Should Canadian REIT investors be worried about a US-style 'doom loop'?

WeWork collapse highlights challenges in US commercial office space, but Canada is a different animal, says Middlefield CEO

Should Canadian REIT investors be worried about a US-style 'doom loop'?

Last week, WeWork, the office-sharing company once valued at close to US$50 billion, filed for bankruptcy. There are many reasons behind its financial fall from grace, but one of the most mortally wounding has been the Covid disruption leading many companies to end their leases abruptly.

WeWork’s downfall comes amid broader struggles across the commercial real estate space, specifically office properties. As more workers embrace flexible work-from-home setups, office vacancies have increased, and some have warned the cratering demand for office space will worsen the risks of an “urban doom loop” dynamic at some of America’s largest cities.

That begs a question: should REIT investors be worried about the same story unfolding in Canada? Not really, according to Dean Orrico, president and CEO at Middlefield.

“I wouldn’t call it a ‘doom loop’ in Canada, but you are seeing challenges in the office market here,” Orrico told Wealth Professional in a recent interview. “There’s a real bifurcation going on in the market up here.”

A tale of two office rental segments

From his vantage point, Orrico is seeing 95% occupancy at Class A offices, whose natural lighting and generally desirable amenities have made them resilient even as many companies adopt full or partial work-from-home policies. In contrast, Class B and C offices, with older facilities and not as many great amenities surrounding them, are seeing low occupancy levels between 20% and 40%.

“You’ve had some major landlords in the US sitting on older office buildings in more challenging markets, where the value of the building is now less than the value of the mortgage on it,” he says. “You’ve seen that in places like LA and San Francisco, but you haven’t seen that in Canada.”

One thing differentiating the Canadian office property space from the US, Orrico says, is the tendency towards full-recourse lending. When the owner of a building defaults on their debt in Canada, the lender has the option not just to go after the building, but the borrower’s other assets as well. That’s in contrast to the US, where borrowers in default can just transfer ownership of the property to the lender, who might not want to own the building.

“We basically have the Big Six banks in Canada … They’re working more with owners of older buildings who might be having trouble servicing the mortgage on those properties,” he says. “You also generally have borrowers with more equity in the buildings versus their counterparts in the US, so there’s a greater cushion for the lender against any potential decrease in value in the building.”

Office-to-residential makeovers: an investable solution?

With some commercial office properties getting hollowed out, some policymakers are seeing an opportunity to help solve Canada’s housing supply shortage by repurposing increasingly vacant office buildings into multi-residential spaces.

While some jurisdictions already allow developers to construct of multi-family properties on land that was previously used for office space – Calgary is providing subsidies to incentivize that, Orrico says – that’s not the case everywhere. “In Toronto, if you want to take down an office building, the regulations require you to put up another one,” he says.

Because office-to-residential conversions tend to be very expensive – partly because of today’s elevated interest rates – Orrico says governments should work closely with the industry to develop incentives that would drive that activity. Beyond that, he says office buildings need to tick some crucial boxes before they can be a candidate for conversion.

“Any residential unit has to have natural light. If you’re converting a building from office to residential, so it’s easier to convert buildings with smaller footprints,” he says. “You want it to be relatively empty, otherwise you’ll have to negotiate with the existing tenants to vacate or convert it. … Often the most feasible strategy would be to tear down an old office building that’s empty, and replace it with a new condo or apartment building with more density because of the costs and challenges of conversion.”

With housing affordability and supply challenges likely to persist for the foreseeable future, Orrico has a constructive view on apartment REITs whose existing portfolio of conservatively managed buildings and well-covered dividends should support them into the future. On the flip side, given all the obstacles confronting office-to-residential conversions, he doesn’t expect they will become a major opportunity for public REITs.

“I don’t think there’s going to be any real opportunity for individual investors to participate,” he says. “There will be some players or companies that can have this as part of their overall strategy … but I don’t see that as being the primary engine of growth for any business.”