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The hybrid work model can be an appealing option for office workers. It’s also led to a more challenging environment for commercial real estate, especially when it comes to vacancy rates.
Colin Lynch, Head of Global Real Estate Investments at TD Asset Management, discusses the outlook for the sector and explains why some smaller markets may have an advantage over bigger cities like Toronto.
Transcript
Greg Bonnell: While the office vacancy rate in Toronto has pushed higher recently, our feature guest today says that if you look past Canada’s largest city, there are some signs of strength for office properties. Joining us now to discuss, Colin Lynch, managing director and head of global real estate investments at TD Asset Management. Colin, great to have you back on the program.
Colin Lynch: Thanks for having me. It’s great to be here again.
Greg Bonnell: I’m looking forward to this discussion because we are going to move it outside the center of the universe, which, of course, is Toronto. But we do need to start with Toronto. It is the largest market. We are not seeing office properties rebound, perhaps, as people had hoped. What is going on in Toronto?
Colin Lynch: Well, yeah. So we can start in the center of the universe, as described. Toronto is an interesting market because Toronto has many portions to that market. We’ve got the downtown financial core. We’ve got Bloor Street, which is to the north, further to the North.
You’ve got St. Clair, Eglinton, North York Centre, right? Just five or six nodes just along one street, before you go further east or west along King Street East or King West, before you get to places like Scarborough Center, Mississauga Centre, Vaughan – so, lots going on.
But you’re right. The vacancy is up but not uniformly. And different places are experiencing different things. One of the stronger places that we have seen has been around the Yonge and St. Clair node, as an example – traditionally, not the first place you would look at office.
But what you do see is great strength around that node. So you have really affluent communities, a lot of new things moving into that area. Think restaurants and a lot of vitality.
You know, Bloor Street’s being a little bit more challenged – and particularly, the concourse that runs from Bloor and Yonge over to Bay and Yonge. But it really has been a building-by-building story on that street. Come further south, into the financial core…
Greg Bonnell: Where we’re sitting right now.
Colin Lynch: Precisely. And I’d still say – so, there’s two pieces to that story. One piece has to be about quality. And like every period of economic dislocation – and I put what we are living through still into that bucket, even though we had COVID, which, obviously, was a big impact – nevertheless, there is a flight to quality.
So if you are a tenant and you were in a class B space – so, a little bit older, a little bit less shiny and newer, a little bit less well transit-connected, not as great from an environmental, social, governance perspective in terms of – call it energy efficiency – but you’re paying this rent, and now you’ve got an opportunity to move into a brand-new building with great amenities that’s right connected to a subway station, or a Union station here in Toronto, guess what. You’ll do that. And so we are seeing that, which is called the flight to quality.
But that being said, there are still buildings, even in the downtown financial core, that don’t fit that new-generation, shiny, new building that’s really well transit-connected.
And those buildings are struggling. And we are seeing vacancy rise significantly more in those buildings. So there is a flight-to-quality dynamic. And we see that in every economic period.
We are, however, shifting from vacancy to actual physical occupancy, seeing tick-ups in physical occupancy. It’s slow, but we have been seeing this since late 2021.
And it’s a steady and gradual sort of tick-up, not so much on Tuesdays, Wednesdays, Thursdays in the core because there, we are not completely at normal, but we are sort of in the approximate range of normal. It’s more on the Mondays that we’re actually seeing a little bit of tick-up there.
So all to say, we are solidly in the hybrid work environment. I don’t think we’re moving from that. But the nature of that work, in terms of the number of days in the office on average, is still slowly adjusting. And that’s the center of the universe.
Greg Bonnell: By the center of the universe – my field of research, which simply means taking the train in every day – I did notice, on a Monday morning, I’m always like, I’m not worrying about getting a seat. I’m going to get a seat. Today, I was like, there’s a few people on the platform. I’m still going to get a seat, but there’s a few more people here. So that’s Toronto.
You’ve talked about the hybrid-work arrangement sort of taking hold. What about moving out of the big cities? We start going across the country. Is there still that reticence to return to the office? Or are we seeing a bigger pick-up?
Colin Lynch: Yeah, it’s a really interesting question because a lot of times, we tend to focus on Toronto, or on Montreal, or even on Ottawa. And of course, they’re in our national consciousness. We think very heavily on those cities because they’re large and big.
We forget to realize that there are other cities. And cities like Winnipeg, and Saskatoon, and Regina. There are cities like Calgary and Edmonton. There are cities like Halifax and St. John’s. And there, we are actually seeing a lot more pronounced return to the office.
So in places like Regina and Saskatoon, most people are in the office between four and five days a week. In places like Winnipeg, it’s close to four to five days a week. In places like Calgary and Edmonton, it’s somewhere between three to four days a week on average.
And so we measure these things on the basis of hours in the office per week. And the max is about 37.5 because – allowing for half an hour every day for lunch out of the 40-hour work week.
Greg Bonnell: What do we think is going on there? They like the coffee in the office? Why do they want to be in the office?
Colin Lynch: You know, I’m tempted to think about the coffee. And I’m sure the coffee’s amazing.
Greg Bonnell: And the amenities.
Colin Lynch: Yeah, the key thing is, actually, commute times. So the commute, in a place like Saskatoon and Regina, might be a 10-minute drive, whereas in Toronto, a 10-minute commute, for many people, would get you, maybe, 5% of the way there, to your office.
Greg Bonnell: That would be a dream. 10 minutes would be a dream.
Colin Lynch: Yes. So that’s a very big driver. The smaller centers have better commutes in general. And so, therefore, the barriers to getting into the office are much lower in some of those smaller centers.
What does that mean? More people in the office. And what we see, from a vacancy perspective, a leasing perspective, and the general sentiment on the office, is much more optimistic in some of those smaller centers than it is in the big, large centers, like a Toronto, or a Ottawa, or a Montreal.
In Vancouver, we still have a bit of hybrid, for sure. But even there, for a different reason, we have a lot more people living amidst office towers. So a lot more people don’t have materially large commutes in Vancouver. So we actually do see a bit more return to the office in Vancouver there, as well.
Greg Bonnell: Fascinating dynamics. This is also – if this year plays out as the pundits have said, as the markets are betting – will be the year of rate cuts, finally, that – people have been waiting for that from the central banks. When they do – if they do come, what kind of effect could that have on office?
Colin Lynch: Well, that’s another great question. Certainly, we expect that the rate cuts will generally be positive for office valuations. The question is, why are the rate cuts coming, right?
So if the rate cuts are coming because we have severe economic dislocation, that’s generally, historically, not great for the office because, again, office, like the other property types, serves economy. So if there’s less jobs and less people working at different companies, that’s certainly not good.
There is a school of thought that says, however, if there’s severe economic dislocation, folks will be more incentivized to come physically into the office.
Greg Bonnell: Show the face. Show the face.
Colin Lynch: So we’ve never seen that dynamic in the past. So it’s hard to really quantify and measure that. But there is a very large school of thought that believes that that would be the case.
But let’s say hard landing is off the table, and we have rate cuts because we are having, generally, a softer landing, which means – whether it’s tepid job growth or flat job growth.
So if that is the scenario, then from a capital-valuation perspective, certainly, it’s a positive for the office sector, like it is for the other sectors in real estate and largely because, if we step back from that, investors into real estate have many things to choose to invest in, not just real estate.
They can choose public stocks. And they look at things like dividend yields and earning yields, and they look at bonds, and they look at yields off bonds.
So if rates are coming down, that almost makes the bar for competition for real estate lower, which means that, for well-performing offices that are producing income and, therefore, cash flow, that becomes more attractive for investors looking for yield. So certain offices will perform much better.
There will still be challenge to office. Regardless of whether rates come down by 100 basis points or 200 basis points, at the end of the day, if income is really low, then valuations will still be quite low because income is low.
So you still need to look at, what is the fundamentals of that office? And, what is the leasing in that office? What is the rental rates in those offices?
And not to go into too much detail, but there’s – call it gross or top-line rents. And then there’s the actual rent that tenants are paying – because they tend to get incentives.
And when you have economic dislocation, those incentives become larger and larger, which means that even though the top-line rent is constant, the actual rent the landlord’s receiving is going down.
So you have to look at that dynamic as well. And for buildings that are challenged, that dynamic is a lot more present than for buildings that are less challenged.
* So even in a declining-rate environment, it helps the office sector, generally. But you really do have to look at, what is the quality of the offices that you’re investing in? It still matters.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
