Real Estate Forum - February/March 2009

International Beat
By Pierre Bergevin
How Canada’s Office Market
Has Eluded the Financial Crisis

AS LANDLORDS AND DEVELOPERS THE WORLD over find themselves at the mercy of a severe global recession, the commercial real estate industry in Canada is proving to be more resilient than most countries, including that of its neighbor to the south. While commercial real estate in Canada is by no means immune to economic crisis, changes made to its industry following the recession in the early ’90s are helping the country withstand the current turmoil.

Canadian office property fundamentals are in relatively good shape in terms of vacancy rates when compared with the US. Canada’s national average at the end of 2008 stood at 6.1%, indicating that most markets in the country are operating near or below equilibrium.

In the fourth quarter, vacancy rates in Canada’s five larg-

Changes made to Canada’s real estate
industry after the recession in the early ’90s
are helping it withstand the current turmoil.

est CBD markets, at an average of 4.5%, were well below those of the five largest US CBD markets, which recorded an average of 9%. Including additional major US office markets in the equation considerably increases the gap between the two countries, thanks to markets such as Dallas, which posted a central-area vacancy rate of 27.6% at year-end. Suburban vacancy rates are consistent with the urban markets, and Canada’s top five suburban areas are also operating with rates well below those of the largest US markets.

Unemployment, considered one of the primary drivers behind office vacancy in any market, is playing a role in the country’s relative strength. Western Canada’s booming natural resources sector—which includes Alberta’s oil sands—coupled with a diversified economy in central Canada, help account for the country’s 6.6% unemployment rate, compared to 7.2% in the US.

A look at previous down cycles in the Canadian office market shows that resilience to high vacancy rates was not always the norm. In the late ’80s and early ’90s, strong demand for office space and limited supply led to a spike in new development. Some 70 million square feet of new supply came on line between 1987 and 1992,

with development peaking at nearly 18 million square feet in 1990 alone. This staggering amount of space hit the market just as the economy went south. Vacancy rates soared from 8.2% in 1987 to a high of 17.3% in 1992. The oversupply was felt well into the late ’90s.

Something had to give. Canada’s approach to investment and development underwent fundamental changes, resulting in a dramatic shift in who invests in office development. In the early ’90s, highly leveraged private entrepreneurs, driven by a high stakes, winner-takes-all mentality, were behind most development in Canada. Today, a much tighter group of institutional developers—primarily pension funds—are the dominant force. These are long-term players with deep pockets, able to take a more patient approach to ROI and less likely to overbuild on spec.

The result is a much more stable market in Canada. This is evident in the self-imposed practice that new space be preleased at 60% or higher before ground is broken. Today, approximately six million square feet of new construction is completed annually, nationwide, in order to meet demand—a stark contrast to 1990’s peak of almost 18 million square feet. The reluctance to overbuild is not only helping landlords maintain healthy rents, it is also protecting the overall value of assets. Therefore, given how tight office markets are throughout Canada, it is unlikely that asset values will plunge as sharply as they have in the US.

What remains to be seen is how Canadian office markets will continue to perform under increasing global economic pressures. Much of the risk this time around relates to US companies closing or downsizing operations north of the border and companies going out of business because of the severity and the length of the recession. Still, the contrast between fundamentals in Canada and the US is quite clear. This begs the question: What measures will US investors take now in order to protect against oversupply and decreasing asset values the next time around? ◆

The views expressed in this column are those of the author and not REAL ESTATE FORUM.

Pierre Bergevin is the president and chief executive officer for Cushman & Wakefield LePage in Toronto. He may be contacted at pierre.bergevin@ca.cushwake.com.