The impacts of commercial industrial leases in Canada
Canada’s real estate lawyers are well aware of the changes in leasing arising from COVID-19. Whereas office and retail portfolios were previously the “jewels” or “trophies” of commercial portfolios, the previously lowly industrial portfolios have now become the darling asset class. Of course, it’s not difficult for even the uninitiated to see why this is so. While the whole world’s office class has been working from home for a year-and-a-half (and, for many parts of the Canadian civil service, still are and likely will still be for some time). Likewise, the iconic large regional shopping centres have laid dormant for almost just as long.
Are these commercial real estate changes permanent?
Of course, speculation whether these are longer-term systemic changes or just pandemic specific anomalies, is anyone’s guess. Economists’ predictions have been vague and thus not of significant value. One economist recently concluded that:
Moving forward, it will be important to monitor trends through the lens of COVID-19-related public policy and broader economic indicators. This will include post-pandemic trends in flexible working arrangements and retail spending patterns.
This statement is broad and unsurprising to most. In the office sector, you have pundits who, at one extreme, argue that the workers per office per day demand will fall by as much as 50 percent post-pandemic for sectors including:
- Non-retail banking
- Law and accounting firms
- Real estate
- Other professional services
Others have argued that suppressed demand will rebound in 2022 once herd immunity has been achieved (whether by vaccination or otherwise. If we look to other major markets outside Canada such as the New York City business milieu, it very much seems as if it will be a universal “all bums in chairs” end to the pandemic.
That said, Canadian government workers are for the most part persistently resisting any rapid return to the office. Most economists seem to predict that demand for office space will indeed fall, with office workers switching to more hotelling and bullpen office arrangements at the office and working instead from home at least two or three days per week.
Offset against this prognosticated reduction in demand is a commonly held suspicion there will be systemic increases in the actual square footage occupied by each office worker (to accommodate physical distancing). Historic space requirements were around 600 square feet per office worker in the 1970s, 300 square feet per office worker in the 1990s, and, in some industries that took to bullpen/hotel arrangements (accountants most notably), down to 150 square feet per office worker immediately before the pandemic.
Against this trend, the need for social distancing could easily see the space per office worker return to 300 square feet, offsetting anticipated demand losses measured just by the number of office workers expected to be physically working from home on any given business day.
Predictions for traditional retail leasing demand are equally uncertain. Traditional retail had been declining, even before COVID-19, and there is not a single economist predicting that the electronic commerce revolution (that everyone agrees matured during Covid) would end with the cessation of the pandemic – but by how much will that also end the demand for traditional “bricks and mortar” retail space?
The direst estimates suggest that traditional mall attendance will immediately plummet by 40% with inside restaurant volumes down by upwards of 60%, even after the unlimited re-opening of the economy. Offset against this retail doom and gloom are economists who predict that, even if sales and fulfillment move entirely online, bricks and mortar locations will regain popularity, but re-purposed to serve as showrooms and demonstration centres, and that entertainment and dining will come roaring back, led by “revenge dining”.
Why is industrial real estate booming in Canada?
While uncertainty swirls around office and retail, the corollary is also true – industrial real estate is now the darling of real estate investors, rising in popularity in inverse correlation to the plight of retail and office space. Just as demand in retail was already significantly falling before COVID-19, so too were industrial properties already gaining in popularity before COVID-19. Unsurprisingly, this surge in the demand for industrial real estate is often exacerbated by the sudden growth of e-commerce entities and third-party logistics suppliers all with their 200,000+ square-foot “big-box” locations. Some estimates suggest that e-commerce and logistics facilities now account for about 50% of the overall Canadian industrial real estate stock.
Industrial properties are in high demand from both tenants and investors, with Canada’s national industrial vacancy rate at 1.7% so far in 2021. National average rents for industrial real estate are up year-over-year by an average of 15% (with Toronto being the mean, Vancouver at about 13% and with Montreal up around 18%). Furthermore, there is no indication that this demand will wane over the coming years (irrespective of any cessation of COVID-19).
There are significant quality differences between the older steel framed industrial properties built in the 1990s and older, and the more modern, 24-feet and taller ceiling industrial properties. However, regardless of the increasing obsolescence of the current Canadian industrial stocks, it remains unlikely that developers will be bringing sufficient new product into Canadian industrial market fast enough to absorb this demand.
What impacts the industrial real estate supply and demand issue?
One reason is because industrial land prices remain at record-highs, with Canada experiencing arguably the lowest industrial cap rates in North America (with some prime sites seeing sub-3% cap rates). Concurrently skyrocketing prices for building materials and shipping costs are also hampering developers’ efforts at bringing more industrial product to the market. As a result, vacancies for Canadian industrial properties will remain depressed, and rents, building prices, and land prices for industrial assets will remain elevated in the near future.
Keep up to date on Canadian commercial real estate legal news
While it may always be “sexier” to negotiate anchor leases in large regional behemoth shopping centres or multiple-floor office leases in the latest downtown glass towers, it seems that the real bread and butter for leasing lawyers in the near future will be the not-so-lowly industrial lease. Whether a familiar practice area or not, lawyers can confidently take on industrial real estate matters with Practical Law Canada.
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