While overall transaction activity remains relatively slow, private buyers continued to be more active than institutional investors in the first quarter, according to CBRE’s new Canadian Cap Rates & Investment Insights report.

CBRE chairman of valuation and advisory services Paul Morassutti attributes that to several factors going back to 2022, including rapidly rising interest rates, an uncertain office market, slowing industrial rent increases and rumours of regulatory changes for multifamily properties.

“Institutional owners don't typically buy $5-million or $10-million properties, they buy $100-million dollar properties, and to commit capital in that kind of environment was simply difficult,” Morassutti told RENX.

“The herd mentality is still alive and well in the institutional world and, until one group moves ahead, quite often other groups are reluctant to do so. So they sort of moved to the sidelines because it was too difficult to get visibility on what was going to happen ultimately with interest rates and what that meant for cap rates and for values, and you had all of these other issues. 

“The private guys tend to be more nimble. They're smaller and quite often less dependent on financing. Some of them can pay cash and worry about financing a couple of years down the road when the interest rate environment has settled. And quite often, their tolerance for risk is higher than institutional buyers.”

Credit conditions have tightened over the past year, but 2023 won’t see the same interest rate escalation as 2022 and the general sentiment is rates will likely hold steady.

This stability should bring about more real estate transactions, according to Morassutti.

Small overall increase in cap rates

While capitalization rates continued to trend upwards in the first quarter, the pace of increase slowed considerably. The national average all-properties cap rate rose by a marginal 10 basis points quarter-over-quarter to 6.12 per cent. 

Combined with the softening of bond yields seen at the end of the quarter, real estate spreads widened further to 322 basis points in the quarter, which eased some of the upward pressure on cap rates.

“I think a lot of the movement in cap rates has already been priced-in through 2022,” Morassutti said. “But there's still an awful lot of volatility and uncertainty in the market, and we definitely acknowledge that. 

“That's one of the reasons why I think we continued to see cap rates creep up in Q1, but you won't see them move at the same velocity as last year because the pace of interest rate increases will not be the same.”

Office investment trends

Cap rates for the office sector continued to rise in Q1, with suburban and class-B product seeing the largest increases.

The national average downtown class-AA and -A and class-B cap rates rose by 14 and 19 basis points, respectively, while yields for suburban class-A and class-B product respectively increased by 19 and 22 basis points.

The gap between the different classes of office properties widened. The national average cap rate for downtown class-AA and -A assets was 6.48 per cent, representing a 106-basis-point spread to downtown class-B yields.

The national average class-A yields for suburban assets rose to 7.19 per cent, creating a 94-basis-point spread to class-B offices.

“If there are winners in that (office) space, the winners are the better-quality properties, the more recently built properties and the properties with very strong ESG credentials,” Morassutti said.

“Right now that seems to be where tenants want to be and that's where occupancy levels are the highest. 

“So if you're going to apply cap rates to the office universe these days, the assets that are really most vulnerable to being left behind are mainly in that class-B and -C space right now.”

Office buildings with plenty of lease exposure over the next few years present a significantly higher risk than recently built buildings with long-term tenants in place.

Morassutti said office building owners who are refinancing, or financed a property in the last five years and now have debt rolling over may face some risks because the valuation has probably decreased while loan-to-value ratios have gone down.

“That could result in more distressed deals coming to the market. To date, we've seen almost none of that.

"Clearly there's some of that happening in the U.S., but that’s something that I don't think is going to define the market in Canada. 

“I don't think it's going to be catastrophic. But I absolutely think, as an industry, we need to keep our eye on that.”

Industrial investment trends

The pace of cap rate increases for the industrial sector noticeably slowed in Q1, with the national average class-A and -B yield rising 11 basis points to 5.57 per cent.

Average industrial cap rates have risen 86 basis points year-over-year and are consistent with yields seen just prior to the onset of the pandemic.

“One of the factors that impacts cap rates is the anticipation of rental upside, or the lack thereof,” said Morassutti.

“And when you were buying industrial buildings a couple of years ago, and you were expecting this very, very strong rental growth, you could accept a lower yield on that property or a lower cap rate because you were going to grow very quickly into a higher cap rate. 

“With the expectation of rental growth now being more muted, I think in general you're seeing cap rates for industrial move up a little bit because the growth prospects are less compelling than they might have been over the last few years.”

Retail investment trends

National retail sector cap rates rose modestly across all categories. Yield expansion wasn’t uniform, however.

The non-anchored strip, neighbourhood and power categories recorded cap rate increases of just six basis points or less quarter-over-quarter.

Meanwhile, cap rate increases for the national average strip, regional and urban streetfront categories rose by an average of 14 basis points quarter-over-quarter.

Strip retail assets recorded the largest quarterly cap rate increase, rising 17 basis points to 6.2 per cent. Regional retail followed, with yields increasing 14 basis points to 6.02 per cent.

“For the last year, not just in Canada but globally, there seems to be a resurgence in demand for retail assets,” said Morassutti. “Sentiment around retail, I would argue, is better today than it's been in a long time.”

Morassutti said there’s significant demand for neighbourhood strip malls anchored by a grocery store, pharmacy or another essential retailer, as well as for large shopping centres with redevelopment potential. 

“Whether you're talking about streetfront retail in a major market like Toronto, or a neighbourhood grocery-anchored centre, or a super regional like Yorkdale, most of the news around retail has been fairly positive.”

Multifamily investment trends

Q1 multifamily cap rates were effectively flat as strong demand continued to counteract upward pressure on yields. The national average cap rate for all multifamily categories rose by just one basis point quarter-over-quarter to 4.39 per cent.

The national average class-A yield for high-rise multifamily assets edged up three basis points quarter-over-quarter to 4.04 per cent, while the spread to class-B assets narrowed slightly to 39 basis points. 

National average cap rates for low-rise properties were flat, with class-A and -B yields at 4.35 and 4.74 per cent, respectively. 

Seniors housing investment trends

Investment activity in seniors housing continued to be low, with most larger investors maintaining a short-term wait-and-see strategy.

While interest rate increases have put upward pressure on cap rates for all classes of seniors housing, the sector is now seeing, and expects to continue seeing, rental rate growth in excess of expense inflation in many markets.

This could serve to minimize, or even eliminate, any negative interest rate effects on cap rates for well-positioned assets. 

Continued stabilization and a modest return of institutional investment activity late in 2023 or early 2024 is anticipated. Until then, however, the market will continue to be dominated by private investment groups.

Hotel investment trends

Hotel performance improved significantly in Q1, with increasing average daily rates and revenue per available room.

Investment remained muted, however. Investors remain selective and patient and are only targeting strategic acquisitions while fully pricing in the elevated cost of debt into their underwriting — leading to expansion pressure on cap rates.

Higher borrowing costs resulted in an approximate 50 basis point cap rate increase in the hotel sector. With interest rates stabilizing and hotel operating fundamentals remaining strong, it’s anticipated transaction volumes will accelerate in the second half of 2023.

Morassutti said hotels have been feeling bottom-line pressures due to labour shortages and increases in wages, realty taxes, utility and insurance costs, but the outlook remains positive.

“In terms of sales, we haven't seen a ton of activity, but that activity is building,” Morassutti said.

“Our brokers tell us that the pipeline is building and we expect sales in the hotel sector to be more robust this year. 

“But it's also one of those cases where if you own a hotel and your average daily rate is going up fairly significantly, and you're doing well with the asset, there's always the question of ‘Why should I sell now when performance is good?’ ”