What’s been happening in the commercial real estate space?

Commercial real estate expert breaks down how the Covid reopening, inflation, and rising interest rates are shaping the space

What’s been happening in the commercial real estate space?

For investors looking to broaden their portfolios outside the public markets, real assets, including commercial real estate, have been an area of interest. But beyond the ongoing COVID recovery and the secular trend of e-commerce, they’ll have to consider other forces that are exerting an influence on different corners of the space.

“The reopening of society that began in earnest around late February, as we got through the initial Omicron wave, has been constructive to certain elements of the real estate world,” said Colin Lynch, Managing Director and Head of Global Real Estate Investments at TD Asset Management.

While not as stiff as previous public health measures, Lynch said restrictions that were in place on retail prior to February had forced certain tenants to close down or reduce their operations. Things have turned around over the past months; according to TDAM’s data to date, traffic has been recovering well since the most recent wave, with spend patterns approaching levels last seen in 2019.

The reopening has also been beneficial for the office sector, he said, though the rebound hasn’t been even. Generally, the rebound has been faster in the west than in the east, with some exceptions: workers in Newfoundland and Halifax appear to have returned more quickly to the office than Montreal, Ottawa, or Toronto. The back-to-office trend, he added, has also been fairly pronounced in Calgary, Edmonton, and Vancouver.

“Certainly in the last three months, there has been continued dialogue and discussion around what does the post-COVID or endemic COVID office environment look like,” he says. “I think it is fair to say that the consensus is a hybrid world where folks mix a certain number of days in office and certain number of days at home.”

Turning to the residential space, one crucial theme has been movement back into the city. After seeing that trend break out in the U.S., Lynch says a broad Canadian comeback into downtown cores has come as people prepared to reenter offices.

Another brewing story that’s having more of a mixed impact on the residential space is the ratcheting tension between inflationary forces and rising interest rates. As costs of factors such as labour, materials, and development go up, so do property values. But as central banks raise interest rates to combat inflation, that also ramps up borrowing costs for certain owners of residential properties that are more highly levered.

“On the one hand, you’ve got very strong demand for residential, plus the movement back into urban centres, plus increases in building values alongside inflation,” Lynch says. “But on the other hand, you've got interest rates beginning to rise. And that certainly is likely to have an effect.”

While industrial real estate continues to show extreme strength around the world, rents in Canada are increasing significantly, as are land values associated with the conversion of farmland into industrial properties. With vacancies being as low as they are and the gap between demand and supply for storage space driven by e-commerce, industrial continues to be a very strong space.

“That being said, as interest rates rise and cap rates decline, you’ll also see certain participants who may be more highly leveraged come under pressure,” Lynch says. “At some point, some of those participants have to revisit the math that’s underpinned their business models.”

Faced with tightening monetary policy and supersized interest rate hikes, some entities that bet on levering up assets have had to pull out of processes to acquire new buildings, or otherwise scale back on their original ambitions. It typically takes time for policy rate effects to filter through down to the real estate company level, but Lynch says hints of challenges are now emerging on the margins in Canada, the U.S., and Europe, particularly the U.K.

Still, many other entities in the commercial real estate business are more conservatively positioned; with loan-to-value ratios of just under 30%, Lynch says TDAM falls squarely within that bucket. As highly leveraged entities find themselves less able to participate and follow through on their investments, it could present buying opportunities for those who are in a stronger position and are willing to take calculated risks.

“For the industry as a whole, we see that the spread between cap rates and 10-year bond yields are in the 248-basis point range, which is still pretty healthy relative to what’s been the average over the past 20 years. But it is compressing,” Lynch says. “We generally continue to see real estate as accretive. But whether you’re in it for the long-term hold, whether your performance makes sense on a reasonable leverage basis, or whether it makes sense on a no-leverage basis, I think these questions are more important today than they were two years ago, when rates were close to zero.”