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Friday, May 6, 2016

Avison Young CEO expands on CRE trends in Canada, the U.S., Mexico, the U.K. and Germany

By Mark Rose (Toronto)

As clients regularly ask us to provide commercial real estate market analysis so that they may gain some insight for future investments, we would like to share some of the highlights from my Q2 2016 Audiocast, which covers commercial real estate trends in Canada, the United States, Mexico, the United Kingdom and Germany.

Canadian market showing resilience
Despite continued woes in Alberta’s oil patch and swirling global economic headwinds, Canada’s commercial real estate market appears to be doing just fine. Jobs growth shows that the economy is bouncing back from the energy industry downturn. According to Statistics Canada, total employment jumped 41,000 in March, reversing declines in the first two months of 2016. After reaching a three-year high of 7.3% in February, the unemployment rate retreated to 7.1% in March. While the growth trend has been modest by historical standards, it shows that employment has held up relatively well. GDP growth was also surprising as Canada’s economy expanded at a 5% annual pace in the three months ending January 31, 2016. The uptick was driven by gains in exports and manufacturing.

Federal budget provides investment boost
The recently released federal budget will provide an investment boost to the overall economy not seen since 2006. Canada’s beleaguered manufacturing sector is also poised for a recovery, bolstered by a lower loonie. This shift in capital spending will make the economy far less vulnerable to the cyclical ups and downs of the oil patch.

Are these early positive numbers sustainable? We will have to wait and see.

Industrial sector ranks as market darling
Notwithstanding how employment and GDP figures may trend in the months ahead, the Canadian commercial property sector remains sound – apart from Alberta, and in particular Calgary and Edmonton – with the market darling being the industrial sector. Speaking of the industrial sector, and before I turn to the U.S., I would like to give you a glimpse of some preliminary results from our upcoming Spring 2016 North America and U.K. Industrial Market Report.

In short, the Canadian industrial sector is doing quite wellexhibiting record-low vacancy (now at 4%), robust demand, a conservative pipeline trying to keep pace, and rental rates approaching pre-recession levels. Much of the sector’s good fortune is driven by lower energy costs, low interest rates, a competitive currency, growing e-commerce activity and exports bolstered by strong U.S. demand.

United States
American industrial sector continues to strengthen
Like its Canadian counterpart, the U.S. industrial market strengthened over the past year as it ended the first quarter of 2016 at sub-6% vacancy overall, with several regions at 4% or less, and rising rental rates. Look for technology disruption in the industrial sector to be met with increased construction. Demand for smart-modern warehouse product, healthy consumer spending levels, the rise of e-commerce, and the need to shorten the supply chain will support this development increase. Our research shows that U.S. industrial square footage under construction is considerably higher today than it was one year ago.

U.S. office market ascends gradually
The 11-billion-square-foot (sf) U.S. office market continued its gradual ascent in the first quarter of 2016, recording positive net absorption – with vacancy approaching 10% overall – and rent growth.  We anticipate that strong preleasing levels will keep both industrial and office supply levels in check through year-end 2016 in spite of increasing construction. On the other hand, overall U.S. commercial real estate sales volume fell 20% in the first quarter of 2016 – due in part to fewer portfolio sales and megadeals – when compared to first-quarter 2015. While the reduced transaction volume hit every sector, save apartments, pricing held and cap rates were steady, according to Real Capital Analytics. 

China is leading all foreign investment in the U.S., pouring $8.8 billion year-to-date in to U.S. properties, according to Real Capital Analytics. This situation contrasts with the previous two years, when Canadian capital dominated the U.S. foreign-investment segment. Canadian capital remains a significant factor, however, with $3.5 billion invested thus far.

Mexican average office asking lease rate remains stable
Mexico’s office sector enjoyed another strong year in 2015, particularly in the areas of class A and A-plus leasing in Mexico City. In total, 464,000 square metres (m2) of office space was leased in Mexico City in 2015 and inventory surpassed the 5-million m2 mark for the first time. Mexico City's office vacancy rate is still considered to be healthy as it averages 9.5%; however, with more than 650 million m2 expected to be delivered during 2016, and another 1.5 million m2 under design, there is rising concern about overbuilding in certain office corridors. The average asking rate, though, will remain stable in 2016. In the industrial sector,  Mexico City's total class A warehouse inventory surpassed 8 million m2 for the first time. And, the industrial vacancy rate at the end of 2015 was only 6.9%.

Central Mexico experiences tremendous Industrial growth
The Bajio, or Central Mexico, area continues to experience tremendous industrial growth, propelled by the fact that the automotive and aerospace industries have made the region their primary location. But Central Mexico is not the country’s only auto-manufacturing location. For example, Audi completed its plant near Puebla in 2015, while Korea’s Kia Motors is close to completing and commencing production at its new production facility near the Monterrey airport. According to the Mexican Secretariat of Economy, automakers invested US$5.5 billion in Mexico in 2015 alone, sparking additional collateral investment as top-end suppliers sought locations near automotive plants.

FIBRA properties to maintain high occupancy levels
The aggregate real estate value of FIBRAs, the Mexican equivalent of REITs operating in Canada and the U.S., reached US$14 billion in 2015, according to the Mexican Association of FIBRAS. FIBRA UNO alone accounted for roughly half of that total. However, the expectation of rising U.S. interest rates, accompanied by a lower peso, significantly limited FIBRAs’ advancement in 2015 compared with previous years. FIBRAs’ appetite for commercial property has driven cap rates to an all-time low, although we believe that they will not compress any further. For the remainder of 2016, we expect that FIBRA properties will maintain their high occupancy levels – with retail, industrial and office assets still exceeding 90% – and continue to post double-digit revenue growth, based on domestic currency.

United Kingdom
Brexit’s uncertainty causes investor tension
It is difficult to have any conversation about the U.K. property market without referring to “Brexit”, the June 23 referendum that will decide whether the Britain remains or exits the European Union. The uncertainty surrounding the potential outcome of the vote is starting to have a profound effect on investor sentiment with a notable decline in investment market activity.

Quarter-over-quarter, Central London office investment dropped 52% to £2.2 billion – the lowest level in more than four years. In addition, investors -- mainly individuals rather than institutions -- pulled more money out of property funds in February than in any other period since 2008. The sector was further squeezed by the increase in Stamp Duty Land Tax rates (a property transaction tax).

The combined effect of all these factors was a 0.4% fall in capital values in March after three years of continuous growth. Therefore, it appears likely that the Brexit vote will have a depressing effect on first-half volumes. But optimists will point to the rebound in investor sentiment towards Scottish property when Scotland voted not to leave the U.K. in 2014.

For the occupier, the limited supply of London offices continues to drive rents upward. In the 12-month period ending with first-quarter 2016, the total occupancy cost of new, well-located class A space rose 16% in the West End and 10.5% in the City of London. The total office occupancy cost differential between the two areas increased to £104 per square foot (psf) from £85. As a result, we continue to witness a continued migration of tenants eastwards towards the City and South Bank.

U.K. industrial supply remains limited
The U.K. industrial market continues to display limited supply and steady demand. Although manufacturing represents only a small proportion of the U.K. economy, Jaguar Land Rover’s resurgence has had a large impact on the supply of industrial property in the automaker’s Midlands heartland. In London, a shortage of supply has been the recurring theme due to the difficulty of assembling large sites and the loss of industrial land to rezoning. This situation has raised rents to new highs with West London hitting £17.50 psf.

Prime rents hold firm in Germany
Germany’s top office leasing markets had an excellent start to 2016. In the country’s top five markets, some 296,000 sf was let in the first quarter. Backed by solid economic growth and a rise in employment, office demand held firm and led to rising take-up levels mostly in Berlin, Frankfurt, Duesseldorf and Munich. Small and medium-sized office deals are the main growth drivers, and letting volumes are expected to remain high in the months ahead.

Across all German markets, vacancy decreases accelerated in the first quarter and are expected to do so for the remainder of 2016. Due to limited office supply, more tenants are now considering renegotiations and lease extensions rather than relocations. Prime rents have held firm across all markets and are trending further upwards, especially in Berlin and Munich.

Large-scale investment deals in pipeline
Total German commercial real estate investment topped €8.31 billion in first-quarter 2016, but fell short of the outstanding first quarter of 2015 total because announced large-portfolio deals had yet to close. However, a number of large-scale deals are in the pipeline and investors continue to show great appetite for German commercial real estate. So far, office deals have dominated the overall market, grabbing almost 50% of total market share. Retail accounted for almost 20% and logistics asset acquisitions accounted for 10%. Prime yields are edging downward across all German markets and segments.

Investors looking for new opportunities
With supply somewhat limited, especially in the core segment, more investors are seeking opportunities outside the core segment. This includes investment opportunities in suburban markets of the major agglomerations as much as investments in Germany’s smaller cities. Logistics and retail investors are also venturing into more peripheral locations. Many domestic investors and foreign players are also making calculated moves up the risk curve. Overall, the German market will remain a focal point for national and international investors and is expected to post an annual investment volume of approximately €50 billion in 2016.

As always, thanks for reading. To obtain more of our in-depth commercial real estate market analysis, please check out my quarterly Video/Audiocasts and the upcoming Avison Young Spring 2016 North America and U.K. Industrial Market Report.

(Mark Rose is the Chair and CEO of Avison Young.)

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