecting rarely available marquee assets,” said Morassutti.

“REITs reduced their buying activity for the fifth year in a row as their growth strategies matured beyond acquisitions. REIT returns were a healthy 10 per cent overall, notwithstanding interest rate pressure and continuing negative sentiments surrounding retail and Alberta.

“Foreign capital in Canada was lower than 2016’s record amount, with many buyers having their wings clipped as a result of capital controls in China. Asian buyers may have retreated from mega-deals, but they’re still making their presence known — especially on the land side.”

Office and multi-family residential sectors

The desire to buy core office buildings will likely produce new record prices per square foot, with Toronto and Vancouver (which had the two lowest downtown office vacancy rates of all North American major cities in 2017) leading the way. Strong leasing demand and decreasing vacancy could produce record high rental rates.

“Job growth is at record levels, new supply is in check and technology-based demand is strong,” said Morassutti. “While there’s continued weakness in Alberta, absorption has been positive for the past two quarters.”

Multi-family residential properties had a 10.3-per cent return in 2017 and they’ve benefited from low vacancy rates, increasing immigration, modest new supply and huge investor demand.

Industrial sector

The industrial sector had a 10.2-per cent return rate last year, while the vacancy rate is at a 16-year low and new supply is at a seven-year low, according to Morassutti.

“There’s strong rental growth and scarcity of land. All of those things are leading some to wonder when we might go vertical.”

The next evolution of logistics and distribution activity will involve a push to revitalize old light manufacturing buildings to support same-day delivery. Inner suburbs and fringe core areas of major Canadian markets are expected to see increased leasing demand in 2018.

Online retail sales in Canada have lagged behind the United States but are expected to steadily increase. Morassutti pointed out that for every $1 billion in online sales, approximately 1.3 million square feet of distribution space is needed. This will continue to drive demand, and raise prices, for industrial buildings and land.

Bricks-and-mortar retail isn’t as badly off as many mainstream media reports have portrayed, Morassutti added.

The recent closing of Sears Canada stores across the country has made 15 million square feet of retail space available, while 4.4 million square feet is still vacant from Target’s 2015 closure in Canada.

“Some of the space will re-lease quickly and at higher rents, while some of it will not, adding to the vacancy,” said Morassutti, who noted shopping centres are moving away from the traditional department store anchor model.

Second- and third-tier enclosed malls heavy on mid-market fashion and located in smaller cities are suffering most, according to Morassutti.

“Not all retail is created equally, and the best assets are well-positioned to thrive,” he said. “Retail isn’t dead. Boring retail is.”

Rising land values

As the market gears up for a new construction cycle and investors plan for the future, land sales will likely continue to set pricing records in a variety of markets. This could also be a boon for shopping centre owners.

“The land under many of the malls in this country has tripled in value over the past few years,” said Morassutti, noting many key retail property owners are looking at transforming them.

“This isn’t a silver bullet for every retail property, but it certainly can’t be forgotten and it’s an essential ingredient in the reinvention of many retail assets. Retail development and redevelopment continues, but it’s not the traditional mall being built.”