Real estate investment trusts are trying to “aggressively” off-load their office space as remote work continues to pummel the market as well as their bottom lines.
It’s a situation experts say brings more turmoil to Toronto’s troubled office sector, and may lead to more building conversions, full-scale demolitions, and declining valuations.
REITs that are heavily invested in office space have taken a financial hit as the sector continues to feel the effects of high vacancy rates. Commercial real estate firm CBRE shows Toronto’s downtown office vacancy rate climbed to 18 per cent in the first quarter of 2024 and valuations have fallen dramatically.
REITs are companies that own or finance a range of income-producing real estate properties and many are publicly traded on a stock exchange. Recently Toronto-based Allied Properties’ REIT had their debt downgraded to junk by Moody’s, a credit rating and risk analysis company, meaning the REIT’s bonds may be a risky bet as the company has a higher likelihood of failing to repay their debts.
Some have also been forced to cut their dividends, some even twice. Slate Office REIT suspended its monthly distribution in mid-November to conserve cash, and True North Commercial REIT slashed its monthly payout early last year.
It’s a challenging landscape for REITs invested in office space looking to sell their assets as there’s a limited buyer pool.
“It’s no surprise that the REIT space is aggressively trying to transition away from office space,” said John Andrew, a commercial real estate consultant and former professor at Queen’s University’s Smith School of Business. “The challenge with transitioning away from office is how do you sell that office space? How do you get close to reasonable value for the office space when there aren’t a lot of buyers out there?”
While few buyers are interested in taking on office space, if it’s the right price they may choose to convert the building for other use. According to CBRE’s first quarter report, since 2021 office-to-residential conversion projects in Canada make up the majority of conversion activity at more than 56 per cent, followed by industrial at 14.6 per cent, education at 8.3 per cent, hotel at 6.2 per cent and life science at 5 per cent.
“There is the capacity to convert office space but it can be a very costly endeavour and to solicit a buyer they may require a significant discount to make the math work,” said Carl Gomez, chief economist at CoStar Group Canada, a commercial real estate database.
For some, the retrofit to residential might not be feasible, Gomez said, and it may be more effective to demolish and construct a new building.
“In downtown, what holds value is land; there’s money in land and scarcity,” he said. “Bigger markets like New York City do this all the time, where they take the land value and build something new. That may be the case in Toronto over the long-term.”
Class A buildings, which are the premium spaces in downtown Toronto, are performing well, but it’s class B and C — the older buildings — that are struggling.
“Transactions are way down across all commercial real estate,” said Michael McNabb, portfolio manager at Purpose Investments Inc. “For B and C office, many have defaulted on their debt, and so what happens to those buildings? They sell to cover the debt, but are left with zero equity.”
But Gomez says it’s less about the class of building, and more about when it was built.
“A bank tower that’s considered Class A built before 1980 has the same issues as class B in terms of poor vacancy rates,” he added. “It’s really Class A buildings that are new which are doing well.”
Owners of B and C office space can’t easily sell, said Andrews, adding, “Some are thinking of investing some capital to try and move that office space up a grade, and won’t raise the rent but will hopefully decrease the vacancy rate by making those kinds of renovations.”
However, REITs own just below 15 per cent of the roughly 270 million square feet of office in Canada, said McNabb. The majority of the best office buildings in Toronto are owned by pension funds and their capital structure means they’re not in a rush to sell off their properties, ensuring the majority of office space won’t experience distressed sales.
And while currently, supply is outstripping demand in the office sector, McNabb said, long-term the balance will level out.
“Because new office construction has dropped, long-term there will be less office supply combined with increasing demand from population growth, eventually getting to a more balanced market.”
