Canadian economic outlook—still waiting for the green light
2021 kicked off in a stall out as global growth threatened to stumble in the first half of the year before picking up the pace in the second half. Even though data shows the economy is now in fact improving—employment increased by 259,000 in February after declining 266,000 the previous two months—fear of a double-dip recession lingers, and uncertainty around inflation clouds our outlook. Still, the solid improvement in the unemployment rate in February, with Canada reaching the lowest level since March 2020 at 8.2%,1 may provide a ray of sunshine.
Even with this economic ambiguity, there are several factors that suggest the second half of 2021 could turn out to be more prosperous than anticipated. The Canadian government has moved from vaccinating just medical workers to including older age brackets while maintaining that all Canadians will have the chance to get the vaccine by September. And, thanks in part to strong demand in the housing market as well as rising commodity prices, real GDP rose 2.3% in the fourth quarter. Then there are the equity markets, which have justifiably received a lot of attention as the disconnect from the overall economy has never seemed more palpable, with the S&P/TSX Composite Index wrapping up Q1 2021 at a new all-time high.
After extensive early discussion about the letter shape that the recovery would resemble, our expectation—and the general consensus—has landed on the letter K, prefiguring a divided recovery with global trade and manufacturing edging toward prepandemic levels and the services sector lagging until the second half of the year. The Bank of Canada (BoC) has shown some muscularity in enacting accommodative monetary policy to buffer the economy from the global downturn, and this seems to have softened the blow. Key policy rates will likely be maintained at current levels until excess capacity is fully absorbed, something the BoC last projected won’t happen until 2023.
Q1 market review and Q2 outlook
Investment markets have been tenacious in their climb back to prosperity, as the initial shock and uncertainty from the pandemic seem to be waning in tandem with increased vaccine availability. Investment volumes in Canada’s five biggest markets, excluding Montreal, bounced back in Q4, recording $5.5 billion in transactions—a 39.5% improvement over Q3. But while fourth-quarter results indicate that investor sentiment is on the rise, and momentum has certainly picked up, overall volumes closed 2020 down 34.5% year over year, totaling $17.7 billion annually.2 There’s no ignoring the ambivalence around the future of COVID-19, but a bastion of hope in the current economic downturn, which differentiates it from the Great Financial Crisis (GFC), is that the availability of capital isn’t an issue with record low interest rates priming the pump to unleash investors once their confidence stabilizes.
As with the last three quarters of the year, the MSCI REALPAC Property Index saw continued deterioration of net operating income, with annual property return declining 4.1% over 2020—the first annual decline since the fallout from the GFC. Investment in Canadian commercial real estate nonetheless remains an attractive opportunity, and in the current low-for-long interest-rate environment, we expect to see investor sentiment continue to improve as the economy gets back on its feet. Healthy supply/demand fundamentals, a positive spread between cap rates and long-term bond rates, steady income, and long-term capital stability are among the benefits investors can potentially anticipate from allocation to Canadian commercial real estate.
Canadian commercial real estate transactions ($)
Demand for office space continues its downward spiral, as business closures and widespread work-from-home measures implemented at the onset of the pandemic have led occupiers to defer leasing decisions. National office net absorption perpetuates the negative trend at –4.0 million per square foot (SF) for the first quarter, an improvement, however, over the previous quarter when net absorption fell to a record low of –5.8 million SF. The pandemic has effectively erased two years of cumulative absorption illustrated by the steep decline in national absorption from 16.4 million SF between Q1 2018 and Q1 2020 to –15.5 million SF between Q2 2020 and Q1 2021. Suburban office markets fared slightly better over the year with absorption at –1.2% of inventory, whereas downtown markets saw a 2.2% inventory decrease.3
One divergence the pandemic has made apparent is that not all industries are experiencing the same business disruptions. Professional, scientific, and technical services employment grew 5.6% year over year in February from prepandemic highs, with the majority of gains concentrated in Ontario and British Columbia focused on the computer and information systems segment.
Looking ahead, strong fundamentals should support demand for office space, as we’ve seen before in response to previous downturns. As the global war for talent wages on despite the pandemic, Canada’s progressive stance on immigration is a competitive advantage for many businesses looking to recruit scarce, highly skilled workers from abroad.
As the weather warms up and vaccines become available to most Canadians, it’s the hope that employees will return to the office soon; however, timing is the issue, since most employers have vowed to give substantial notice before recalling staff. The idea of more flexible working arrangements has also gained widespread popularity, but as work-from-home fatigue grows, companies may find employees eager to get back to a prepandemic “normal” workday in a physical office space. While the pandemic has certainly disrupted traditional office use in the short term, priorities such as instilling company culture and attracting the highest-quality talent are no doubt best achieved in a collaborative environment in which knowledge transfer can flourish. Even with the virtual tools at our disposal, this experience can’t be replicated while sitting in your basement or at your kitchen table. The prevailing sentiment may be that the future of the office is flexible, but employees are expected to want more elbow room, leading to higher square footage per employee—an about-face from the decades-long trend toward a denser, more open-concept office design.
Industrial real estate markets continue to surpass expectations, showing impressive resilience in the face of an ongoing global crisis. Demand for industrial space has withstood the uncertainty and flourished across Canada, as Q1 industrial space registered the third-highest quarterly national net absorption on record, only behind Q3 2018 and Q4 2005. The pace of demand isn’t expected to decelerate any time soon, and even some of Canada’s more challenged markets have caught the upswing, with Calgary leading the charge, accounting for nearly 20% of quarterly national absorption.
Going into the pandemic, industrial real estate was already red hot, as logistics and warehousing tenant demand couldn’t be met in an already historically tight market. From big box to last-mile fulfillment, tenants of all shapes and sizes scoured their local markets for locations close to their employees and customer bases. But as availability dwindled and search areas expanded, most were left in the lurch. The pandemic has only exacerbated this impasse, as vacancy continues toward record lows, while rent growth jumped ahead 8.6% nationally in 2020.
As demand has ramped up, the response in supply, a lagging fundamental, hasn’t been able to keep pace: Construction activity across Canada remains depressed in major markets, at 1.4% of existing inventory relative to the U.S. average of 2.2%.4 This subdued supply response will likely intensify fundamentals going forward as the forecasted uptick in space—that rapidly expanding e-commerce occupiers will be looking for—is expected to accelerate as shopping continues to shift online. This disconnect in supply and demand combined with a fundamental shift to a digital economy is expected to be the underlying driver of industrial real estate markets nationwide.
Social distancing and stringent lockdown restrictions have heavily buffeted the retail real estate sector, although not all retail has suffered the same impact. Grocery stores and pharmacies have withstood the barrage as their status as essential has kept the doors open. Demand for building materials and gardening-related retail is expected to stay strong into the summer as homeowners continue to concentrate on their homes and backyards. Enclosed shopping malls, traditionally among the most desirable retail, remain in limbo as shoppers try to avoid crowds; however, one positive indicator of the sector’s health is that overall rent collection numbers have been improving since the initial shock in spring 2020. Market vacancy for shopping malls may have stabilized, as the average across Canadian markets is unchanged from Q1 2020, after being pummeled by volatility over the final three quarters of 2020.
Retail markets faltered nationwide throughout 2020 as the pandemic placed a stranglehold on foot traffic, with restrictions aimed at curtailing the spread of the virus. As the pandemic comes under control, retail sales, specifically in discretionary services, are set to see a significant upswing as consumers and businesses look to deploy the record excess cash amounts sitting in bank accounts, effectively priming the pump to stimulate retail sales across Canada.
It’s likely that, in the long term, e-commerce will continue to apply pressure to physical retail, although it will be a moderately paced transformation due to bottlenecks in logistics infrastructure—notably, available modern warehousing space close to urban centres and the investments required to modernize inventory management and delivery systems. The pandemic has accelerated a structural shift in consumer shopping as government restrictions have forced retailers to curtail or halt in-person shopping, pushing consumers online. As shoppers increasingly searched for products online, so too did businesses ramp up their online advertising, which has had the knock-on effect of crowding the marketplace, making consumers ever more difficult to reach and increasing the cost of acquiring online customers. As of January 2021, online sales still only accounted for 7.8% of retail trade, suggesting that the future of retail is still physical, but retailers prioritizing store design paired with developing digital channels stand to lead the recovery.
Retail national vacancy rates by segment, Q1 2021
Multifamily has been a bright spot over the course of the pandemic, showing stability and resiliency in the face of massive employment losses that could have sent the sector into a tailspin. Government programs aimed at helping those most affected by the pandemic encouraged recipients to use the benefits to pay rent, another positive sign for the prosperity of this asset class. Downtown core rentals, especially in Toronto and Vancouver, saw rents come down as the restriction on short-term rentals triggered a flood of new units on the market. These smaller-format units, however, have proven less desirable in the current work-from-home environment, with many tenants looking for more space. This has led them to swap their central downtown locations for larger-format rentals farther from the core and into areas with better access to outdoor space.
Government programs such as the Canada Emergency Response Benefit (CERB) helped keep rent collections stable in 2020. This trend will likely persist as the Canadian government essentially carbon copied CERB with the rollout of the Canada Recovery Benefit, which runs until the end of Q3 2021.
We’re facing a more balanced outlook for multifamily rental markets in 2021, as the initial shock triggered by the pandemic waned through last year and government programs helped renters stay afloat. From the outset, lighter immigration brought on by border restrictions hindered rentals. This situation looks to be short-lived, however, given the recent renewal of the government’s commitment to recoup the 2020 shortfall by targeting an additional 1.2 million new permanent residents by the end of 2023. In 2020, rent demand also took a hit as post-secondary education shifted online; however, this trend is expected to reverse as vaccine availability for younger demographics is within sight and schools are aiming to bring students back in person in the fall of 2021.
There’s no doubt that the Canadian housing market came under attack in 2020, as the general consensus predicted the collapse of residential real estate prices, but, remarkably, the average home price continues to rise across Canada, with a 25% year-over-year increase in February of this year. This trend will likely track upward through the year as we enter the traditionally hot spring market, with the BoC signaling that interest rates should stay low for the foreseeable future. Conditions remain particularly difficult for first-time home buyers, which will ultimately keep more people in the rental market.
1 “Labour Force Survey,” Statistics Canada, February 2021. 2 CoStar, as of April 5, 2021. 3 CBRE Research, as of Q1 2021. 4 CBRE Canada Market Outlook Report 2021, CBRE Research, as of Q1 2021.
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