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Friday, April 29, 2011

Q2 2011 Update

By Mark E. Rose (Toronto)

As we close the door on the first quarter of 2011 and look ahead, Canada’s commercial real estate market and economy in general, remain on solid ground.

Though leasing challenges remain in some sectors and asset classes, availability and vacancy rates are firmly in a downward trajectory and putting upward pressure on rental rates.

Canada’s office vacancy rate dipped below 9% to 8.7% in the first quarter of 2011, while the availability rate is approaching single-digit territory, currently at 10.2% -- this is a notable improvement from the same period last year when vacancy and availability rates were 140 and 200 bps higher, respectively.

Robust leasing activity and diminishing large-block options in the country’s major downtown markets have some developers planning for the next development cycle, with announcements imminent in the coming months – this an encouraging sign.

All this is supported by a key ingredient to a sustained recovery -- steady job growth. Canada's unemployment rate finished Q1 2011 at 7.7%, and over the past 12 months, employment has risen by 1.8%, or 305,000 jobs. By comparison, the unemployment was 8.2% in the same period, one year prior.

Improving leasing fundamentals have spurred on investment sales. Investors acquired at total $18.5 billion worth of commercial real estate in 2010, of which $6 billion was deployed in Q4 2010.

Preliminary figures show investment volume cooling in Q1 2011 (with approximately $3 billion in trades), compared with Q4 2010; however, buyers remain hungry for product as they look to take advantage of the continued low cost of capital – the pause is not a concern and simply the rate at which product is being brought to the market.

As is the case with the broader industry, our investment sales and capital market teams across the country are actively pitching and winning new business and are building a strong book of business for the remainder of the year.

Pricing (that is, cap rates) for trophy assets has already surpassed 2006/2007 levels (the previous peak), and cap rate compression is now more closely connected with secondary product and or locations.

Canadian REITs, one of the most active buyers last year (on both sides of the border) continue to take advantage of the capital markets raising a total of approximately $1.3 billion in Q1 2011 -- the largest equity offering of the quarter came from Dundee REIT amounting to roughly $144MM.

Turning to the U.S…..

The U.S. Office market ended the first quarter 2011 with a vacancy rate of 12.6% -- unchanged since year-end 2010.

The country experienced its fourth consecutive quarter of positive net absorption, but a similar volume of space was delivered, keeping the vacancy rate steady.

Service sector office jobs growth over the next year will strengthen the overall office conditions.

In February, 76% of U.S. metropolitan areas reported over-the-year increases in non-farm payroll employment. The largest employment increase occurred in the Washington D.C. Metro area (+75,000). As well, Houston Texas had the 4th largest increase, adding nearly 51,000 jobs.

Some markets are already experiencing more landlord-favorable conditions and tenants who have sat on the sidelines over the last 24 months are stepping back into the market.

Dearth of construction starts will bring further tightening as the supply overhang is slowly absorbed. The U.S. will experience rent growth in select markets for larger tenants.

By February 2011, the U.S. closed $5.9 B in sales of office buildings.

Over the past 18 months, cap rates have contracted on most asset types and real estate has been considered a higher-yielding asset than monetary assets like stocks and bonds, and a prudent use for excess investor cash. As such, we continue to see investor interest rise across all asset types and classes, although the rise in value is beginning to slow its trajectory a bit.

Avison Young foresees a potential increase in interest rates -- which is beginning to look more likely as 2011 progresses.

Austerity plans in local and national government are having difficulty gaining traction, and bond investors are beginning to worry about possible inflation.

In the investment markets, perception rapidly becomes reality and if this condition persists (and the Fed continues to send mixed inflation and policy signals), then we could see a ramp up in funding costs later this year.

This blog has also been posted as an audiocast on the Avison Young web page.

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