Costs, Deals, and Capital Markets
Emerging growth opportunities versus “the years of the great staring contest”
“Money is available, but to few people on fewer things.”
One issue raised with interviewees this year was whether the environment of price discovery that emerged in 2023 would continue in 2024. This was a very notable trend in last year’s report that reflected a wide gap in valuation expectations between buyers and sellers of real estate assets as rising interest rates began to increase financing costs and put a damper on deal activity.
Most interviewees believed overall uncertainty about asset prices would remain a key factor in holding back transactions for the time being, while those deals that do proceed will likely be smaller as large investors pull back from the market and the amount of capital available for real estate declines. Interviewees also spoke of added barriers to closing deals as market challenges lead some buyers to renegotiate prices they had previously agreed to pay. One interviewee summed up much of the industry sentiment in their description of the business environment now and in the year ahead: “2023, 2024—the years of the great staring contest.”
Those hoping for bargains to emerge in this environment may be disappointed. Interviewees tended to believe that opportunistic or distressed deals would remain hard to find given that many sellers do not have to transact if bids are not meeting their expectations. Even so, some interviewees pointed to examples of the types of sellers who will likely need to transact, such as owners of poorly performing office properties and investment funds that are winding down and must liquidate their assets.
A Multitude of Challenges for Canadian Real Estate
Evidence of the challenging environment for deals can also be found in PwC’s 2023 Global CEO Survey. According to the survey, 56 percent of real estate CEOs said they had either already delayed deals or were considering doing so in response to economic challenges and volatility. This was significantly higher than the findings for all CEOs, 37 percent of whom had either delayed deals or were considering doing so.
The issues facing real estate companies have only continued to grow since then, with industry players expecting little relief on interest rates as they look ahead to 2024. For some companies, the result has been negative leverage as borrowing rates exceed yields on their investments. This challenge is compounded by uncertainty about whether investors can count on asset values going up. In struggling asset classes such as offices, interviewees note difficulties securing refinancing because banks are unwilling to renew mortgages without additional equity infusions for some of these properties. “We’re starting to see cracks that we didn’t see before,” said one interviewee, citing the challenges faced by those feeling the biggest impacts of current market trends. “Everyone is keeping a brave face on.”
The Bank of Canada’s monetary policies are not the only factor putting a damper on Canadian real estate activity. In the wake of worries about the impacts of bank failures in the United States earlier in 2023, Canadian banks have faced tighter regulatory requirements on their capital reserves. This has led to more restrictive lending conditions, reduced availability of debt financing, and even higher borrowing costs for Canadian real estate companies. At a time when investors can get relatively good risk-adjusted returns elsewhere—by, for example, putting their money into guaranteed investment certificates—the attraction of real estate as an asset class has declined, which further reduces the amount of capital available.
Productivity Challenges Adding to Cost and Labor Pressures Facing the Industry
Interest rates and capital availability are not the only things creating challenges for Canadian real estate players. Amid high inflation and supply chains that, in some cases, continue to falter, costs for some key materials have continued to rise.
While some interviewees said cost increases for certain construction materials had softened, many noted they continue to face pressures on this front.
Further evidence can be seen in recent Statistics Canada data on construction costs. On a year-over-year basis, residential construction costs for 11 Canadian census metropolitan areas were up 7.5 percent in the second quarter of 2023. For nonresidential construction, the increase was slightly lower, at 7 percent. The report identified concrete as one of the key materials increasing costs, while skilled labor rates and shortages are creating additional challenges for the industry.
Labor and skills shortages were clearly on the agenda of real estate executives who participated in PwC’s 2023 Global CEO Survey. The survey found 61 percent of real estate CEOs believe labor shortages will affect profitability to a significant extent over the next 10 years. While the Emerging Trends in Real Estate® reports have been tracking trends in labor and skills shortages for some time, this year’s interviews showed a growing concern about two related issues: productivity and quality of the work. Several interviewees noted productivity has generally gone down while instances of work defects have increased, both of which cause further challenges and cost pressures for development projects.
Recent research from the Canadian Imperial Bank of Commerce (CIBC) economics team suggests labor challenges will continue to grow given an aging construction workforce and a lower retirement age compared with other areas of the economy. The CIBC report, released in June 2023, estimated at least 300,000 construction workers will retire over the next decade. The report also highlighted a lag in bringing in new workers to replace retirees as the number of apprentices falls. Although the Canadian government has made changes to increase the number of skilled tradespeople coming to Canada through the immigration system, the CIBC report noted a need to do more. The percentage of new immigrants who work in construction is very low and has fallen during the past decade, the report found.
Creativity Key to Pursuing Growth Opportunities in 2024
The result of all these pressures is that both development of and investment in Canadian real estate have become even more challenging for many interviewees.
But in an increasingly bifurcated market in which a growing divide exists between assets with more potential to deliver value and those with challenged prospects, companies that carefully plan their next moves can find the winning opportunities to pursue.
So what are interviewees doing to navigate this environment? When asked what their best bet is for 2024, one interviewee—speaking with a touch of humor—said their favored asset class is L, which they explained stands for liquidity. The comment reflects the sentiments of many interviewees who said generating liquidity will be key because the strongest players will be in the best position to pursue emerging opportunistic deals as well as navigate uncertainty in the future. Opportunities to do this include selling off noncore assets and increasing or clearing lines of credit.
For investors, various forms of commercial debt, such as preferred equity and mezzanine financing, are a growing focus given the opportunity to deliver better risk-adjusted returns. This emerging trend of debt funds, which many interviewees identified as offering attractive opportunities to provide credit and liquidity to other industry players struggling to access capital and manage rising financing costs, is a moment-in-time opportunity. “Debt funds have a popularity contest every 10 years, and 2024 is their year,” said one interviewee.
Real estate players are also carefully eyeing other ways to create value during these uncertain times, even as dealmaking activity, especially for larger transactions, slows. Some interviewees, for example, are looking to strategically reposition their portfolios to diversify their assets by focusing on secondary markets that are seeing high population growth and offering attractive investment and development opportunities. Other interviewees are exploring opportunities in subsectors of key asset classes, such as student and senior housing, that are benefiting from trends such as growing international enrollment at Canadian postsecondary institutions and the overall aging of Canada’s population. Another growing trend is considering income-generating assets when acquirers can buy them below replacement cost and where they see opportunities to add value.
Many interviewees also stated that being agile and creative in structuring deals will be key to pursuing opportunities that emerge in the year ahead. This could mean including earnout provisions for sellers to bridge bid-ask spreads as well as vendor take-back mortgages to manage financing gaps and other challenges in closing transactions.
Harnessing Data, Digital Transformation, and Technology Trends such as Generative AI
Besides repositioning their assets and portfolios, real estate companies have an opportunity to create further value in an uncertain market by accelerating investments in both their data and technology capabilities. While interviewees tended to downplay the need to look for the most groundbreaking property technology (proptech) solutions this year, there was a general feeling that further digitization remains important in an industry that has tended to lag other sectors on digital transformation.
Interviewees described a variety of ways they are embracing digital solutions that improve business performance by reducing costs or growing revenues. Some, for example, are automating financial reporting activities to save time, while others are embracing construction technologies and process changes to speed up building timelines and manage labor shortages. Interviewees also described how machine learning tools to improve and predict maintenance requirements are helping them better manage energy systems. Further investment in data analytics capabilities is also key to optimizing portfolio, investment, and forecasting decisions; better understanding customer and tenant needs and preferences; and enhancing performance and efficiencies across the business.
While digital adoption focused on solving business problems and improving operations continues in Canada’s real estate sector, the industry is also taking notice of a technology that has been making waves since late 2022: generative artificial intelligence. Interviewees offered a variety of views on how they are approaching generative AI, with some saying it is too early to assess its impact on real estate, others starting to assess use cases, and several interviewees having already begun exploring opportunities to incorporate it in different ways, such as performing initial analysis of investment decisions and generating architectural drawings and designs.
Despite the diverging approaches, there was a feeling among many interviewees and survey respondents that generative AI has the potential both to significantly disrupt the real estate business and also to create new opportunities for companies that embrace it. “Something that would normally take a week, now takes three hours,” one interviewee shared about their experience using generative AI tools to conduct market research and analysis. Whichever stage they’re at in exploring generative AI, given the complex issues it raises, companies should keep in mind the following key considerations:
● Carefully assessing the use cases: Real estate company leaders can expect to hear about a range of applications for generative AI to their businesses. Many will offer attractive value propositions aimed at increasing revenues, changing the business model, or reducing costs. But given that it will not be possible to pursue all potential opportunities, leaders will need to take a strategic and systematic approach to determining which use cases to move ahead with, considering the impacts on the bottom line.
● Data quality and availability: Ensuring availability of good quality data is key to optimizing generative AI tools. This will require real estate companies to look at which data they have moved to the cloud and what else they may need to migrate to pursue the use cases they are focusing on.
● Responsible AI: Generative AI creates some unique risks, including the possibility of wrong or misleading outputs that erode trust if data sources are not reliable, accurate, and unbiased. The best time to consider risks is at the beginning of the generative AI journey to ensure that the right strategy, controls, and responsible practices are in place before moving ahead.
For those real estate companies that are unsure about AI uses and risks, it is important to keep in mind that it is possible to focus on experimenting with the technology for the time being. One approach is to develop proofs of concept and test ideas in secure environments to assess the impacts before fully adopting a generative AI tool or application.
Real estate companies also need to remember the key role of human judgment and creativity in making the most of generative AI. Human insights will help real estate companies not only manage the ethical risks involved but also ensure proper oversight of the outputs the technology creates. This is especially critical given that generative AI has proven to be most effective in producing directionally accurate results rather than the precise outputs a company needs. It could, for example, help a real estate company build the first draft of a sales plan that an employee would supplement and edit with further insights.
ESG Strategy, Reporting, and Performance
Ensuring tangible returns now versus investments in long-term value creation
“Many still view this as a cost center. We see it as a profit center.”
The ESG agenda has continued to evolve for Canada’s real estate industry, with sentiment about the importance of environmental, social, and other concerns shifting among some interviewees. “Quietly, the sentiment among investor feedback is that it’s maybe less important than the year before,” said one interviewee. This statement reflected the views of some real estate players who suggested that the focus on ESG matters had diminished, given the current economic environment and questions about timelines to see payback from investments to address issues such as sustainability and climate change. Another concern is a lack of consistent key performance indicators to assess progress on the social and governance aspects of ESG matters, making it hard for companies to measure the success of their actions and initiatives. Those choosing to focus less on ESG matters as a result say they are not paying a price for doing so, with most emphasizing that they can still move deals forward because most investors prioritize finding the best returns. They are not ignoring ESG matters, but are just currently taking a slower approach.
Even so, the survey showed environmental matters such as climate change ranked as a top issue for survey respondents this year, and a noteworthy segment of interviewees felt the importance of ESG performance has continued to rise. While the divide on these issues tends to be between smaller, privately owned real estate companies that view ESG investments as adding to inflationary pressures and larger institutional players that see this as a strategic priority, the differences are largely a question of how quickly to make changes and how far companies should go in taking action on issues like decarbonization. Some interviewees said that, while they are not looking to be leaders in this area and are more likely to focus on meeting minimum requirements, they are ready to pursue ESG initiatives that show a return on investment.
The temptation to focus on the most immediate pressures such as economic volatility and inflation is understandable. But, even with an uncertain outlook for 2024, real estate companies have several reasons to be proactive about issues such as sustainability, diversity, equity and inclusion, and social inequality in the year to come. These include not only the ripple effect of large Canadian pension funds focusing on ESG investing and performance, but also the following key trends in the market.
1. Evolving Reporting and Regulatory Requirements
Requirements for reporting on ESG issues have evolved quickly in Canada and around the world. In Europe, the Corporate Sustainability Reporting Directive has the potential to affect some Canadian companies, while new requirements are also moving ahead in Canada. Particularly noteworthy is the finalization by the International Sustainability Standards Board (ISSB) of two key standards in June 2023: general requirements for disclosure of sustainability-related financial information and climate-related disclosures. The Canadian Securities Administrators has indicated it will adopt these two standards, although the timing is uncertain.
While the ISSB standards, once adopted in Canada, will apply directly to publicly listed companies, they will affect privately owned businesses in several ways. The businesses may face requests from tenants subject to the ISSB standards for a building’s sustainability and climate-related information, for example. At the same time, the new rules could set a broader baseline of what is expected of any organization reporting on its ESG performance. And once an organization discloses data about an issue, there is a natural expectation that it will take action to address any gaps.
The ISSB requirements are broad, covering an organization’s strategy, metrics, and targets and requiring disclosure of its Scope 1, 2, and 3 greenhouse gas emissions. The requirements also include key real estate metrics, such as energy and water consumption at both the corporate and asset levels.
Also noteworthy on the social side of ESG regulations is new federal legislation on addressing forced labor in Canadian supply chains. Companies subject to the legislation must report annually, starting in 2024, on steps taken to prevent and reduce the risk of using forced or child labor at any step in the supply chain. Real estate companies will need to pay close attention to the new law, given the extended supply chains in the construction industry.
2. Emerging Opportunities to Create Value and Competitive Advantage
One of the key issues highlighted by the ISSB’s new sustainability and climate disclosure standards is the increasing importance of ESG performance in both mitigating risks and creating new opportunities that could affect cash flows, access to financing, or the cost of capital in the short, medium, and long term. Avoiding risks has traditionally been a focus of assessing ESG benefits. This could include addressing the physical impacts of an ESG matter such as climate change on an organization’s operations and supply chain. There are also transition risks. In the context of climate change, this could include policy, legal, technology, market, and reputation risks as the world shifts to a low-carbon economy.
These are all important, but increasing evidence shows that some companies and investors are seeing ESG considerations as a strategic lever to create business value. Real estate companies have a growing recognition of how ESG initiatives can lead to improved cash flows. This could mean, for example, being able to charge higher rents for more sustainable buildings, reduced operating costs from energy efficiencies, and long-term improvements in margins.
More broadly, ESG performance is emerging as another example of growing bifurcation in Canada’s real estate market, which was evident in the words of one interviewee: “An ESG divide is coming. The smoke will clear on those that are talking about ESG and those that are actioning ESG change.” Many interviewees have a sense that companies and assets that meet high ESG standards will be better able to attract more discerning sources of capital and deliver stronger growth and performance, while those that lag behind significantly may see negative impacts on valuations and find their businesses permanently impaired.
So what are Canadian real estate players doing in response? One interviewee described their approach to finding win–win approaches to ESG matters by focusing on initiatives with clear payback. In their case, that means investing in newer types of heat pumps that are more efficient, as well as working with their teams to identify ways to reduce the emissions of their highest-emitting properties. The interviewee noted they are also in touch with their insurers to better understand the risks and costs of weather events and other climate-related changes. As part of their broader plans to recycle capital by selling off assets, they are considering how some properties may be permanently impaired by climate change risks.
3. New Technologies, Incentives, and Taxes
The good news is that, even for Canadian real estate players focused on taking a more measured approach to ESG matters, a growing array of supports and solutions are available to help them in their journeys, including the following.
Technology-enabled ESG reporting: Even with the growing focus on ESG matters and the pending implementation of ISSB disclosure standards, reporting practices on issues such as greenhouse gas emissions, biodiversity impacts, workplace diversity, cybersecurity protections, and labor practices remain challenging. But the landscape is changing quickly, with technology-enabled ESG reporting solutions emerging to help real estate companies produce disclosures that meet high standards for quality and assurance. While technology will be key to creating more effective, efficient, and accurate ESG reporting, the quality of the solutions offered by vendors varies, meaning real estate companies will need to carefully assess which products to adopt and implement meaningful review practices to ensure data integrity.
Sustainable building solutions: The array of tools, technologies, techniques, and solutions to create more sustainable real estate assets is also growing quickly. One interviewee, for example, noted how installing vertical wall solar panels on the sides of a building allows real estate companies to go beyond putting the panels on roofs. Others described their efforts to achieve emissions reductions by participating in district heating and energy systems, while several interviewees are focusing on low-carbon construction techniques to reduce the embodied carbon in building materials such as concrete. Building automation tools are another area of focus for real estate companies looking to reduce their energy use and emissions.
Taxes, incentives, and partnerships: For many real estate companies, a key challenge is managing the significant upfront costs of investments to reduce emissions. While interviewees tended to feel strongly that the array of government programs available to support these investments is insufficient, an approach that considers the full life-cycle costs—not to mention the evolving tax implications of emitting greenhouse gases—can make a difference to the business case for proceeding with decarbonization initiatives.
This would mean, for example, taking into account the avoided costs of federal and provincial carbon pricing frameworks due to emission reductions. Governments in Canada are also rolling out a growing number of incentive programs to help companies manage the costs of clean energy equipment and technology initiatives, building retrofits, and efficiency upgrades. Although a few programs are targeted specifically at the real estate sector, many are applicable to all industries and would cover building and constructive activities.
The Housing Market at a Breaking Point:
The challenge of tightening supply versus growing demand
“We’re missing a strategic vision in Canada by all three levels of government.”
Concern about housing affordability continued to grow in 2023, and this trend is expected to deepen in 2024 given the overall shortage of houses and current homebuilding trends. According to an August 2023 report from the Canadian Home Builders’ Association, 22 percent of industry panelists surveyed said the current market slowdown was causing them to cancel building projects entirely. And two-thirds said market conditions were causing them to build fewer units, signaling further constraints on the supply of homes in the near future.
The prospects for significantly alleviating affordability pressures in the near term are low given factors that are increasing housing demand amid tight supply. On the demand side, Canada’s population—which surpassed the 40 million mark this year—will continue to grow as the country raises immigration levels. The federal government has raised its target of 431,645 new permanent residents in 2022 to up to 505,000 in 2023, 542,000 in 2024, and 550,000 the year after. The numbers of international arrivals needing housing becomes even bigger when accounting for nonpermanent residents such as international students holding study permits and temporary foreign workers, both of whom have been coming to Canada in large numbers recently. While newly published population estimates from Statistics Canada for the period spanning July 1, 2022, to July 1, 2023, shows Canada welcomed 468,817 immigrants during that time, the country also saw a large increase—697,701—in the net number of nonpermanent residents.
While there are excellent reasons for Canada to increase its working-age cohort through immigration and other measures given the overall aging of the population, the country also needs to make sure it can house new arrivals. This is especially important in light of studies tracking troubling housing affordability trends in Canada. According to the Royal Bank of Canada, for example, homeownership costs as a percentage of median household income reached 65.9 percent for a single-detached home in the first quarter of 2023. While the Bank of Canada’s monetary policies have helped soften home prices, interest rate hikes have still put upward pressure on the cost of carrying a mortgage.
One notable change in the affordability discussion this year is the increased focus on challenges in the rental market as potential homebuyers continue to rent after finding themselves unable to purchase homes. Canada’s rental vacancy rate was just 1.9 percent in 2022, according to the Canada Mortgage and Housing Corporation (CMHC), and the tight rental market has helped lead to rapid rent increases in many Canadian cities.
According to the Toronto Regional Real Estate Board, the average rent for a one-bedroom condominium apartment rental rose 11.6 percent in the second quarter of 2023 compared with the same period last year. The affordability squeeze has continued to spread to rental markets in cities other than traditional high-cost centers such as Toronto and Vancouver. In its latest annual report on Canada’s rental housing market, for example, CMHC found a record increase in average rents for Halifax in 2022. Cities in Atlantic Canada such as Halifax are seeing strong population growth, in part due to the region’s rising share of immigrants coming to Canada. Coupled with the large number of Canadians moving to Halifax from other provinces in search of cheaper homes, the city’s housing market has tightened to the point that some residents are now leaving the Nova Scotia capital for more affordable communities, CMHC reported. Other communities seeing record rent growth include Kitchener-Waterloo-Cambridge, where CMHC noted increases were higher than for other Ontario cities such as Toronto.
Supply Measures Welcome, but More Consistency Needed
Interviewees are resolute that government measures to facilitate supply are key to improving affordability, and that means working more collaboratively with the industry to mitigate the cost pressures builders are facing. A key way to do that is for both provincial and municipal governments to streamline approvals processes, because current timelines can add significant costs to development projects, especially when interest rates are high.
To be sure, several municipal and provincial governments have introduced changes recently aimed at speeding up approval timelines and facilitating new supply. In Ontario, for example, the provincial government has recently pursued a series of housing supply measures, including actions to streamline land-use planning, to set minimum density targets near major transit stations and to support the development of infrastructure needed for new homes. It has also enacted legislative changes to expedite approvals and zoning changes to facilitate building near priority transit projects through the Transit-Oriented Communities Act and, importantly, has moved to exempt affordable housing from development charges. In British Columbia, the province’s Housing Supply Act allows the government to set housing targets in municipalities as part of efforts to speed up local approval processes. And in Nova Scotia, the province has established several special planning areas in the Halifax region to support the development of up to 22,600 new residential units.
Large Canadian cities, notably Vancouver and Toronto, also have taken action to address the so-called “missing middle” of medium-density homes and create more alternatives to single-family houses, which tend to be more expensive. At the federal level, significant recent moves include plans to remove the goods and services tax (GST) charged on new purpose-built rental housing projects—a move some provinces plan to build on with sales tax changes of their own. The federal government has also introduced changes to facilitate immigration by skilled tradespeople, which is key to mitigating labor shortages that are limiting new housing supply.
Interviewees are watching these changes with interest but are mostly reserving judgment on how much of a difference they will make, given the flurry of policy measures introduced in the past year. Many expressed a concern about the need for greater coherence of actions across different levels of government and for recognition that the real estate and building industries are a critical part of the solution to the overall problem of housing affordability and supply. Some expressed concern, for example, about policy measures, such as potential changes to the tax treatment of real estate investment trusts involved in rental housing, that could limit their investment in the market. Some interviewees also worried that discussions about introducing or tightening rent controls to address rising affordability concerns will deter investment in and development of rental housing, which would only increase the supply woes at the heart of the problem.
Ensuring Housing Attainability for More Canadians
Another issue mentioned by several interviewees is the need for policies and programs to better distinguish between affordable and attainable housing, both of which are in short supply. Truly affordable housing for the lowest-income Canadians requires a different set of solutions—especially greater amounts of funding and other direct financial supports—than those needed to ensure suitable homes are attainable to a broader spectrum of homebuyers and renters. Tailoring programs and financial incentives to target varying needs and circumstances will be critical.
Both scenarios require more supportive measures to facilitate supply, with higher interest rates, financing issues, and cost increases creating challenges for all players involved in building homes, including nonprofit organizations focused more on deeply affordable housing and for-profit companies serving a broader range of renters and homebuyers. When it comes to supporting the delivery of housing supply for middle-income earners to buy or rent, interviewees emphasized the importance of creating the right conditions for real estate companies to build the homes required through measures like reducing development charges and taxes charged on residential construction projects. These levies have a significant impact on affordability in some provinces, including Ontario, where the Building Industry and Land Development Association estimates that fees, taxes, and charges imposed by all levels of government account for almost 25 percent of the cost of the average new home.
Industry players interviewed tended to emphasize that ensuring the supply of deeply affordable housing for low-income earners is more of a social responsibility of governments and an issue they need to take the lead on solving. “It’s going to cost money to get this done, and it can’t be the developer,” one interviewee stated, echoing the concerns of others that measures to put the costs of delivering deeply affordable housing onto developers will only make the market-rate homes they build more expensive. “Nobody asks grocery retailers to charge some customers more so others can be charged less,” another interviewee said, summing up the sentiment of many in the industry.
But while emphasizing the need for governments to take the lead by putting more funding into affordable housing, interviewees also acknowledged their role in bringing solutions forward. Many referred to creative ways to increase housing attainability for more Canadians, such as making units smaller and less costly while finding ways to make up for the reduced space by enhancing common areas of buildings with more amenities. This is one more reason for companies to adopt construction technologies, innovative approaches to building housing, and process changes that help mitigate the cost pressures making homes even more unaffordable.
Some interviewees, in fact, reported that they are embracing their role in helping address a key issue on the social side of ESG matters. While emphasizing that governments need to do more through the right incentives, some interviewees said they are finding ways to make the numbers work as they consider how to incorporate affordable housing into their developments.
Markets to Watch
What are the top markets to watch across Canada in 2024? Following are key trends in large Canadian cities, which appear according to their ranking in this year’s survey.
Property Type Outlook
Industrial Property
Industrial real estate remains a favoured asset class, with low vacancy rates helping push up rents for leased space. The national vacancy rate of 1.2 percent was up just slightly from last year, according to Colliers’ second-quarter data, while rents saw a bump to $14.03 per square foot (from $11.00). But despite ongoing demand drivers like the need for space to accommodate the growth of online retail sales, there are cautious views on the outlook ahead as the industrial market, like other asset classes, becomes increasingly bifurcated.
Rent for industrial assets is peaking and starting to stabilize, and there’s general consensus that further increases will be hard to achieve, especially if the economy enters a significant downturn. Investors can no longer assume valuations will rise as quickly as in past years, which has led to lower transaction volumes. As one interviewee told us: “Industrial has run its course.”
But other interviewees say they’re moving ahead with development, believing that industrial real estate continues to offer an attractive proposition. Companies that have built up strong land banks are more likely to move forward with development, while sites located reasonably close to major cities will have a greater ability to demand higher rents.
In this environment, some believe it’s helpful to be strategic with land acquisitions by, for example, partnering with existing owners of industrial property. While in the past, interviewees would often say they’d buy any industrial asset, they’re now assessing it more carefully to see which types of properties in which locations are most attractive.
When it comes to ESG investments, there’s growing interest in the use of solar panels. Solar power can provide a dependable supply of clean electricity to tenants, helping to address rising energy costs while reducing carbon footprints. This is one way for industrial players to make their properties stand out, which could, in turn, help them attract high-quality tenants.
Retail Property
One of the more interesting trends this year has been the comeback story for retail property, with many interviewees more bullish about this asset class. There is generally a brighter outlook for retail real estate, thanks to a limited supply of space and the willingness of consumers to keep spending despite economic uncertainty. This includes in-person shopping: 38 percent of Canadian respondents report shopping in-store at least weekly, according to PwC’s latest Consumer Insights Survey.
“Retail is recovering,” said one interviewee, summing up the general sentiment found this year. Other interviewees say they are fully leased and ahead of budget on their retail assets as some tenants look for more space, whether for larger showrooms, last-mile fulfillment, or brand development opportunities.
Similar to other asset classes, there’s bifurcation in the retail segment also. The largest regional shopping centers and grocery-anchored retail properties are doing particularly well and seeing healthy traffic—back to prepandemic levels—while suburban strip malls continue to struggle. Interviewees believe it is important to invest in amenities and experiences, as well as ensure a variety of uses—including residential development—to create a greater sense of community and make the shopping center a destination for a diverse mix of consumers. For some, this could mean using creative leasing strategies to ensure a strong tenant mix that includes lifestyle, wellness, and entertainment uses.
With the ongoing decline of large anchor tenants, some mall owners are seeing success by shifting toward smaller-format stores. In some cases, retailers are using part of their space to hold inventory for pickup and fulfillment of online orders from customers. They are also experimenting with store-within-a-store concepts, in which a company sells its products through another retailer’s existing locations. This avoids the costs of setting up new retail locations while compensating the other retailer for the use of its space.
Overall, interviewees feel that the long-term outlook for retail assets is favorable, particularly given rising demand resulting from immigration to Canada and population growth. This makes neighborhood retail developments aiming to serve the needs of new and growing communities a particularly good bet.
Offices
With offices considered a “bad word” in real estate at the moment, in the words of one interviewee, many industry players are taking a wait-and-see approach to this asset class. Construction is declining, and the national office vacancy rate sat at 18.1 percent in the second quarter, according to CBRE. The downturn in the technology sector has added to the challenges for office properties. As a result, there’s a general sense among interviewees that it will be several years before the sector starts to recover. Office categories also tended to rank near the bottom of investment and development recommendations in the survey.
Questions remain about tenant space requirements. Although the percentage of employees going into the office at least some of the time has risen, many continue to want to work remotely. PwC’s 2023 Hopes and Fears Survey found that among 2,000 Canadian respondents, 51 percent of those whose job can be done from home are working in a hybrid arrangement, with just 16 percent in the office full time.
Despite these challenges, many tenants in the best office locations are renewing their leases. Top-quality buildings with rich amenities and experiences in the best locations will remain in demand. Other buildings will suffer, with owners considering what to do with their struggling assets. This is reflected in CBRE’s data: downtown class A vacancy rates are lower than for class B properties (16.5 versus 23.3 percent).
Some office owners are looking to sell their properties, but those looking for a deal are finding relatively few distressed buying opportunities. Some contrarian investors are buying up office assets at higher capitalization rates as they are more confident in a long-term recovery for the sector, while others are looking to buy fully leased buildings at relatively attractive prices and add value by refurbishing them.
Some industry players compared the outlook for offices with the situation faced by the retail segment in recent years. “Office is the new retail,” said one interviewee, a comment that raises questions about the extent to which lessons learned from the repurposing of retail properties apply to office landlords navigating rising vacancy rates. For some owners, the current uncertainty is leading them to look at opportunities for adaptive use to incorporate, for example, health care, light industrial, and educational uses. “Offices could be the new schools,” said one interviewee.
More discussion is also occurring about repurposing offices to housing, although the overall sentiment among interviewees is that it’s still early, given that existing layouts tend to not be amenable to residential conversion. Even so, recent reports indicate that scores of buildings across Canada could be candidates for conversion. And experiences in Calgary, where conversions have been a factor in the recent decline in the local vacancy rate, prove it can be done successfully provided that there’s meaningful support from the government to make it work financially.
Similar to the trend toward experiences, activities, and entertainment in retail real estate, many office owners are focusing on amenities that attract tenants and their employees. This could include, for example, converting traditional work areas to bar and cafe spaces as well as reimagining building amenities, such as lobbies, to host events and offer activities that all tenants can access. Investing in ESG features could be another key differentiator to create value in an increasingly bifurcated market.
Purpose-Built Rental Housing
This asset class has been a significant focus for both the real estate industry and governments recently. Among the most notable developments was the federal government’s September 2023 announcement of GST relief for new rental housing construction. The move has industry players watching for similar actions to remove provincial sales taxes, which, combined with the federal announcement, could lead many to take another look at development opportunities in this asset class. Some provinces have already announced plans to follow suit, while several developers have said they will be moving ahead with development plans as a result of the tax changes.
The tax relief comes amid the growing recognition of the need for significant investment in and development of purpose-built rental housing, given current trends in the market. According to the latest Canadian census data, the number of renter households grew by 21.5 percent from 2011–2021, which was significantly higher than the 8.4 percent growth on the ownership side. Rents are also rising quickly, especially for vacant units. According to CMHC’s 2023 annual report on the rental market, the average rent jumped 18.3 percent last year for a two-bedroom unit that turned over to new tenants.
Immigration is generally an important source of demand, but another key segment of international arrivals who need rental housing is the growing number of foreign students attending Canadian postsecondary institutions. Another factor is spillover demand from people unable to afford homes at higher interest rates. Some interviewees believe this will push more people into the rental market, with the full impact being seen in 2024.
While government action on the GST and potential provincial sales tax changes may have an effect, current conditions have made it challenging in many markets to invest in the supply needed to meet the high demand for rental housing. Rising costs and interest rates are holding back some new developments, particularly in the largest markets such as Toronto, Vancouver, and Montreal. Introduction of new rent control rules or further tightening of existing regulations could make conditions even more challenging, which would only add to the affordability issues facing many renters.
If a developer already has a rental project under construction, they will likely continue building, but they may postpone moving forward with developments that have secured approvals or been planned for the future. In some markets, interviewees are looking at buying older rental properties to modernize or add value to rather than develop new products. Having CMHC financing support and density bonuses for building purpose-built rental housing can often make the difference when deciding whether to proceed with a development. And some categories of the rental market, such as student housing, are more attractive to interviewees than others in light of current growth trends in certain niche segments.
Condominiums
Interviewees are taking a cautious approach toward condo developments, with many saying they are delaying new launches, given the current environment, even as they maintain a strong optimism on the long-term prospects for this segment of the residential market. While rising costs, labor shortages, and long timelines for municipalities to approve new developments have created challenges for the industry for some time, higher interest rates have increased the cost of debt to the point that it is no longer feasible to proceed with many projects, particularly in Canada’s largest and most expensive markets.
An additional emerging trend is the decline of investor activity, with rising interest rates deterring investors from buying new units to rent out. This reduces demand from a key buyer segment: data published earlier this year from the Canadian Housing Statistics Program found the share of condos used as an investment in 2020 reached 39.4 percent in the five provinces (Nova Scotia, New Brunswick, Ontario, Manitoba, and British Columbia) studied. The absence of investors creates added challenges for developers, who rely on investors to buy up units during the critical presale phase of launching a condo project.
To manage these challenges, some interviewees are trying to lock in costs for labor and materials earlier to avoid increases later that threaten the viability of a project. Others are releasing product in smaller batches so they have greater leeway to reflect rising costs with each launch of new units. They are also looking at ways to increase their value proposition. As one interviewee explained, the ground floor in a condo is a “dead zone” that does not offer a high return. Rethinking traditional condo design could mean adapting the ground floor for hybrid work by turning it into a coworking space. Other options include turning underused common areas into spaces for activities, socializing, or entertainment.
Despite the current challenges, the long-term outlook for condos is generally positive given strong housing demand. Condos continue to offer a more affordable price point compared with single-family housing for those looking to buy property, especially first-time homeowners.
Transit-oriented development centered around the large number of transportation projects underway across Canada represents another important opportunity to build condos as part of vibrant, mixed-use, and amenity-rich communities for Canadians looking to buy a home. Some interviewees expect to see a jump in demand for high-rise units in 2024 because there are not enough low-rise buildings to meet the needs of a growing population. But they will be paying close attention to what happens with interest rates in 2024 and how that could affect the condo market.
Single-Family Housing
Affordability has deteriorated for single-family housing, creating an ongoing headwind for developers. According to RBC’s June 2023 housing affordability measure, ownership costs as a percentage of median household income reached 65.9 percent in the first quarter of 2023. Although that was down slightly from a peak in October 2022, it was up from 57.2 percent at the start of last year. In the face of other challenges, such as labor shortages and rising costs and interest rates, single-family construction activity has been slowing.
Developers are adapting by paying close attention to price points, given that many Canadians have reached the limit of what they can pay for a single-family home. Single-family housing construction continues to move further away from Canada’s biggest cities, not only to suburbs but also further afield to secondary markets, given the growing appeal of smaller communities. These markets tend to be more affordable and are often an attractive option for Canadians who can work remotely and do not need to commute to major city downtown cores every day.
Looking at the low-rise category more broadly, affordability pressures are shifting the market toward smaller houses and townhouses rather than more expensive detached units. One trend that interviewees expect to see more of is stacked townhouses to increase density while appealing to suburban homebuyers. Some expect to incorporate fewer optional features upfront—such as appliances and finished basements—to make new single-family developments more affordable. They also expect to see more low-rise residential developments with a high-rise component.
Best Bets for 2024
What are the best bets for the year ahead? Through the interviews and survey of industry participants, three key opportunities were identified: industrial real estate, multifamily residential housing, and necessity-based retail property.
1. Industrial Real Estate
The industrial segment remains a best bet for many interviewees, although there is greater caution around the outlook for the year ahead. With industrial real estate perfectly priced and a sense that the recent fast pace of rent growth is unlikely to continue, sentiment around this asset class was mixed compared with last year. But given strong fundamentals such as a very low vacancy rate across Canada, industry players still see opportunities in industrial properties, particularly in the manufacturing and warehousing segments and niche areas such as data centers. For some, while current conditions may be more challenging, the long-term outlook is positive.
For investors and developers pursuing industrial assets, it will be important to focus on finding the right opportunities to generate required returns. For some, this could mean investing in assets with strong ESG characteristics or opportunities to enhance sustainability features. Others note they are still willing to develop new assets on a speculative basis in cases where they have been able to buy the land at a relatively low cost. Although land costs are a significant challenge, some interviewees said recent softening of prices in the industrial segment is helping solidify investments in this asset class.
2. Multifamily Residential Housing
While talk of condo and rental project delays or cancellations reflect challenges in the multifamily residential class, this segment, like industrial real estate, boasts of solid fundamentals that make it a best bet in the coming year. Amid strong population growth, the ongoing lack of supply and the relative affordability of rental units and condos compared to single-family homes, the long-term outlook for multifamily housing remains positive. As one interviewee noted, it’s a segment of real estate that has largely become resistant to a recession.
While both investment and development have become more challenging for the time being, interviewees noted some of the opportunities for real estate companies planning their next moves. Prospects are generally better in markets with fewer or no rent controls, one interviewee noted, while others suggested niche assets, like student and senior housing, are attractive. While some interviewees pointed to complications with these niche areas, many felt underlying demand drivers are strong. These include the growth of the international student population as well as Canada’s aging demographics. But as one interviewee noted, it’s important to differentiate even within niche asset classes. They’re focusing on homes for Canadians aged 55 and up, as opposed to traditional senior housing for the oldest retiree age groups.
Within the rental segment, interviewees were bullish on specific types of opportunities even with current cost and financing headwinds. For some, this could mean finding good income-generating opportunities from investing in existing, well located rental buildings that they can then add value to. “Given the current market conditions, rental will be a key growth area for us,” one interviewee told us, a comment that resonates even more given the recent federal announcement of GST relief for new rental housing construction and the possibility that provinces may follow suit with further sales tax changes.
3. Necessity-Based Retail Property
A perhaps surprising addition to the best bets list this year is this segment of retail property, especially when it comes to grocery-anchored developments that serve communities seeing strong population growth. Neighborhood/community shopping centers ranked particularly high for investment prospects in the survey this year.
A warmer sentiment was also found toward the retail asset class overall. The sector’s rebound reflects the fact that, unlike for offices, there has been little development of new retail supply in recent years. One interviewee noted they are seeing opportunities to buy quality retail assets at more attractive yields than they have seen in a long time. Repositioning retail properties to add value through mixed-use development is a significant trend, with scores of such projects underway in cities across the country.
Honorable Mentions
Besides these three best bets, an honorable mention this year goes to debt funds. While it is not an asset class in the survey, many interviewees cited this as a key opportunity at a time when there is a significant undersupply of debt and equity capital. By providing debt capital to those struggling with financing challenges, companies benefit from both higher yields as well as the security of the underlying real estate if the borrower cannot pay the lender back. Even so, one interviewee cautioned that companies will need to move quickly to take advantage of the opportunities they offer. They stressed that debt funds represent a “moment-in-time opportunity,” especially in a smaller market such as Canada.
Another interesting finding was the high ranking in the survey for medical offices, which scored well for both investment and development prospects but saw relatively little discussion among the interviewees this year.
