The state of Canada’s residential housing market has dominated headlines as the Bank of Canada sharply raised interest rates this year, raising concerns about home values and housing affordability. Yet what is talked about less often is commercial real estate, which is facing challenges no less significant – and which is evolving rapidly in a changing economic environment. CWB Senior Vice-President Mario Furlan, based in Vancouver, and Victoria Girardo, Vice-President, Real Estate Lending, based in Edmonton, have decades of experience supporting developers and investors in real estate transactions, and in this Q&A they discuss the drivers of change and the realities facing commercial real estate in Canada today.
Q. With interest rates soaring and the threat of an economic slowdown looming, there has been a lot of concern over Canada’s residential housing market. Do the same concerns apply in commercial real estate?
Victoria: To a certain extent, yes. We have seen the economy in general perform well for the last while, and that has created a demand for new commercial space that we haven’t had for a long time. Most of the activity is in industrial real estate, where the economics have been very good, and leasing has been strong across the country. Here in Alberta, the big drivers have been the availability and the affordability of land. It’s a little bit different in markets like British Columbia and Ontario given the price of land in those provinces, but even there we have seen a lot of activity around new projects and even existing industrial assets. Offices, of course, are a different animal, where the pandemic and future of office work still has some uncertainty in Alberta.
Mario: Industrial here in B.C. has been very strong, but there is a fair amount of risk in the market. One factor is the price of land – industrial is now at about $5 million an acre. As well, especially in the Lower Mainland, long approval processes are a headwind for the entire commercial market. It’s not uncommon for development approvals to take two or three years for new projects. What is the market going to be like after all that time? That creates risk. Then add the price of land, the time element, and the fact that construction costs have soared, and you can see that there is a lot of risk to bring projects to fruition despite the strong demand.
Victoria: Another headwind, which is emerging because of rising interest rates, is that commercial lease prices have generally not climbed as quickly as rates have. So as projects come online, the leases don’t necessarily support the mortgage amount the developer might have qualified for when rates were lower. That means some projects require higher equity investments. In the short term, it creates a very challenging environment, and it is pretty common across the board. With residential rental projects, developers have a bit more flexibility to adjust because their buildings don’t start leasing until they’re done or near completion. Leases are generally for a year at a time, giving a chance to renegotiate lease rates sooner than commercial buildings. For commercial construction, we often see projects partially or fully pre-leased and those leases generally run five years or more, which really limits their ability to respond quickly.
All that aside, I recently had a conversation with a developer client who said they don’t worry about interest rates too much – they worry about employment and the general health of the economy. When you look at it that way, people need places to live and work, and while there are headwinds, employment is high and the economy is going pretty well in general, so we have some tailwinds behind us. And with that come good projects and good value for our clients.
Q: In industrial real estate, is the growth because of the pandemic boom in e-commerce?
Victoria: We have seen a lot of growth in logistics warehousing for e-commerce in Alberta, as well as in other markets. But the strong industrial demand is not just because of e-commerce. Brick-and-mortar retailers are moving away from just-in-time inventory because of the supply chain vulnerabilities that were exposed during the pandemic. So even traditional retailers want more warehousing space so that they have an assured supply of products to put on their shelves. I think we will see more of that going forward.
Mario: You can see the impact of that in warehouse design. Ceiling heights have grown over time.
Q: So warehouses can store more stuff?
Victoria: Yeah. I used to work for a retail distributor about 15 years ago, and back then we racked inventory [in our warehouses] up to 24 feet. Warehouses now are 40 feet high, and they rack all the way up. They’re quite impressive operations. Lots of technology goes into inventory management today.
Mario: What’s happening in industrial now is interesting because it was always kind of sleepy, where rates stayed the same year after year. Now, there has been a huge increase in lease rates, and land prices have changed along with that.
One other area I wanted to mention was self-storage facilities. As cities become more and more densely populated, they have continued to do well. They used to be just old warehouses with a few dividers installed, but they are so much better designed today – high ceilings, multiple levels.
For clients, self-storage offers a relatively inexpensive alternative to throwing things away, but it can create significant accretive revenue for clients. We have financed many self-storage facilities in Vancouver, where it’s been a stable and growing market.
Q: Let’s talk a bit about residential. Rents are up while home prices are under pressure. Are developers moving to rental housing and away from other areas?
Victoria: I think this is where you see interesting regional differences. When it comes to purpose-built rental space (developments made with the intention of renting individual apartments, instead of selling them), the economics make sense in some markets and in other markets it’s really tough. In Toronto, for instance, given the timelines and the cost of land, the economics are especially difficult. In Alberta, high-rise rental in Calgary has done well, but in Edmonton the downtown rental market has remained quite challenging. And in other markets, particularly in the Prairies, we’re starting to see purpose-built rental townhomes and even single-family homes, I think because of a cultural element where there is demand for rentals but renters aren’t quite ready for a downtown lifestyle. They want to live in a house or townhouse.
Mario: In Vancouver, it’s very difficult to make the economics work for purpose-built rental developments. The rental that has been built is in market housing, where condominium projects are required to include rental units. But given immigration (pre-COVID, at least) and the length of time it takes to get projects approved and built, demand has always exceeded supply.
That probably won’t change soon. Investors have always been a big component of purchasers, but they basically disappeared during the pandemic, and they have been very slow to come back. And as rates have continued to rise, investors are taking a wait-and-see approach. They have questions about affordability, about rates, about building costs. So a number of projects have been stalled. And there is no big rush to pre-sell condos anymore. Before, you would have wanted to pre-sell your entire building, but that would actually be a negative today because of all the uncertainty. So some projects have been put on hold. They will come back. It’s just a matter of timing.
Q: Are there similar pressures in Toronto?
Victoria: 100%. Supply in housing is still very constrained. Until recently, we had an escalating cost environment but also an escalating price environment, so if you were careful with a project you could rely on a revenue uptick. Now, the market is softening on the price side because of rising rates. It creates uncertainty. So with projects that are just getting started, you see a bit more of a wait-and-see mentality among developers to make sure they know what to expect on the cost side and to better understand the revenue side.
Q: It sounds like this wait-and-see could have a ripple effect over the longer term.
Mario: Absolutely. It accentuates the gap between supply and demand. If you stall projects today, nothing gets built for a while – and it takes a long time to build when you finally start up again. Then, if you have population growth, you end up putting even more pressure on prices. We’ve seen this before when there have been changes in the economy and things slowed down.
Q: With office space, has there been any recovery from the worst days of the pandemic? What’s the outlook now?
Mario: Vancouver has done fine. There has been a surge in demand for office space from the tech industry here.
Victoria: Toronto is similar to Vancouver. With more people returning to work, office space in the last quarter has seen a rebound. And there’s been an uptick in investment in Toronto in the last couple of quarters. That’s a positive, given that Toronto office space has been tough for investors for the past couple years due to uncertainty and opportunities for better returns elsewhere.
In Edmonton, we had seen new office buildings being constructed, and then the pandemic hit. There hasn’t been the same velocity of people returning downtown to the office as in other markets. It will be something to watch over next couple years as we think about people returning to downtown. Meanwhile, the Calgary office market has long been overbuilt, and vacant office towers have been a big challenge for the city. Interestingly, though, the city has provided significant grant funding to convert some office towers into affordable rental units. Office conversions don’t always go smoothly, but if this is successful, it could really help fill the massive vacancy problem within the Calgary office space market. It still has a long way to go to return to being healthy. That being said, it does look like there are lots of people downtown in Calgary these days which has been great to see.
Q: How are you helping your clients during this uncertain period?
Mario: We generally try to deal with developers who know what they are doing in this industry and have the capacity to carry their business forward despite the headwinds. You have to have a good understanding of clients to make sure you’re dealing with people who can bring projects to fruition. And we support those people, both in good times and in bad.
Developing commercial real estate requires a fair amount of equity, and we provide the capital that’s required over and above our clients’ equity to get projects done. But development also requires a lot of staying power – it takes patience. So on our side, we have to be prepared to finance land acquisitions that might not get developed from three or four or five years. And once we are involved, we offer advice and try to play a stable and supportive role in the development team.
Victoria: As part of that team, we look for opportunities to save our clients time and money, and to help them address any challenges with their real estate financing. We can also assist in connecting them with the right partners. We have solid relationships with engineers, appraisers and other players in the industry – and lots of experience with the quality of their reporting. So we can help our clients engage partners who, ultimately, can help financing go much more smoothly.
At the end of the day, this is a people industry, and it’s all about the relationships we have built over the years. Just about every meeting I have these days, a client will ask, ‘Are you guys still lending?’ And the answer is yes. It’s really important to understand and work through all the different market pressures with clients, especially in times like these. That’s a key part of our culture here.
A good project is a good project. There are always going to be headwinds, but knowing the right players and having experience are key pieces that let us get behind projects.
Mario: We take the long view. Most people look at a new building and think the clock starts when machines start digging. But in reality, there are three to five years before that. There are going to be ups and downs, but you’ve got to be dealing with the right people and assessing these pressures properly. So yes, we are always still lending – but lending in the right way.