Rising pandemic cases and heightened geopolitical risk impede Canadian economic recovery
After an initial bounce back, the Canadian economy appears to be facing an impasse with diminishing gains and activity levels stalled at below pre-COVID-19 levels. The initial removal of social distancing requirements in May produced a sizable rebound with GDP gains of 6.5% and employment increasing by 953,000 in June. Growth, however, has since fallen off with a 3.0% GDP decline in July and monthly employment gains averaging just 350,000 from July to September.
While recent economic gains haven’t been disappointing, a number of factors foreshadow an increasingly challenging recovery for the rest of the year and well into the first half of 2021. The pandemic-driven shutdown earlier in the year took a heavy toll on consumer and business viability, and with the recent surge in COVID-19 case counts, any hopes for a speedy return to pre-COVID-19 norms have been dashed. Furthermore, heightened geopolitical risk such as the ongoing U.S.-China dispute, an uncertain Brexit, and discussions between the EU and Russia could very well derail the global economic recovery.
We also expect to see further bifurcation among sectors, with manufacturing, which is far less affected by social distancing, continuing to improve, while the service sector remains under pressure. This widening performance gap between sectors is already reflected in economic indicators. As of September, services employment is down 3.5%, but manufacturing is almost back to pre-COVID-19 levels. In fact, manufacturing sales have been showing healthy gains, with volumes tracking up 5.0% in the first two months of the third quarter.
While our base case scenario paints a picture of gradual expansion, a full economic return to pre-COVID-19 levels is shaping up to be a tall order. The Canadian economy will likely rely on low interest rates—expected to remain persistently low for years to come—along with credit availability and government support to encourage economic growth going forward.
Employment change month over month (%)
GDP growth month over month (%)
Canadian commercial real estate market review and outlook
While third-quarter investment activity has remained far below normal, markets have nonetheless begun to show real signs of life. CoStar’s preliminary estimate shows that Q3 saw a 15% quarter-over-quarter upswing in real estate sales volumes¹. With the exception of office, which experienced a further decline in total volume, all other property types shared improved sales activity. Although improved economic conditions are providing investors with a clearer picture of the property market outlook and pricing, there appears to be less agreement about the outlook for office markets, prompting wider bid/ask spreads and weaker transaction volumes.
Despite weakening occupancy levels and rent growth, most Canadian markets continue to enjoy healthy fundamentals. A sustained low interest-rate environment makes real estate an attractive proposition from a relative yield perspective—the spread between MSCI’s core property fund index cap rate and the Government of Canada’s 10-year bond yield was over 420 basis points (bps) as of the end of the third quarter. Furthermore, the long-term nature of commercial leases may act as a property income shield against short- to medium-term market fluctuations.
Going forward, the market impact will likely continue to vary across real estate sectors with some stabilizing and recovering more quickly than others. Multifamily and industrial, which benefit from exceptionally strong property essentials and solid long-term demand drivers, might remain better protected, while retail, hotel, and some segments of the office market could see a more pronounced impact.
National* commercial real estate sales volume (US$ billions)
* National data comprises aggregate data for markets tracked by CoStar, which include Calgary, Edmonton, Ottawa, Toronto, and Vancouver
Source: CoStar, as of Q3 2020.
The Canadian office market entered the economic downturn on strong footing with high occupancy and robust rental rate growth; however, market fundamentals are now suffering from a historic pullback in demand.
The economic slowdown together with challenges posed by social distancing continued to put pressure on office leasing activity in the third quarter. This saw national office net absorption fall to negative 3.7 million square feet (SF)—the sharpest single-quarter decline on record². This weak demand combined with the impact of 1.6 million SF of new supply produced a 120bps quarter-over-quarter uptick in average national vacancies, from 10.8% to 12.0%.
Looking ahead, however, strong fundamentals should support 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 dependent on our global talent pool to fuel growth. Specifically, Toronto, Vancouver, Montreal, and Ottawa have been the chief office market beneficiaries of strong tech industry demand. Although technology firms won’t be untouched by the economic slowdown, COVID-19’s physical distancing protocols will likely boost the digital economy, providing sustained sector growth in the long term.
Although changes in office workspace planning are a risk factor for office demand, it’s not yet clear what the impact will be. The widespread work-from-home experiment, prompted by COVID-19, could very well prove that many employees can continue to work from home and still be productive. While we do envision employers will generally be more flexible in arranging the employee workplace, we’re unlikely to see the role of physical office space in company operations disappear. Priorities like preserving organizational culture and maintaining collaborative/creative functions are helped by keeping employees under one roof, and the right office space can help attract talent, establish credibility, and provide prestige. Furthermore, changes expected in workspace planning—de-densification of office space and greater provision for social areas and larger collaborative spaces, for example—can help offset some of the impact of expanded work-from-home setups. We also foresee a structural shift in the balance of demand as a desire for shorter commutes combined with economic constraints could potentially spur a revival of suburban market demand.
National office supply, demand, and vacancy rate
Canadian industrial markets seem determined to defy the economic woes that have weakened demand for other property types. Despite the pressures of social distancing on closing leasing deals, national net absorption for industrial space in the third quarter was an impressive 6.6 million SF. Healthy demand has been widespread across Canada, with seven out of ten major markets tracked by CBRE reporting positive net absorption in Q3 2020. Evidence of just how solid the industrial market is can be found in asking rents, which are up by 6.25% on a year-over-year basis.
The innovative buildout of retail distribution networks and e-commerce fulfillment platforms has clearly 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, which can serve as last mile delivery facilities, especially benefit from e-commerce-related demand. And 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.
National industrial supply, demand, and vacancy rate
COVID-19 and social distancing requirements have had the most arresting effect on the retail real estate sector, although with uneven impacts across different retail types. Needs-based retail such as grocery and drug stores saw sales remain relatively stable, while leisure retail came to a near halt early in the economic downturn and will likely experience a sluggish recovery going forward.
Weaker leisure sales coupled with greater health concerns over visits to malls have had the most dramatic impact on occupancy levels. Although availability rates across all retail types have trended up recently, increased availability for malls is substantially higher at 130bps year to date, from 2.3% to 3.6% as of the end of Q3⁴.
Retail sales growth will likely remain under duress for the rest of the year, weighed down by elevated unemployment and wavering consumer confidence. These are obstacles for retail sales across all channels, but brick-and-mortar retail will likely take the greatest hit in the short term with forced closures and curtailed hours of operations. It’s likely that in the long term, e-commerce will continue to put pressure on physical retail, but this will be a moderately paced transformation due to bottlenecks in logistics infrastructure, including the availability of modern warehousing space close to urban centers and the investments required to modernize inventory management and delivery systems. We could see retailers gravitate toward an omnichannel strategy, with physical retail holding firm as an integral part of overall sales strategies.
National* retail availability rate by center type (%)
* National data represents aggregate data for markets tracked by CoStar, which include Calgary, Edmonton, Ottawa, Toronto, and Vancouver
Source: CoStar, as of Q3 2020
Multifamily real estate is still showing impressive resilience despite the economic downturn with stable vacancies and high tenant rent collection rates. A year-to-date net addition of 6,400 units in major markets tracked by CoStar³ hasn’t pushed up vacancy rates, which have remained relatively flat at around 1.6%. Market conditions are also tight across the various markets—except Calgary and Edmonton where vacancies have seen an upturn to almost 4.0%. As well as showing a stable vacancy rate, multifamily tenant rental income is leading other property types with added inducements and a trimmed back rent growth picture generally limited to the high end of the market. RealPAC’s survey of rent collection for July of this year reports an average multifamily rent collection rate of over 95.0%⁵.
The outlook for multifamily rental markets suggests a balanced outcome, with both demand and supply potentially constrained in the near term. On the demand side, slower household formation, scaled back immigration, and more measured wage growth could affect the size 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.
While home ownership is a risk factor for rental demand, it’s not the case in the current environment with tightened mortgage regulations making it more difficult for Canadians to purchase their first home and ultimately keeping more people in the rental market.
National* multifamily supply, demand, and vacancy rate
* National data comprises aggregate data for markets tracked by CoStar, which include Calgary, Edmonton, Ottawa, Toronto, and Vancouver
Source: CoStar, as of Q2 2020.
1 CoStar, as of Q3 2020. 2 CBRE, as of Q3 2020. 3 CoStar’s market coverage includes Greater Calgary, Greater Edmonton, Greater Ottawa, Greater Toronto, Greater Vancouver, and Outer Greater Toronto. 4 CoStar, as of Q3 202. 5. RealPAC Rent Collection Survey, September 2020
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