Office fundamentals solid despite COVID-19

There may be some hesitation from Vancouver office developers given how quickly the market turns due to COVID-19 containment measures

By
Western Investor
June 30, 2020





Oxford tower MNP
— Oxford Properties, Vancouver

Metro Vancouver, particularly the downtown peninsula, was not prepared for its newfound popularity among office tenants.  At year-end 2017, office vacancy across the region was sitting at 8 per cent with vacancy downtown at 7.1 per cent; essentially a balanced market between landlords and tenants. The largest development cycle in the history of the downtown core had just wound down and while most of the new inventory had been absorbed, there was uncertainty regarding future demand.

New entrants to the market such as WeWork, Amazon and Spaces began arriving in 2018. Vacancy started trending downwards sharply as these groups absorbed as much space as they could secure.  A strong economy also meant that traditional Metro Vancouver tenants also needed additional space to facilitate growth. Moreover, additional U.S.-based firms, particularly from the technology sector, started dipping their toe into the market.

By year-end 2018, vacancy had decreased to 5.1 per cent across the region and was less than 3 per cent downtown.  As a result, lease rates climbed to new heights and inducements decreased as tenants had fewer options to choose from.

With minimal new inventory in the pipeline, developers quickly started playing catch up as few expected the market to change as quickly and dramatically as it did.  The result has been the largest development cycle downtown Vancouver has ever experienced with more than five million square feet of new developments being kicked off (a 22 per cent increase on the existing downtown inventory of 22.8 million square feet). One of the largest surprises, given the typically risk-adverse nature of pension fund developers, was that most of this new development was going ahead with or without any prelease commitments in place. Vacancy continued to tighten in 2019 and by year end finished at 4.4 per cent for Metro Vancouver and 2.6 per cent for downtown Vancouver. Rental rates were again pushed to new heights.

The record-high lease rates and record-low vacancy resulted in building valuations that had never been achieved in downtown Vancouver. However, the million-dollar – or even billion-dollar question depending on the asset – is: ‘how sustainable are these valuations given recent workplace restrictions due to COVID-19 and the effect of the new inventory being delivered into the market over the next 12 to 36 months’?

Market forecast: For the downtown, the past expectation was that vacancy would remain low and that there would be further upward pressure on rental rates into 2020 and the first part of 2021 as no new significant inventory was delivered. However, in light of the COVID-19 containment measures, it is not certain as of April 2020 if the market will continue as it was previously or whether there will be an increase in availabilities as companies downsize or cease operations altogether. Regardless, vacancy relief was expected to materialize in 2021 when Reliance Properties delivers The Offices at Burrard Place, a 133,000-square-foot building. While the potential impact of COVID-19-related construction delays remains unknown, there are several significant developments still scheduled to follow in late 2021 with the delivery of 320 Granville Street, 601 West Hastings Street and Vancouver Centre II at 733 Seymour Street, which combined will offer more than 579,000 square feet of vacant and available space (as of Q1 2020). As we look into 2022 and the first half of 2023 as developments such as The Stack at 1133 Melville and B6 at 1090 West Pender are delivered, the amount of uncommitted space increases to more than 700,000 square feet. It is important to note these totals do not include the backfill space coming back in existing buildings and assumes that construction remains on schedule.

When all this new inventory is delivered, where will vacancy land and what will be the impact on lease rates?  The answer lies in how substantial the impacts of the COVID-19 containment measures are on office tenants’ requirements and how many new entrants will be drawn to Metro Vancouver. According to Avison Young’s downtown office vacancy forecast for 2023, vacancy will range from 0 per cent in a high-growth scenario to 2.4 per cent in an average growth scenario and up to 10.7 per cent in a no-growth scenario. These scenarios will need to be updated in light of the current crisis as more data becomes available.

If vacancy continues to remain near record lows, developers will respond by continuing to build to meet demand. However, there may be some hesitation from Vancouver office developers given how quickly the market turns due to COVID-19 containment measures. The end result, whether this occurs immediately, or in 2022/23 and beyond, is that overall market vacancy will rise thus reducing upward pressure on rental rates and potentially lowering rental income as pockets of vacancy emerge, which will translate into a lower building valuation. Given the current office market dynamics in Metro Vancouver, accompanied by the record low cost of capital and decline in the value of the Canadian dollar, it will be interesting to observe how investors respond over the next 12 to 24 months.

Note: The spread of COVID-19 and the containment policies being introduced are changing rapidly, and some of the views expressed herein may not reflect the latest opinion of Avison Young.

 

- Glenn Gardner is a principal with Alison Young, Vancouver, and a specialist in the office leasing sector across Metro Vancouver. Visit avisonyoung.com


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