Andre Hardy:
Welcome to the Industries in Motion Podcast from RBC Capital Markets, where we'll be exploring what's new and what's next in today's fast-moving markets and industries to help you stay ahead of the curve. Please listen to the end of this podcast for important disclaimers. My name is Andre Hardy, and I am head of Canadian and Asia Pacific Research. Let's get into today's episode.
I'm very pleased to introduce our guests, Pammi Bir and Jimmy Shan, who lead our Canadian Real Estate and REITs Equity Research coverage. Pammi joined RBC in 2019, bringing over 17 years of real estate and Capital Markets experience from similar previous roles.
Jimmy joined RBC's real estate and REIT research team in early 2022. Previously, he was a founding partner of a real estate securities platform as a global asset manager and has 15 years of prior real estate equity research experience.
Today, we'll be discussing the state of the real estate sector in Canada and trends across the office, retail, industrial, and residential subsectors, including perspectives on trends driven by the COVID pandemic, rising interest rates, and recession risk.
First, the pandemic has clearly had a significant impact on how, when, and where we work and live. Let's start by looking at how we work. Pammi, as the return to some form of normalcy continues, what impact do you see on office markets going forward?
Pammi Bir:
Thanks, Andre. Office markets have been under pressure since the onset of COVID. Today, vacancy across Canada has increased to 16.5%, up from 11% at the end of 2019. Downtown markets in particular have seen more significant pressure than the suburbs from a combination of longer commute times, a slow return to office, and a larger impact from new supply. Now, looking ahead, office remains the one property type where visibility from our standpoint is the lowest. We believe we're now in phase two of the experiment, or more specifically, hybrid work arrangements. Now, that compares with phase one, which was work-from-home, or as some refer to it, living at work. The reality is, employers today are still experimenting with what works best for their organizations. Policies are being rewritten as we speak, as the old playbook has seemingly become stale. While most appear to have adopted a hybrid model, a select few have mandated a full return to work, while others have gone fully remote.
From our standpoint, the benefits of being in the office are very difficult to replicate remotely, particularly the building of relationships and organizational culture and really true learning experiences. However, we also recognize the benefits of remote work, particularly flexibility, which is highly valued by many. In the near term, as many employees return to office over the fall, we expect office leasing velocity will modestly improve, particularly as more sublease space is taken off the market. However, the impact of new supply coming online, combined with the slowing economy, will likely dampen these advances. As a result, we believe office vacancy will continue to increase through 2023, limiting the ability to drive rent growth. Now, with that backdrop, we think the operating performance gap between landlords with higher quality versus lower quality office buildings will continue to widen as tenants will increasingly gravitate toward offices that have attractive amenities, are modern, and are well located.
Andre Hardy:
Interesting. Thanks for that perspective. If we shift to the retail market, pandemic lockdowns inflicted pain on many retailers, particularly those with an inability to quickly expand their online capabilities. The full reopening of the economy this year has breathed a new life into retail, but concerns over a slowing economy have raised new questions about the health of those same retailers. How is this shifting landscape impacting your view on retail real estate?
Pammi Bir:
Well, the pandemic was clearly quite painful for retail property owners around the world. The inability for many non-essential tenants to open for business materially impacted their ability to pay rent. This ultimately led to almost $200 million of bad debt charges among the retail rates over a two-year period in 2020 and 2021. Now, we also experienced significant bankruptcies and closures, with over 2,000 stores closing over that two-year period. The impact on apparel and department stores was particularly negative. Collectively, these store closures accounted for about eight million square feet across Canada.
However, there are some silver linings to these challenges. First, the closures comprised less than 1.5% percent of total retail square footage in Canada, so the impact on occupancy rates was not that material. Secondly, the pandemic accelerated the demise of many weaker retailers that would likely have failed anyway in the years ahead. So today, we're left with a retail base that's in much better financial health. As a result, the number of store closures and failures materially decelerated last year. This year, it's been even quieter.
So as economic activity slows, we believe that the retail base in Canada is more resilient and better positioned to work through challenges from a potential slowdown in consumer spending. As well, retail occupancy among the retail rates has recovered lost ground and currently sits at 97%, which is back in line with pre-COVID levels. Rent growth has also started to improve. Bottom line, we believe the majority of retail rates are in good shape to deliver moderate organic growth in the year ahead. We're particularly constructive on defensively positioned, grocery anchored and open-air retail properties. However, we are less constructive on enclosed malls, which we believe will continue to face some structural pressures over the next few years.
Andre Hardy:
So shifting from office and retail, let's move on to the industrial market. Demand for industrial real estate materially accelerated during the pandemic, making it one of the few commercial property types that actually benefited, yet the industrial REITs have lagged in terms of relative performance this year. How do you explain that disconnect?
Pammi Bir:
Yeah, it's a great question, Andre. Industrial fundamentals, they actually remain exceptionally strong in many parts of the world. Demand was already quite strong pre-COVID, and it actually only accelerated with the onset of the pandemic. Here in Canada, national availability sits at a record low of 1.6%, with several major markets operating at around 1%. Now, the robust demand, it's being driven by a number of users and tenant segments, including e-commerce, logistics, the re-shoring of production, and companies building supply chain resiliency amid these significant disruptions to global supply chains. And as a result, industrial rents in Canada are up over 40% since the end of 2019.
As well, the scarcity of available land has materially driven up land prices, pushing the cost to develop new industrial space significantly higher. Supported by this demand-supply imbalance, the investment appetite for industrial materially increased, compressing the unlevered yields or cap rates to record lows for industrial properties. Yet you're correct, that despite all this positive momentum, the industrial REITs have lagged in many developed markets including Canada. From our standpoint, we think the weakness is largely attributable to the substantial increase in bond yields and investor concern over the impact on property values, particularly how much industrial prices have risen through the pandemic. Yet even with the slowing economy, we expect industrial fundamentals will hold up relatively well, particularly given the shortage of space, rising rents, and increasing replacement costs.
Andre Hardy:
Thanks, Pammi. Great insights. Turning to the residential market, Jimmy, how has COVID changed the industry and what are the major trends you're seeing in the for-sale and rental residential markets?
Jimmy Shan:
Yeah. Thanks, Andre. So I'd say there are a couple of major trends we're seeing. The most obvious change that happened due to COVID was the migration trend we saw to smaller, more affordable cities. This happened on both sides of the border, probably more so in the US where we saw the migration of jobs and people from coastal cities like New York, San Francisco, to the cheaper, warmer, so-called Sun Belt states of Arizona, Florida, and Texas. This migration trend was already on the way and really accelerated during COVID.
In Canada, if you look at the highest population growth markets last year, you'll find markets like London, Nanaimo, Waterloo, Oshawa, Halifax, Guelph, Moncton. And this trend, when you think about it, makes a lot of sense. If you're working from home most of the time and commuting only a few days a week, why not move to a bigger and more affordable house outside city centers? Now, today, we're seeing that trend normalize somewhat. We've seen a return to city centers as things have opened up and employers have mandated some form of return to work. So the very reasons why people want to be downtown, entertainment, restaurants, amenities, work, that seemed to be almost alive and well again.
Now, the most significant trend though we've seen in the market affecting the residential market today and is just resulted not just from COVID but events of the last few years is a large housing demand/supply imbalance. Real estate is all about demand/supply. So if you think about the demand side, we've seen significant residential price growth, given high savings and low interest rates of the last few years. On the supply side, construction delays because of labor shortages, delays in getting permits have constrained supply. Now, today, things are a little bit different. With the sharp rise in rates, residential prices have started to move lower, although still up year over year, but supply is being further constrained as developers have become more wary of higher interest rates and higher construction costs.
So as an example, we've heard that about a third of development projects in Toronto have been canceled to-date. We've heard from developers that getting permits can take longer than constructing the building. And when constructions are running away, developers just cannot afford such long permitting time. So although housing demand has slowed, it remains a pretty tight housing market. In the residential rental sector, which we follow more closely with our coverage of the listed apartment REITs, the demand and supply issue is likely going to be even more pronounced. On the demand side, there are about three major groups of tenants who typically reside in apartment buildings: immigrants, students, and seniors. On the immigrant side, the federal government has increased immigration targets to about 450,000 over the next couple of years. And to put that in perspective, we had about 340,000 before COVID. Students, this year, there are about three cohorts of students looking for a place to stay, as many have returned from online studying during COVID. And then seniors, over the next few years, over the next decade, we know that demographic is continuing to accelerate.
And then on the supply side of rental, it's already tough to build purpose for a rental. For decades, the new supply has come in the form of condo development, which we call shadow supply, and these are condos that are owned by individuals who then rent them out. Many of them banking on capital appreciation more so than rental income. So affordable rental development is just not economical, and the ones that we've seen built have tended to target the high end of the market. Today, with higher interest rate, the math is even harder. And then you layer on potential new regulations that the federal government is contemplating and the fact that provinces are getting pressured to make rent control even more stringent. You can imagine that if you're a developer of rental housing today, you're not very incentivized to go ahead with a project in this kind of environment. So bottom line, we think the current tight rental housing market is likely going to remain like that for a while or even accelerating near term.
Andre Hardy:
Thanks. You talk about shadow supply, and I got to ask, there are so many individuals who own condos as an investment rental property. Is that a good idea in your mind?
Jimmy Shan:
Yeah, it's a great question. It's a topical one, Andre. As I mentioned earlier, you're right, a lot of the rental apartment supply has come mostly from individuals buying condos to rent. Many have done very, very well over the last decade, but they've done well because prices have increased quite materially. Today, things are a little bit different. If there's no further capital appreciation, the math does not make too much sense in my view. So to take the average GTA condo price of just under $800,000, we estimate that the total monthly carrying cost, mortgage payments, condo fees, property taxes, to be about $4,400 a month. And that's being generous because we don't include things like repairs and maintenance. This would be for condo that you could probably rent out for less than $3,000 a month. That's called negative cash flow.
So that's where it gets interesting if you compare condo ownership for rental versus ownership of multi-residential REITs in the public markets. If you put aside valuation for a moment, the multi-residential REITs represent, in our view, a less riskier way to play the tight rental fundamentals. Unlike an individually-owned condo, they generate positive cash flow. They pay yield. They're run professionally by established operating teams. They're more diversified, so you're not at the whim of one specific market or a specific location. Plus, each of them tends to have a geographic tilt, which allows you to pick and choose which markets you want to focus on. And then they're more liquid. Think about all the friction costs involved in closing a condo versus buying a REIT on the stock market. And probably most importantly, you don't have to do any work.
Today, the multi-res REITs are cheaper. The public market has discounted a lot of uncertainty facing the sector, and we would argue that the condo prices have yet to do so. Now, the multi-res REITs do come with stock volatility, which I understand can be a bit nerve-wracking for many investors, but higher volatility does not necessarily mean higher risk. I would suggest investors thinking long term, treat an investment in the multi-res REITs in the same way they would treat an investment in a condo rental. And that is, have a long-term horizon and only go look at the property, and in this case, the stock screen, about once a year.
Andre Hardy:
That's a great perspective, and it will be very interesting to see how the real estate market continues to involve or evolve, excuse me, across the various subsectors we discussed. Pammi and Jimmy, thank you very much to both of you for your insights today.
What else lies ahead in today's ever evolving markets and industries? We'll be keeping track right here on Industries in Motion. Thank you for joining us on this episode recorded on September 23rd, 2022. Please make sure you subscribe to Industries in Motion wherever you listen to your podcasts. If you'd like to continue this conversation or you are interested in more information, please contact your RBC representative directly or visit our website at www.rbccm.com/industriesinmotion. Thank you very much.
Speaker 4:
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