CoStar July 2020 Market Report Ontario

With the first half of 2020 behind us, Canada now looks to move forward with the gradual reopening of the economy across the nation. Although Canada overall is reopening at a much slower pace than our neighbours to the south, our reopening plans do not seem to be suffering from the same setbacks, lending credence to the old adage that slow and steady wins the race. Having avoided a major collapse of the economy due to the federal government injecting over $250 billion to keep the economy afloat during the pandemic lockdown, the nation is now paying the price as Fitch Ratings downgraded Canada’s credit rating from AAA to AA+. Although Canada’s government debt-to-GDP ratio increased from 88.3% in 2019 to 115.1% in 2020, Canada continues to be in a stronger financial position than many other G7 countries as global markets continue to invest in Canadian bonds. Going forward, the credit agency has confidence in Canada's economic recovery in 2021 because of the advanced, well-diversified and high-income nature of its national economy, however, expects that Canada’s debt-to-GDP ratio will continue to increase before stabilizing at approximately 120% between 2022 and 2024.

On the provincial level, as a historic second quarter approaches its end, phase two of Ontario’s economic recovery plan is well underway with signs of a calculated return to a semblance of normalcy and widespread discussions around how that ‘new normal’ will shape up, albeit under a lingering cloud of economic uncertainty. And while the full scale of human catastrophe and economic impact is yet to be seen, consumers are clearly seeking the light at the end of the tunnel. As national and provincial officials begin weighing easing lockdown restrictions, they are now faced with finding a balance between personal safety and personal freedom. Real estate owners and operators across every asset class are considering potential longer-term effects of the outbreak and the implications that these fundamental shifts are likely to bring. Municipalities are also facing operating deficits due to the heightened need for municipal services and the simultaneous drop in revenue streams. This could put provincial infrastructure investments at risk as the government may be inclined to cover these municipal deficits using the provincial capital budget, reducing funds available for new projects and necessary ongoing operations and maintenance. The alternative is for municipalities cut costs, services, and their workforces, adding to total job losses precipitated by the pandemic. And with large expected declines in both provincial and federal GDP, the government response to this crisis will have long-term implications for growth even when the economy starts to recover. Beyond the immediate challenges, the duration of the pandemic and the potential for additional waves will ultimately determine the true extent of these transformative and lasting changes in corporate and consumer behaviour.

Social distancing and the largest work-from-home experiment in history has drastically changed the way people interact with commercial real estate. Companies are rethinking their office footprints, retail formats, and warehouse needs on a daily basis. Consumers, forced to shop online because of closed malls and shopping centers, may permanently adjust their buying habits toward e-commerce, accelerating a trend a trend that was already in place prior to the pandemic, but creating an even more acute problem for many previously struggling brands that will likely be forced to radically rethink and reduce their footprints, or risk tipping over the edge into bankruptcy. Furthermore, the virus and corresponding shutdown have drastically impacted global supply chains with the entire retail ecosystems now in peril. Not surprisingly, assets that have greater density have been the hardest hit with demand in regional malls, hospitality, healthcare facilities and student housing dropping considerably. By contrast, self-storage facilities, industrial assets, and data centres have faced less-significant declines. Within the office sectors, the multi-decade trend toward densification and open-plan layouts may reverse sharply. Public-health officials may increasingly amend building codes to limit the risk of future pandemics, which will affect standards for HVAC, square footage per person, and enclosed space ratios.

Although it has been insulated from the recessionary effects of the pandemic, leasing activity in the office sector has slowed as companies are generally avoiding expansions and making conservative decisions. Tenants are now carefully looking ahead to reopening their offices while factoring in social distancing, symptom monitoring, availability of PPE and hygienic supplies, and adherence to regulatory requirements. In the near-term, expect heightened pressure on certain industries, such as coworking or physical-product-based businesses, and landlords with exposure to short-term leases. Office occupiers in the technology, healthcare and creative services sector are expected to fare relatively well. Whereas the federal government, the stabilizing force in Ottawa’s office market, may finally embrace on a larger and more permanent scale, which could create some instability. If sublet space is the canary in the coal mine, then the 300,000 SF jump in sublet space in the downtown Toronto office market this quarter is a sign of what is to come. In fact, downtown Toronto vacancy has jumped from 2.9% in Q1 2020 to 3.6% in Q2 2020, and sublet space now represents 21.1% of that vacant space, up from 15.2% in Q1 2020. This situation is similar to what is occurring in the Ottawa office market as well. With a plethora of sublet options coming to market, reduced tenant competition and more options in general on the market for potential occupiers down the road, it is likely that rent growth will level off this year and certain submarkets in both Toronto and Ottawa will see negative growth by year-end. Reduced investment activity lends credence to this expectation with acquisition capital temporarily freezing and minimal foreign investment activity entering the market. Office construction activity resumed after a brief hiatus, as developers are striving to return to business as usual, while at the same time amending development proposals to brace for potential fallouts from the crisis.

Toronto’s industrial market should be resilient through the pandemic and may see late-year growth. Manufacturing, production, maintenance and supply chains are still among the most essential services and provide an opportunity for revenue during a time of uncertainty. E-commerce sales have spiked, driven by demand for the delivery of essential items and groceries while there is renewed demand for dark kitchens and order fulfillment warehouses. Owners and tenants alike will need to coordinate closely with the public sector to forge plans that are essential to both public safety and the solvency of their workforce, while keeping the lights on in their operations. This will be particularly relevant to manufacturers of critically important components, parts and finished goods, especially those involved in critical infrastructures such as energy and power, transport, communications and food and agriculture. For many companies in the sector, it will mean taking every measure to survive now and thrive in the future.

The National Capital Region’s industrial market has entered a period of uncertainty. Some further degree of vacancy increase is expected in the coming quarters, along with an easing of rental rates. In the past, the lack of big box space available for lease meant that built-to-suit was the only viable option for most large occupiers. Now, with the looming economic impact of COVID-19, new speculative construction is unlikely in this already risk-averse market. For large users, built-to-suit may continue to be the best option if the market softens. However, the industrial sector is expected to be fare better than others as the importance of online shopping and other elements of distribution and supply chain have seen a spike in demand. Ottawa’s retail market is experiencing catastrophic declines similar to those seen in Toronto and cities across the globe. With consumer shopping habits bound to change and retailers needing to adapt to remain financially viable, focusing on consumer needs and building loyalty has never been more important. Retailers with modest or no online presence are moving quickly to change their business trajectories. The pandemic has accelerated the rise of e-commerce and with risks of a potential second wave, consumer loyalty to e-commerce is likely to continue rising. As a result, brands are increasingly pivoting to a direct-to-consumer business model and many e-commerce businesses are experiencing sizable growth.

The deterioration of Toronto’s retail sector has been swift and the true extent of the damage to the economy is likely going to be widespread. The shutdown of all but essential stores added further strain to several years of weak retail sales, rising property taxes and the shift to e-commerce. Entire retail ecosystems are now in peril with new bankruptcies, store and restaurant closures and layoffs announced daily. The retail industry might have effectively reached a tipping point with the pandemic, allowing e-commerce to emerge as the logical successor to traditional brick-and-mortar models. Due to the lockdown and warnings to avoid high-traffic indoor areas and places without proper ventilation, many shopping malls and underground pathways will inevitably see a large reduction in shoppers. Depending on the governmental decrees, neighbourhood streetfront retailers may actually find their foot traffic not significantly reduced, as the perception of safety is higher within this retail subtype. Assets in retail nodes with necessity-based retailers, primarily grocery and pharmacy, will likely find that their consumer traffic remains relatively high. Notwithstanding that, tech giants like Amazon and Shopify continue digitalizing the industry and driving consumer behavior to e-commerce channels, further diminishing hope of a recovery for traditional retail performance.

These insights are made possible through CoStar, the largest commercial real estate source for property listings for sale or lease in Canada.

This post may include "forward-looking statements" including, without limitation, statements regarding CoStar's expectations or beliefs, which are based on our current beliefs and various assumptions concerning future events and circumstances that are subject to change. Actual results and events may ultimately be materially different. All forward-looking statements are based on information available on the date published, and we assume no obligation to update these statements. You should not construe this post as investment, tax, accounting or legal advice.