The Turning Tide in Canada

Welcome back readers to a special Canadian takeover of this newsletter featuring insights from BGO 's Research Team in Canada - Phil Stone and Tom Vo . We've got a comprehensive edition for you this week as we dive into a market where we are observing some important inflection points. Let's dive right in.

The Bank of Canada a (BoC) is now clearly set to continue cutting interest rates through the end of the year and into 2025. Inflation in Canada has now surpassed the BoC’s median target of 2% to the downside. Unemployment is rising, and economic growth has been weak, with per capita GDP falling in seven of the last eight quarters. Growth has been largely bolstered by strong immigration. The Federal Reserve's 50 basis point rate cut in September and a clear message that it will continue to loosen monetary policy, also gives the BoC more room to lower its policy rate at a faster pace. Consensus is that the BoC must continue to shift its policy rate out of restrictive territory to stimulate the economy.

Signs of a capital market recovery

Despite a weaker near-term economic growth forecast, we believe that the BoC can navigate a soft landing. Lower interest rates are a net positive for real estate that should stimulate a CRE capital markets recovery. Lower debt costs are a boost for real estate sentiment and risk appetite. And increased capital availability should help grease the wheels of the transaction market. Bid-ask spreads are expected to narrow further as sellers recognize declines in values, and buyers become more comfortable with underwriting in this higher interest rate environment.

There are a few indicators that suggest we are at an inflection point for commercial real estate. First, we believe that property valuations have bottomed in most sectors, with the exception of the office market, which continues to experience write-downs to varying degrees. Second, while the public REIT market in Canada isn't always the best proxy for the private market, the S&P/TSX Capped REIT Index has turned a corner since the mid-year point – implying a shift in momentum. Finally, cap rate spreads over risk free rates are now within target range of long-term average, suggesting private asset prices are closer to fair value. ?

Lack of multifamily starts sets up tighter conditions

Property fundamentals remain healthy, with vacancy rates at or below long-term averages in most sectors. However, there has been some softening in the multifamily and industrial sectors, where recent quarters have seen supply outpace demand. Multifamily rent growth is slowing to varying degrees across different markets due to the recent influx of new purpose-built and condo rental units. We expect these more balanced conditions to continue until 2026, when the construction pipeline finally peaks. Tighter market conditions are expected to reemerge later in the decade, as limited new project starts over the past 18 months will result in fewer completions in 2028 - 2030.

Industrial demand recovery in 2025

The national industrial availability rate increased to 4.4% in the third quarter, below its long-term average, but significantly higher than the low of 1.5% in Q3/22. This has resulted in a fourth consecutive quarter of falling net asking rents. However, a positive sign was that net absorption was nearly 1.9 msf in the third quarter, compared to nearly 4.9 msf of negative absorption in the first half of the year. As the economy recovers and businesses gain confidence in making expansion decisions, we expect leasing activity to improve further.

Green shoots in office leasing

The national office vacancy rate remains high but stable at 18.6% as of Q3/24. While the market was unable to produce a third consecutive quarter of positive absorption, it also did not return a significant amount of space either, with net absorption being nearly zero. 2024 is shaping up to be an inflection point for office fundamentals, as the leasing environment shows signs of life aided by numerous “return-to-office” mandates. Most importantly, the development cycle of the past six years is coming to an end with only 4.2 msf still under construction, primarily concentrated in downtown Toronto (2.6 msf). This national figure represents less than 1% of existing office inventory.

A strong emphasis on quality continues to characterize office performance. The vacancy rates for “class B/C” buildings (25.1%) and “trophy” buildings (10.1%) continue to diverge. In the war for talent, the office is likely to remain a key differentiator, with modern, well-located, highly amenitized buildings in high demand among occupiers.

New retail supply hasn’t kept pace with population growth

Based on our observations of the investment market, needs-based retail remains the most desirable property type with strong bid depth. Fundamentals were resilient through the pandemic, and supply/demand imbalances continue to support steady rent growth. According to the Altus Investment Trends Survey, the food-anchored retail strip has the highest buyer-to-seller ratio by far, surpassing both industrial and multifamily. The bottom line is that supply has not kept pace with the rapid population growth that we have seen in recent years.

Cautiously optimistic as we navigate downside risks

Canadian commercial real estate appears to have turned a corner with sunnier skies ahead, but we are mindful of the following downside risks:

1) Weaker consumer spending;

2) Slowing population growth due to lower immigration targets; and

3) Heightened geopolitical risk with multiple wars in Europe and the Middle East, and a second Trump administration which could strain trade relations.

Nonetheless, we maintain a cautiously optimistic outlook for real estate. Historically, when the Bank of Canada starts cutting interest rates, valuations and overall investment returns start to improve. And while history doesn’t always repeat, it often rhymes. We expect some moderate cap rate compression due to lower risk-free rates, but the key to outperformance will be active asset management, including a focus on leasing and expense management to drive net operating income growth.

That's it from us for this week and thank you to Phil and Tom for their deep-dive on Canada and the optimism and momentum that is clearly present. Tune in for next week's post-election newsletter and more insights from our research teams across the globe.

Ryan S.

Sources: Macrobond, Statistics Canada, CBRE

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