Publicly traded office real estate trusts have seen their values drop precipitously in recent months as a combination of high interest rates and rising vacancies in the wake of the pandemic have sent tremors through the sector. Now Carl Gomez is waiting for the other shoe to drop.

The chief economist at commercial real estate analytics company CoStar said valuations for privately held office real estate assets in Canada, mostly held by large institutional investors such as pensions, are “not adjusting to reality” and face a reckoning that could see their values, too, cut by as much as half.

“The total return on (office) REITs has seen almost a 50 per cent correction,” he said, referring to the combination of unit price declines and cuts to distributions.

“I think there’s a disconnect … between what’s happening in the private market and what’s happening in the public market, which is already sensing that these changes (in valuation) need to occur.”

Cash flows at risk

Gomez said public investors seem to be acknowledging that changes to capital market conditions as well as “structural changes related to the nature of how we work — including hybrid and work-from-home” mean that valuations must adjust.

“Cash flows are at risk,” he said.

Among the publicly traded real estate investment trusts operating in the space that have already been punished is Slate Office REIT, which reduced its monthly distribution to one cent from 3.3 cents in April. True North Commercial REIT, which owns properties in British Columbia, Alberta, Ontario and the Atlantic provinces, announced a 50 per cent reduction to its monthly distributions in March to shore up cash to improve the trust’s capital profile. The unit prices of both REITs plummeted and are still off by more than 40 per cent.

The question of whether privately held assets will meet the same fate has been swirling ever since commercial real estate was thrust into the spotlight by market watchers who see it as one of the most vulnerable sectors to current interest rate and inflation trends, as well as credit tightening in the wake of a pair of bank failures in the United States.

“You can’t talk about vulnerable asset classes in Canadian real estate without addressing office first,” said Victoria Girardo, senior vice-president of real estate lending at Canadian Western Bank.

“The sector is facing considerable headwinds including high vacancy rates,” she said, as large numbers of workers continue to work in part from home. At the same time, rising interest rates are putting pressure on landlords, particularly when renewing loans or refinancing properties.

“High debt costs are eating up a much higher portion of rents from a shrinking tenant base,” said Girardo, adding that refinancing and renewal problems are further complicated by declining property values.

High-profile defaults

Toronto-based investment giant Brookfield Asset Management spooked some market watchers by defaulting on US$750 million in loans tied to two Los Angeles office towers in February and, later, a further $161 million on a portfolio of office buildings largely located around Washington, D.C. Girardo also cited PIMCO-owned Columbia Property Trust’s default on US$1.7 billion in notes secured by seven buildings in some of the largest U.S. cities, one of the largest office defaults since the start of the COVID-19 pandemic in 2020.

While Gomez said those defaults may have been affected by additional stresses in the United States, such as tighter borrowing conditions, and can be handled by large players such as Brookfield and PIMCO, the Canadian sector is not immune to the factors driving such decisions.

Equity analysts at CIBC Capital Markets recognized the challenges in a report April 12, in which they broadly reduced price targets across the office REIT segment of the market, citing “erosion in both sentiment … and fundamentals.”

At the time, the four Canadian Office REITs the CIBC analysts covered were trading at an average 41 per cent discount to net asset value, suggesting investors were already somewhat soured on the office sector.

While the analysts, led by Dean Wilkinson, emphasized that their outlook covered only the next 12 months and was “not an overtly negative perspective on the long-term prospects for office properties per se,” others aren’t so sure.

“I think in the short-run, investors are well capitalized. However, we will see impacts in the long run,” said Erkan Yonder, associate professor of real estate at Concordia University’s John Molson School of Business.

“It might not lead to (a) high number of bankruptcies, but I suspect that … the vacancy problem (could) lead to strategic defaults.”

Like Gomez, he sees trends including continuing vacancies alongside an uptick in subleasing as an indication tough times lay ahead, with newer buildings in good locations having the best shot at withstanding them.

But what Gomez sees as an inevitable adjustment or “revaluation” in privately held office real estate — unless trends in interest rates and hybrid work suddenly reverse — could be slowed by a concentration of office real estate ownership in Canada.

“A good chunk of office buildings, particularly in the downtown office buildings, are in the hands of well-capitalized investors like pension funds,” Gomez said. “They’re resisting taking write-downs right away (because) they’re not feeling distressed like some of the REITs, which are a little bit more leveraged and need access to capital to keep them going.”

Another drag on a forced reckoning is that, so far, there has been little actual trading of assets to set new “comparables” on which valuations are based, he said.

Two of Canada’s largest commercial real estate investment and development companies — Cadillac Fairview, with $40-billion in assets largely concentrated in office and retail properties, and Oxford Properties, which has an office portfolio of more than 23-million-square-feet in Canada, the U.S., the United Kingdom and Europe — are owned by the Ontario Teachers Pension Plan and the Ontario Municipal Employees Retirement System (OMERS), respectively.

Jo Taylor, chief executive of the Ontario Teachers Pension Plan, said in an April 5 interview that office occupancy was holding up relatively well in Teachers’ portfolio through Cadillac Fairview, particularly in desirable “class A” buildings in major cities, adding that Cadillac’s investment model is not predicated on external financing.

But even these coveted high-end office complexes in Toronto suffered in the first quarter, as the Canada’s largest city contended with “an influx of availabilities both in direct and sublease space … including space in Class A towers,” according to a report by real estate services firm Jones Lang Lasalle Inc.

In the April interview, Taylor acknowledged that there had been no recent “marquee disposals” in commercial office real estate that would establish “comparables” for future asset sales based on current conditions.

In the meantime, capitalization or cap rates — a key measure of a building’s value based on the income it generates from rent, taking into account the costs associated with the building — are being scrutinized by market watchers as they assess the situation and risks.

Average cap rates rode down from around seven per cent in the early part of the decade to about five per cent as interest rates fell. But they haven’t reversed course despite the rapid rise in interest rates, said Gomez.

“If net operating income goes down, your cap rate should go up, but what we’re seeing is that they haven’t adjusted by as much, if (at all),” he said.

“Those cap rates are, for the most part, staying sticky, mainly because of the appraisal lag.”

‘Significant’ writedowns coming

In late March, Jim Keohane, a director at Alberta Investment Management Corp. (AIMCo) who spent eight years at the helm of the Healthcare of Ontario Pension Plan (HOOPP), predicted “significant” write-downs were coming on office and commercial real estate as owners and lenders digested the effect of rising rates and lingering vacancies and their impact on traditional metrics including cap rates. The higher financing costs combined with lower rents would have a steeper impact on valuations than rising rates alone, he said.

Gomez said the spread between current average cap rates and 10-year government bond yields is another strong indicator that a revaluation is likely coming to the office segment.

The spread is a proxy for the level of risk taken on by investing in real estate instead of bonds, he said, and it would be expected to stay the same or even widen with new perceived risks — such as vacancy rates in some markets rising above 10 per cent, double what they were before the pandemic. Instead, the typical 400-basis-point spread has shrunk to around 200 basis points as interest rates have risen, he said.

Rising subleases

Rising subleases are also among the signs he sees of a reckoning on the horizon. These suggest that while landlords are still getting their full rents, companies are reassessing and reducing their space needs, and aren’t likely to occupy as much on lease renewal. Toronto showed the biggest absolute increase in sublets by square footage in the first quarter of 2023 from the previous year, according to an online presentation Gomez made April 19, while Vancouver’s increase was highest in percentage terms, at 55 per cent.

One of the most prominent examples of this trend was Shopify Inc.’s decision to abandon plans to move into The Well, a new retail, office and residential development on the west side of Toronto’s downtown. This put 350,000 square feet up for sublease, adding to 87,000 square feet of sublease space already available in the new building that was put up by other tenants who pre-leased space prior to the pandemic being declared in March 2020.

Other worrying trends such as shorter leases at renewal are starting to take hold, he said, suggesting these sector pressures show no signs of easing any time soon. And there are some that aren’t even on the radar yet.

“We’re starting to see an increase in the amount of incentives … so there’s a lot of discounts, free months’ rent,” Gomez said. “So the net effective rent that the landlord is getting is much lower than the base (rent) value … and that doesn’t necessarily get captured in the data.”

Some markets have had a head start when it comes to grappling with a glut of office space.

Calgary, hit hard by the last energy downturn, is offering grants to convert vacant office space into housing and has approved at least 10 projects under consideration as part of a downtown incentive program, said Girardo, the Canadian Western Bank executive.

Those projects face challenges including floor sizes and mechanical systems that are not conducive to residential units, and difficulty estimating renovation costs.

“Grants help remove some barriers but not all,” Girardo said.

For Gomez, these attempts to retrofit or overhaul the sector are playing out against the “slow burn” of changing fundamentals, including what he sees as a protracted increase in vacancy over the foreseeable future due to both supply and demand issues.

Unlike the 2008 financial crisis, when the lending taps were turned off and building owners went into immediate distress, he expects this market drama to play out over a longer period of time.

“Office valuations simply haven’t adjusted (this time) … even though market expectations of all the cyclical and secular trends have,” he said.

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