Rising interest rates are putting stress on Canadian real estate — but it’s not just homeowners feeling the pinch.
Experts are warning that Canada’s commercial real estate sector could be a “canary in the coal mine” for a steeper downturn in the economy as an uncertain return to the workplace leaves many office landlords in a precarious position.
Much of the fears for commercial real estate — a sector that includes office towers, retail spaces, warehouses and production plants — stem from the United States and recent instability in the banking industry.
First Republic, a regional bank that catered to a wealthy clientele, was the latest casualty of the instability that has seen shockwaves spread beyond the U.S. to global banking institutions.
It was Charlie Munger, vice-president of Berkshire Hathaway and right-hand man to investment magnate Warren Buffett, who rang alarm bells over the weekend about the state of U.S. banks with exposure to the commercial real estate sector.
Munger told the Financial Times on April 30 that he felt U.S. banks were “full of” what he deemed “bad loans” tied to commercial property prices that are falling in value.
Experts who spoke to Global News this week said the situation for commercial real estate, and offices specifically, could worsen significantly as higher interest rates put pressure on loans and banking fears see landlords unable to access the credit they need to avoid selling off their buildings.
So how could this result in a wider economic collapse? Here’s what they said about the situation, and how Canada might fare.
Hybrid work leaving more offices empty
Craig Alexander, an independent economist who previously was chief at Deloitte Canada, says that while Canadians have seen the impact of rising interest rates on the slowing housing market already, the commercial side is “of equal importance.”
“There’s a lot of reasons to be concerned about the commercial real estate sector,” he says.
For office spaces in particular, demand has been markedly lower for businesses — limiting the rents that landlords can charge to their tenants, Alexander says.
While it was long theorized that the way we work would transition to allow more remote and flexible working, he says the pandemic “dramatically accelerated” the pace at which this happened — a transition that likely caught many building owners off guard.
Today, office buildings are struggling to keep and attract tenants amid uncertainty about the return to work, says Carl Gomez, chief economist and head of market analytics at CoStar, which tracks the global commercial real estate industry.
Gomez says that in Toronto, before the COVID-19 pandemic struck and drove employees en masse to work from home, vacancy rates were extremely tight at around four per cent.
Today, since lockdowns lifted, those Toronto numbers have skyrocketed to the “mid-teens,” he says, noting that a swath of newly completed buildings hitting the market is driving this figure higher.
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Gomez says there’s a fundamental question in the markets today about whether the traditional office market will ever return to pre-pandemic levels.
“Do employees or employers need all that office space again, or are we in some sort of new normal where people are going to work sometimes in the office, sometimes at home? This is the great unknown,” he says.
Recent developments in Canada show workers’ appetites for flexibility aren’t going away.
In the Public Service Alliance of Canada’s negotiations with the federal government, the right to remote work was a sticking point. The negotiated tentative deal included some language to allow these roughly 120,000 public servants to work out hybrid models that suit their individual needs, rather than following department-wide edicts.
Gomez says markets, too, are widely expecting vacancy rates will remain elevated in cities such as Toronto and other major North American markets like Vancouver, New York City and San Francisco.
That means commercial landlords’ cash flows are likely to be affected as they’re unable to rely on the same growth in rent they could in the past, he says.
“It’s very expensive to keep elevators going up and down,” Gomez says. “So that’s impacting their bottom line as well.”
High rates, banking fears put chill into commercial real estate
Commercial landlords are taking a hit just as higher interest rates and banking uncertainty puts pressure on their ability to weather financial challenges.
Both Canada and the U.S. have had relatively low interest rate environments over the past decade or more, and that’s been “unambiguously positive” for commercial real estate, Alexander says.
Not only do low interest rates help businesses finance and build new projects, they also make office properties with their reliable rates of return through rent payments more attractive targets for investors who are turned off from lower rates of return on safe government bonds, he explains.
But the days of rock-bottom rates ended roughly a year ago. Central banks around the world — the U.S. and Canada included — have rapidly increased their benchmark interest rates over the past year to tamp down inflation, with the U.S. Federal Reserve delivering its latest quarter-point hike on Wednesday.
Like residential real estate, the commercial side of the industry is especially sensitive to interest rate hikes, Alexander says.
Recent failures of U.S. banks will tighten credit conditions across the industry, Alexander says, as the remaining lenders get more skeptical about the quality of clients they’re willing to take on.
This is bad news for the commercial real estate sector, he says, because the cycle reverses and buildings become less attractive investments and more difficult to build.
“This is why I think that there’s a lot of speculation that we’re going to hear more about weakness in the commercial real estate sector,” he says.
Commercial real estate is losing its favour in the market just as banks are expected to get more selective about whom they choose to extend credit.
Alexander says that the recent failures of regional banks in the U.S. will tend to make all lenders more “conservative,” and they’ll be especially reticent to extend loans to sectors that are set for hardship in the new higher interest rate environment.
The result? Commercial landlords could find it harder to get credit at a time when the future of their business is uncertain, when they most need a lifeline.
“There’s a general feeling that commercial real estate could be one of the sectors that feels a disproportionate amount of the pain from this tightening in credit conditions and from the rise in interest rates that we’ve had,” Alexander says.
How bad will the fallout be in Canada?
All of the experts who spoke to Global News — plus Berkshire Hathaway’s Munger, in his interview with the Financial Times — said the looming downturn in commercial real estate is not expected to produce a collapse the likes of the 2008-09 financial crisis.
Gomez says concerns are particularly acute on the U.S. side of the border, however, where many large office buildings in metropolitan markets are financed by massive loans and individual owners might not have capital on hand to “fill the holes” of lower rents, higher rates and a reduced access to credit.
In San Francisco, he gives as an example, high vacancy rates are forcing some building owners to sell off their properties at a steep discount, leading to fears other markets could face similar waves of sales.
“There are knock-on effects that happen to the broader economy when something as big as that starts to feel distress,” he says. “As those dominoes connect, that really creates a treacherous sort of economic environment.”
But Gomez points to a different ownership model north of the border — wherein well-capitalized pension funds own a fair chunk of the downtown office buildings in major cities — that could spare the country the worst of a commercial real estate downturn.
Alexander agrees Canada’s risks in commercial real estate are likely reduced compared to the U.S., and gives partial credit to the country’s relatively stable banking system, which has shown comparatively less signs of instability amid turmoil south of the border.
He says Canada’s big banks are more diversified in their holdings and are less likely to — as Munger warned of U.S. bank’s commercial real estate exposure — be invested too heavily in any one particular industry that’s sensitive to higher rates.
That doesn’t mean the country is immune to a steeper downturn tied to its office market, Alexander warns.
High interest rates take a year or more to work their way through the economy, he notes, and different sectors feel the hits of higher borrowing costs before others.
While Canada’s economy has proven “resilient” to date, with a robust labour market and surprisingly strong output in the early months of 2023, Alexander worries those days will not last forever with a slowdown in many economists’ forecasts.
“The fallout will take time to appear,” he says.
The pressure that’s building in the commercial real estate market is a symptom of the economy shifting from a low interest rate environment to a high one, Alexander says, and other sectors will soon start to see that early resilience “diminish” in the months ahead.
“I think the big risk is not that we’re going to have any sort of catastrophe in the banking system. I think the big risk is we’re going to see weaker economic times ahead,” he says.
“And I think that the problems in commercial real estate are a canary in the coal mine.”
— with files from Global News’ Anne Gaviola
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