The Next Bubble to Burst

The vacancy rate in the Canadian downtown office market is a staggering 18.4%, almost double its pre-Covid rate. In Toronto, it sits at 15.3%, the highest rate since 1995. Vancouver is at 10.4%, a level unseen since 2004.

Many companies are walking away from their leases. According to CBRE, 10 of the last 12 quarters produced negative net absorption, which means more office space came onto the market than was leased. Shopify opted to sublease all seven floors of the space it previously planned to occupy in downtown Toronto. Telus Health did the same. After all, foot traffic is only 40% of its pre-pandemic levels.

If it weren’t for the pandemic, working from home would be considered rare. Now, it is far more embraced. Several individuals within my network have caught me by surprise, saying their virtual workplace is far more productive than a traditional office environment.

For businesses that occupy physical space, other considerations beyond teambuilding and collaboration are now under consideration. Following a decade and a half of ultra low interest rates, the cost of borrowing has made it more expensive to operate a company that carries debt on its balance sheet. As leases come due, who has the upper hand: landlords with too much supply or the tenants paying much higher interest costs than before?

Over the next three years, 50% of America’s $2.9 trillion in commercial mortgages will be renegotiated at interest rates likely 350 to 450 basis points higher than their current borrowing rate, according to Morgan Stanley.

Debt-laden office REITs will be a terrible future investment. Though many investors will remain blinded by the high distribution yield, don’t be fooled by this value trap. In the last several weeks, both Slate Office REIT and True North Commercial REIT slashed their distributions by 70% and 50%, respectively. We expect more to follow and cut their payout to unitholders.

Other investors will cling to the stubborn belief that things will “one day return to normal.” However, there is a new normal. The five-day workweek from a desk in an office will never fully return. Instead, we believe the hybrid work model will continue to gain popularity.

With companies needing less square footage going forward, many office buildings will be repurposed. This isn’t a bad thing because Canada (and many other jurisdictions) suffer from a clear housing shortage. Though it will take years for conversions to complete, it is a welcome solution to a major societal problem.

While office real estate investments have posted declines, we have yet to see the sector truly reflect today’s market rate pricing and higher interest rates. There is an oversupply of office space and rents will decline as leases come due. Meanwhile, landlord debt will be refinanced at significantly higher rates.

These headwinds will all lead to declines in office property investment values in the years to come.