Canadian economy outlook—year of two halves
The Canadian economy is off to a challenging start in 2021 with the surge in COVID-19 infections and the reimposition of lockdowns. After seven consecutive months of gains, current data indicates that the economic recovery has stalled going into 2021 with employment falling by 63,000 in December and the unemployment rate increasing to 8.6%. With these headwinds, the jobless rate is likely to remain elevated throughout the first half of this year. Looking further outward, the vaccine rollout and warmer weather should set the stage for strong economic gains in the second half of 2021.
Optimism for a recovery later in the year mainly comes from the government of Canada securing enough vaccines to immunize the majority of Canadians by the end of September.¹ We can likely expect the majority of services begin to return to normal some time before then, which would drive employment gains and consumer spending higher in the second half of the year. The current business sentiment seems to be in agreement with these expectations—the Bank of Canada’s Q4 Business Outlook Survey predicts a sharp improvement in business confidence, with most firms anticipating their sales will increase over the next 12 months.²
We expect the economic recovery to be K-shaped with a bifurcation in the recovery of different segments. In the services sector, areas such as accommodation and food, that depend on peoples’ mobility and social interaction, will likely continue to lag the rest of the economy. Manufacturing, on the other hand, has already improved back to near pre-COVID-19 levels. The December employment report confirms this trend with job losses entirely in the services sector and manufacturing posting employment gains.
Q4 market review and Q1 2021 outlook
Investment markets continued their recovery in the fourth quarter, enabled by increased clarity surrounding the outlook for the economy and the property market. Preliminary CoStar data shows that total transaction volumes expanded by 31% quarter over quarter, with all property types reporting improved sales activity except office which was flat quarter over quarter.³ Uncertainty over the impact of work from home and the redistribution of demand between city core and suburban office markets are both contributing to the softness in office markets.
We believe investing in Canadian commercial real estate remains an attractive opportunity and we expect to see this sector continue to improve throughout the year. Healthy supply-and-demand fundamentals, stable income, and long-term capital strength are attractive characteristics that can be found in this market. From a relative yield perspective, sustained low interest rates also make Canadian real estate an attractive proposition—the spread between MSCI’s core property fund index cap rate and the Government of Canada 10-year bond yield was close to 430 basis point (bps) as of the end of the fourth quarter.⁴
The office market experienced a historic drop in demand as business closures and pervasive work-from-home arrangements left a considerable amount of office space empty for most of the year. National office net absorption fell to negative 8.3 million square feet—the lowest annual level on record. This weak demand combined with the impact of 4 million square feet of new supply produced a 260 basis points (bps) year over year increase in average national vacancies, from 10.8% to 13.4%.
At the same time, strong fundamentals favor demand for office space. Canada enjoys a competitive advantage with its accommodating immigration and foreign worker policies—especially attractive to technology firms that have become more and more dependent on a global talent pool to fuel growth. Strong tech demand has chiefly benefited Toronto, Vancouver, Montreal, and Ottawa, and although technology firms will not be untouched by the economic slowdown, COVID-19’s physical distancing protocols are already boosting the digital economy, which should provide sustained sector growth over the long term.
Changes in office workspace planning have been a risk factor for office demand, although it’s still not clear how demand for office space will be affected. The widespread work-from-home experiment prompted by COVID-19 may prove that many employees can continue to work from home and still be productive. While we do envision employers will generally be more flexible around the employee workplace arrangement, it’s unlikely that we’ll see the role of the physical office in company operations diminish. Priorities such as maintaining collaborative/creative functions often depend on keeping employees under one roof, while the right office space helps attract talent, establish credibility, and provide prestige. Furthermore, changes in workspace planning, including de-densification of office space and increased provision for larger social and collaborative space, can help offset some of the impact of the ramped-up work-from-home arrangements. We also expect some structural shift in the balance of demand as desire for shorter commutes combined with economic constraints could revive demand within suburban markets.
The industrial real estate market posted strong gains throughout 2020 with national industrial net absorption an impressive positive 18 million square feet. Demand for space also traced an upward trend through the year, with net absorption increasing quarter over quarter in the second half of the year.
The innovative build-out of retail distribution networks and e-commerce fulfillment platforms has helped sustain demand for industrial space—from both existing and new tenants. Large-bay, high clear height warehouse space, as well as smaller, lower clear height facilities near urban areas, serving as last-mile delivery facilities, especially benefit from e-commerce-related demand. With new industrial supply constrained over the past few years, most markets have enjoyed exceptionally low vacancy rates, as well as rapid rent rate growth.
This sector could also experience a surge in demand driven by structural changes in manufacturing and supply chains. With COVID-19 challenging global trade and supply chain networks, businesses are likely to pay more attention to local manufacturing and the buildup of inventories in local markets rather than outsourcing and importing from abroad. These changes could be net positive demand drivers for industrial real estate in the long term.
COVID-19 and social distancing requirements have had an uneven impact on the retail real estate sector. Needs-based retail such as grocery and drug stores have seen sales remain relatively unscathed, while leisure retail came to a near halt early in the economic downturn and is facing a sluggish recovery going forward. Weakness in leisure sales coupled with greater health concerns over visits to malls has begun to register in market fundamentals. The market vacancy rate for shopping malls increased by 110bps year over year, substantially higher than the total retail market average that saw only a 40bps uptick in vacancy rates.
As the pandemic comes under control, overall retail markets are likely poised for a healthy recovery in the second half of the year. Retail sales, especially in discretionary services, are likely to see a significant upswing as “revenge” spending takes hold—where consumers overcompensate for lack of spending during quarantine by splurging even more.
It’s likely that in the long term, e-commerce will continue to put pressure on physical retail, but this transformation will be moderately paced. This is due to bottlenecks in logistics infrastructure, including the lack of available modern warehousing space close to urban centers and significant investment required to modernize inventory management and delivery systems. We might see retailers gravitate toward an omnichannel strategy, with physical retail holding firm as an integral part of the overall sales strategy.
In spite of the economic downturn, multifamily real estate continues to show great resiliency, with stable vacancies and high tenant rent collection rates. The average multifamily vacancy rate in major markets tracked by CoStar⁵ rose by only 20bps year over year, from 1.8% to 2.0%. Market conditions are also tight across the various markets, with the exception of Calgary and Edmonton where vacancies have risen to almost 4.0%.
In addition to solid vacancy, multifamily rental income has felt less of an impact than other property types. REALPAC’s survey of rent collection showed continued improvement last year, with national delinquencies declining from above 8.0% in April to under 4.0% in October.⁶
The 2021 rental market outlook remains balanced, with both demand and supply potentially constrained in the near term. On the demand side, slower household formation, scaled-back immigration, and more gradual wage growth could impede the growth of the renter pool. On the supply side, work stoppages and construction restrictions are delaying completions and slowing the rate at which new residential units are coming to market.
Home ownership affordability remains handicapped by high prices and tightened mortgage regulations. The conditions are especially difficult for first-time home buyers, which may ultimately keep more people in the rental market.
1 “Government secures another 20M COVID-19 vaccine doses from Pfizer,” CBC News, as of January 12, 2021. 2 “Business Outlook Survey—Winter 2020–21,” Bank of Canada, as of January 11, 2021. 3 CoStar, as of Q4 2020. 4 MSCI, Bank of Canada, Manulife Investment Management, as of Q4 2020. 5 CoStar’s market coverage includes Greater Vancouver, Greater Calgary, Greater Edmonton, Greater Ottawa, Greater Toronto, and Outer Greater Toronto. 6 Rental Collection Survey, October 2020, REALPAC.
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