While office towers in most big cities across Canada are enjoying the lowest vacancies in years due to a number of reasons, that has still not translated into a landlord’s market, according to a panel of industry executives gathered at the Toronto Real Estate Forum last week.
“Unless you have a need for a large block of space in a real hurry, which seldom happens, you always have choices,” said Tom Burns, Executive Vice-President and COO of Allied Properties REIT. “Today, tenants are still getting options to renew, they are still getting first rights of refusal, they are still getting allowances, they are still getting signage, they are still getting favourable lease provisions. So in my mind, if those things are happening, it is not a landlord’s market.”
Sandy McNair, President of research firm Altus InSite, sees two office markets. The immediate, spot market, which today is a seller’s market in high-demand centres like Vancouver or Calgary. In those locations, with “almost no space available those spot prices are hitting all-time highs or certainly approaching them.” The other office market, is a much more tenant friendly one, for those looking for space two or three years out.
Office no longer a dirty word
It is difficult for someone who entered the real estate business 25 years ago, like Michael Kitt, of Oxford Properties Group, to compare today’s office market to what existed when Ronald Reagan was still the U.S. president.
“The office space world was almost a dirty world, Cadillac Fairview had gone broke, O&Y had gone broke, Campeau had gone broke, those were the guys who built the big office towers,” said the Oxford Executive Vice-President, who worked through Cadillac’s restructuring.
“It was hard to ever imagine ever building an office building.”
So what has changed over that span? Demand slowly came back, rents stabilized as institutions invested heavily in the sector and “cap rates came down, interest rates came down, and that made geniuses of us all.”
The big challenge for Oxford today as it tries to allocate capital and generate a decent return for its pension fund owner is to determine whether to buy or build at 70% of what it would cost to buy existing product.
Recent activity illustrates the math. The Scotia Plaza purchase netted out at $700 a square foot versus $500 per sq. ft. to build the Bay Adelaide Centre.
“So there is an opportunity to make money in the office development world,” said Kitt.
“Now that backs up quick if cap rates go up 150 basis points, that margin virtually disappears. The only way that margins are maintained is if rents go up 30%.”
An unlikely scenario given rents have not really grown during his time in the business, he added.
Oxford Properties Group proposed $3-billion office and convention centre development in downtown Toronto
Greece is the word
Far off issues such as the prospects of a Greek bailout and the uncertain economic fate of the European Union (not to mention the U.S. and Chinese economies) also factor into the mix.
“It is one we debated yesterday in real time,” recalled Kitt in response to a question by the panel moderator.
“We are looking at another office building (development) here in Toronto and we had 10 people in the room and part of that room is ‘Are you crazy?’ and part of the room is, ‘Well the market is very good and we have a great pre-let opportunity and there is enough demand that the market will lease up.’”
Oxford execs also know that with its existing $9-billion portfolio in Toronto (about half of it in office), that any new building will cannabalize some tenants from its current roster of office space.
“So it becomes a debate about backfill, and I think you get romanced about building a new building and it being full, but then you have to worry about where those tenants are coming from and what impact it has on the market.”
Rush of capital into Canadian real estate
With real estate becoming a favoured asset class for institutions over the past two decades there has been “a logical rush of capital,” observed Kitt.
That has allowed Oxford to “rotate capital” by selling into the strong market, selling about $1-billion worth of property and putting those funds into developing new office buildings, to the point he described his company as “the most active office developer in the last five years,” with a $1-billion development pipeline in office, industrial and retail developments.
Oxford has also been pulling some money out of Canada and redeploying it into a select group of cities in the U.S. and U.K.
The rush of capital could result in some “trouble” in the form of over-development in certain parts of certain cities, the Oxford executive warned.
That theme was picked up by Peter Cohos, CEO and Managing Director of Calgary’s Triovest Realty Advisors.
“I do think the development cycle that is taking place could turn out to be a game of musical chairs and the person not having a chair might be those holding a 20-year-old building, it may not necessarily be the person who built the last building.”
Executives not so green
Calgary’s Cohos, whose firm specializes in smaller office developments, described the environmental building boom best characterized by the LEED standards as a temporary phenomenon.
“I really think it is overblown, everybody talks about it, the tenants demand it but they are not prepared to pay for it,” he said.
“It works in this low-interest rate environment because we can all in theory make money but we the landlords are paying for it and when interest rates start to rise and they will and all of a sudden the return on real estate has to compete and the tenant isn’t prepared to pay for this I think the rubber is going to hit the road.”
That ambivalence to environment building standards was picked up by fellow panelists, who gave half-hearted support for LEED and its ilk.
“Tenants are really keen to be in a LEED building, but not so keen to build their own building to a LEED standard,” said Allied’s Tom Burns.
“I don’t think it is as big a deal, I think if you are a landlord today you have to go with the flow and build to a LEED standard, but it is not that big a deal to tenants.”
Allied’s stock of downtown brick and beam buildings are not facing any challenges from potential tenants because their charm and relatively low rents outweigh any such considerations. That brick and beam inventory is also the “ultimate in sustainability” considering the former industrial buildings are reused, rather than torn down and replaced.
The LEED theme was also picked up by Oxford’s Kitt. “You would be hard pressed to find a tenant who knew what LEED stood for.
It is a very effective marketing tool and it has become necessary for new buildings, an important benchmark to build to, but I think there is an equal chance that LEED starts to fade if new construction stops.”