Canada's inflation has reached the highest level in decades. To manage inflationary pressures, the Bank of Canada has begun raising its policy interest rates in early 2022. And the rise in interest rates and inflation is pushing Commercial Real Estate (CRE) investors to reassess how to maximize their returns.
Do they need to continue favoring industrial and multifamily assets that performed well throughout the pandemic? Or would a higher risk, higher yield investment be a better option?
Well, in our experience and according to many industry professionals, combining the two strategies seems to be the best approach.
Overview of the post-pandemic Commercial Real Estate industry
Like many other industries, commercial real estate (CRE) in Canada has also been impacted by the COVID-19 pandemic. Property managers, landlords, and developers have had to adapt as uncertainty and changing rules and policies have impacted their businesses. However, despite this, Canada's commercial real estate sector has thrived throughout the pandemic and has generated record investments since the economy recovered. The effects of this revival can be seen not just in the increase in real estate transactions and property development projects but also in how transactions are handled throughout the process.
According to a 2022 market outlook report, many of the challenges posed to Canadian CRE have eased in 2022 and an increase in the Bank of Canada policy interest rate is not expected to affect investment volumes or cap rates adversely. The outlook for real estate in 2022 is positive and expectations remain high for a year of healthy returns.
Deal volume increased in the retail, apartment, and hotel sectors. Multifamily investment activity in Canada set its fifth consecutive record in 2021 and in 2022 volumes are predicted to grow an additional 3.5% to $14.5 billion.
Interest rates are certainly impacting the post-pandemic CRE market in general. However, CRE investment activity in Canada is expected to reach record levels in 2022 as well. Retail and office sectors will continue to recover and with large trophy asset sales and M&A activity returning, the CRE investment market will close 2022 strong. The elevated activity levels will also lead to continued cap rate compression, an ideal scenario for Canadian investors.
Asset Classes With High Demand During the Pandemic
Even with the market shifts, multifamily and industrial assets have not experienced a massive transformation. There was a high demand for these asset classes during the pandemic and they continue to be sought after additions to portfolios. In multifamily, rent growth has been strong and occupancy is high.
By promoting lease terms for 12 months or less, landlords can combat inflation by pushing rates. In the industrial sector, rent growth has been phenomenal in recent years. Hence, properties with near-term rent rolls have an opportunity to capture substantial mark-to-market rents, which will help counter some of the recent inflationary pressure.
Given the low vacancy rates and high demand for industrial space, a property on the market with a very short-term lease will be a highly contested asset, as new owners are confident they can backfill the property. In other words, that asset will immediately see a dramatic increase in net operating income due to capturing the last several years' rent growth.
According to global economist Richard Barkham, despite the market being "slower and less active," trades are still taking place, especially in industrial real estate. There is a wait-and-see attitude among investors in regards to how the government will use fiscal tightening to address inflationary pressures and whether there will be a recession in Canada which is looking increasingly likely. However, investors with a diversified portfolio and strong property fundamentals will likely do the best as the economy downturns.
Due to strong demand and the ability to increase rents to keep up with inflation, rising interest rates will drive greater interest in apartments. Because housing affordability has plummeted and more people are being forced to rent and live in apartments for longer, multifamily investments continue upwards. Even in this scenario however, investors need to be well-informed around regional nuances. The regulatory environment of some areas of the country can make multifamily assets untenable. In addition, the area's population and job growth trends have a major impact.
Diversified High Demand Asset Classes
While multifamily and industrial continue to be the shining stars of the market right now, there are plenty of other, more niche opportunities for CRE investors to consider as well. These include:
Medical Office sector
Hotels and Warehousing
Life sciences properties
We’ll take a quick look into these alternative asset classes offering opportunities for diversification…
Throughout the pandemic, this asset class performed well and continues to attract investors.
According to MSCI data, student housing sales reached $2.4 billion in the first quarter of 2022, up 121 percent from a year earlier. Historically, when times are uncertain economically, people stay in school or go back to school to stay current or retrain. Investors looking for a reliable and predictable return will be considering student housing in the current climate.
Medical Office Sector
A property that requires a greater amount of infrastructure and has a higher replacement cost is also a more attractive investment in today's market. A prime example is the medical office sector, where constructing necessary infrastructure like HVAC, X-ray-proof walls, and MRI machines can be extremely costly.
Having such features in a building means it is more stable, predictable and stickier as tenants opt for buildings already equipped with the features to meet their needs; this makes it one of the most attractive alternative asset classes.
Hotels and Self-Storage
An inflationary environment may favor investments such as hotels and self-storage facilities since they can change their rental rates more frequently. Hotels, for instance, have returned to their pre-pandemic occupancy levels and their average daily rate has increased. Investments in the hotel industry are picking up because it moves with inflation more quickly.
It is also possible to hedge inflation through storage properties which saw record low vacancies during the pandemic. It is possible for the rent at such facilities to change from month to month so rising costs may be easily passed on. The warehousing industry is seeing capital from other property types flow into it, especially from growth markets.
Life Sciences Properties
Life sciences has come into focus for the Canadian government as it has for many countries post-pandemic. The sector is growing exponentially and represents a very lucrative opportunity for investors as Canada seeks to lead the way in this industry and suitable properties remain in severe short supply. Public sector Investment from the government is gathering steam to support the expansion of biomedical businesses with $2.2B being directed into biomanufacturing initiatives over the next 7 years according to Torys and tenants in this space are known to be stable and profitable.
Although some investors think of these projects as highly capital-intensive, there are a broad range of businesses operating in this area, some of which will have highly specialized, complex requirements and others will just need an office or clean assembly space so there is certainly opportunity to incorporate life science into a portfolio in one way or another.
All CRE Investment Sectors Impacted
As interest rates rise, all CRE property sectors may be affected. When compared to other investment alternatives however, namely stocks, bonds, cryptocurrency, or something else, commercial real estate has the advantage of stability and inflation resistance. Commercial real estate investment is becoming a little bit more of a ‘pick-and-mix’ in the current economic environment. Still, compared to other investment options, real estate has fared well in the recent stock market correction and proves time after time to be a more resilient, predictable investment option that provides a better hedge against rising inflation.
For more information on your CRE investment options in the GTA, reach out to our experienced team.