Sharpest ever economic decline met by extraordinary government stimulus
While it’s still too early to know how long the COVID-19 pandemic will last, early indicators are that the Canadian economy is experiencing a sharp and deep contraction—a flash GDP estimate for the month of March points to a 9% decline, the largest one-month falloff since Statistics Canada began tracking this data in 1961.1 The depth of this crisis largely depends on the success of containment efforts and the point at which authorities will feel comfortable lifting social distancing requirements. Short-term economic effects are already palpable, but the crisis is likely to accelerate ongoing structural shifts in the global economy, including further deglobalization and the emerging dominance of the digital economy.
Labour market and household spending
Segments of the economy have experienced a sharp decline in employment, triggered by social distancing requirements and the forced shutdown of nonessential services. Early estimates for the month of March are that just over one million jobs have been lost. Although this represents the largest one-month decline on record, the final March job loss number could be even greater since the labour force survey was conducted before month end.2 The March unemployment rate estimate is currently 7.8%, with the expectation it will rise to 11.0% this year.3 Consumer confidence is sure to be a casualty of this sharp decline in the health of labour markets. And although low interest rates can help mitigate the burden of servicing debt, the high level of consumer debt remains a risk and could weigh down the recovery of household spending.
Trade and business investment
After a year hindered by heightened trade tensions and sluggish global economic growth, there was hope for Canada’s trade sector to improve in 2020. However, short-term transportation constraints related to the spread of the coronavirus and the ensuing economic downturn have set the stage for yet another difficult year for trade. Business investment was also a notable weak spot last year—2019 investment spending increased by just 0.4% in real terms4—and is set to contract this year. The recent precipitous decline in energy prices is also going to weigh heavily on investments in the energy sector.
Government takes extraordinary steps to cushion economic fall
In an effort to offset the economic consequences of the COVID-19 pandemic and attempt to sustain the health of the financial markets, the government of Canada has issued an unprecedented amount of relief to households and businesses. Measures include a 150 basis point cut in the overnight rate to 0.25%, an increase in wage subsidies for small and medium-sized businesses to 75%, the creation of an Emergency Business Account, providing small businesses with up to $40,000 in loan facilities, and an extensive asset purchasing program targeted at Canadian government, provincial, and corporate bonds.
Canadian commercial real estate market review and outlook, June 2020
Following the COVID-19 outbreak, markets have reacted with a flight to safety and a repricing of a wide range of assets, and commercial real estate won’t be immune. However, with investment markets not functioning as usual and transaction flows essentially cut off, we cannot reliably point to actual evidence of repricing in the private real estate sector.
At this point, it’s still too early to measure and state with certainty the magnitude of the effect that the COVID-19 pandemic will have on commercial real estate investments. It’s possible that historically high occupancy in most Canadian real estate markets is providing a buffer, absorbing some lost demand before severe supply-and-demand imbalances can materialize. The long-term nature of commercial leases can act as a property income shield against short- to medium-term market fluctuations. In terms of property valuations, as previously advised, appraisers are including limiting conditions and assumptions that specifically address the COVID-19 pandemic on their appraisals. This has the potential to create uncertainty in property valuations. Prior to any price adjustment, the cap rate in MSCI’s core property fund index was 3.7% above the Government of Canada 10-year bond yield as of the end of the first quarter of 2020.
We believe that this will affect all sectors of real estate to some degree, with some of these sectors stabilizing and recovering more quickly than others. The multifamily and industrial segments benefit from exceptionally strong property fundamentals and solid long-term demand drivers; therefore, they might remain better protected, while retail, hotel, and some segments of the office market could see a more pronounced impact.
Most Canadian office markets are entering the next phase of the cycle showing remarkably strong occupancy fundamentals. Excluding Alberta, the average national office market vacancy rate has contracted in each of the past seven quarters, reaching a near historic low of 6.9% as of Q1 2020. Strengthening occupancy fundamentals have been driven on the one hand by a growing demand from technology and professional services firms, and on the other by a constrained supply pipeline to meet that burgeoning demand. Toronto and Vancouver are the two largest tech hubs in Canada, and their downtown office markets enjoyed exceptionally low vacancy rates, 2.0% and 2.2%, respectively, as of Q1 2020.5
Alberta office markets are unfortunately uniquely positioned to go from bad to worse. Following the oil price crash in 2015, Calgary and Edmonton office vacancy rates rose sharply and are now at 24.0% and 19.0%, respectively, representing a total of 22 million square feet (SF) of vacant office space across the two markets.5 It was widely expected that these markets would stabilize this year, but in light of plummeting oil prices and a weak global demand outlook for oil, business investment and, by extension, demand for office space in these markets may weaken even more over the next year or two.
Nationally, tightening market conditions have been a boon to construction. Total national office space under construction, excluding Alberta, stands at 17 million SF, which is equivalent to 4.9% of the current office space inventory. Even though overall this represents a sizable supply set to enter the market at a low point in the cycle, construction activity is highly concentrated in the two strongest markets, downtown Toronto and downtown Vancouver, together accounting for 13 million SF of all construction under way.
Of all real estate sectors, industrial is best positioned to weather the downturn, buttressed by solid occupancy fundamentals. Accelerating e-commerce penetration, combined with a relatively slow-arriving supply of industrial space—especially suited to the needs of modern logistics—have translated into low vacancy rates and strong rental rate growth in many markets. The national average industrial availability rate hovered at a near-historic low of 3.1%, while average net rents were up 12.0% year over year as of Q1 2020. And these strong market fundamentals have proven encouraging for new development: Construction activity has been steadily on the rise, cumulatively now at 25 million SF. But only in absolute terms is this activity at historically high levels; space under construction in fact represents only 1.3% of total existing rentable space, not significant relative to the size of the market.5
It’s possible the slowing economy could dampen short-term demand for industrial space, but we believe current events will likely have the opposite effect on the long-term demand drivers in the sector for two reasons. First, the pace of e-commerce penetration will likely accelerate, with current social distancing requirements encouraging more online retail transactions. While this trend may only be temporary, its effects could prove longer term as consumers explore online shopping and become more comfortable making purchases online. Second, companies will likely rely more heavily on local sourcing to build buffers in supply and inventory, as current events reveal vulnerabilities in global supply chains and just-in-time delivery systems. Both these trends will involve additional warehousing and logistics space, which could increase demand for industrial real estate in the long term.
The COVID-19 pandemic and social distancing requirements have had the most significant effect on retail performance, and the adverse consequences will likely last longer for a sector already undergoing longer-term transformation driven by growth in e-commerce.
Household spending is expected to fall this year, weighed down by rising unemployment and faltering consumer confidence. While this decline sets a challenge overall for retail sales across all channels, brick-and-mortar retail will likely take the greatest hit in the short term, with forced closures and curtailed hours of operations. In the long term, the evolution of e-commerce will continue to put pressure on physical retail, but the bottlenecks in the logistics infrastructure—including availability of modern warehousing space near urban areas and investments required to modernize inventory management and delivery systems—will moderate the pace of this transformation. This suggests retailers could generally gravitate toward an omnichannel strategy, with physical retail remaining an integral part of sales channels.
Longer term, physical retail will likely feel the impact unevenly. The grocery segment, for example, has seen e-commerce take hold, but physical stores will no doubt remain an integral part of future sales channels. As a result, grocery and other essential retail should experience the least dramatic drop in sales during the downturn and would likely lead the retail sector more broadly during a recovery. In addition, consumer preference for experience-related services6 should mean a strong comeback for destination retail properties that offer dining and other experiential retail.
Canadian multifamily fundamentals have continued to tighten in recent years and most major markets currently enjoy vacancies in the 1.0% to 2.0% range.7 Conditions in major urban centres are particularly strong, benefitting from disproportionately high immigration flows and outperforming economic growth.
There is currently a supply and demand imbalance affecting multifamily real estate, due in large part to housing supply shortages in recent years. Over the past eight years, Canadian households have increased by about 234,000 per year, outpacing housing starts of 204,000 (on average) per year. There is clearly a chance that the slowdown in the economy and possibly reduced immigration could cause household formation to weaken over the next few years, but the impact to housing market would likely be moderated by the pent-up demand.
Multifamily rental occupancies are also supported by limited supply, with most Canadian markets offering a smaller inventory per capita compared to their global peers.8 Weak rental property supply over the past few years has been partly due to developers’ preferring to build condominiums, which historically have proven more profitable than dedicated rentals.
The outlook for multifamily rental markets is more balanced, with supply holding up at current levels and demand likely moderating. On the supply side, completions of purpose-built rentals and condominium projects currently under way are unlikely to be substantially delayed. Furthermore, with pandemic fears obliterating the demand for short-term rentals, we can expect a share of that market shifting back into long-term rentals. This suggests we can expect supply to remain at or above its current pace over the next one to two years. On the demand side, slower household formation, reduced immigration, and slower wage growth, would likely weigh on the growth of renter pool and rental rates.
1 Statistics Canada, April 15, 2020. 2 The March Labour Force Survey (LFS) results reflect partial monthly job losses, as surveys were taken during the week of March 15, 2020. 3 Based on the median forecast of Canada’s six largest banks, 2020. 4 Conference Board of Canada, Canadian Economic Outlook, Spring 2020. 5 McKinsey & Co., “Cashing in on the Experience Economy,” December 2017. 6 CMHC, October 2019. 7 “Canadian Multifamily Overview—Demand Drivers and Market Fundamentals, Mid-Year 2019,” CBRE, 2019.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
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