In their latest reports for the second quarter, both CBRE and Colliers have highlighted the cooling effect of higher interest rates on the Canadian commercial real estate sector. These reports delve into market conditions and capitalization rates (cap rates) across various asset classes and regions in Canada.

Cap Rates on the Rise

One key takeaway is the consistent upward trend in cap rates across most major asset categories. Cap rates represent the returns on investment for commercial properties. CBRE’s report notes that the national average for all property types increased by 16 basis points to reach 6.28% during Q2.

Real Estate Spreads Tighten, Then Widen

Despite a temporary tightening of real estate spreads due to a rebound in bond yields, these spreads have overall widened. Over the past four quarters, they’ve expanded by 56 basis points to reach 301 basis points, according to CBRE Chairman Paul Morassutti.

Mixed Q2 Investment Activity

Overall, Q2 witnessed softer-than-expected activity in the commercial real estate investment landscape. Here’s a breakdown by asset class:

Office Space

Investment in office properties remained subdued, primarily due to uncertainties surrounding the return of office-based work and lender caution, as noted in the Colliers report.

Cap rates for class-AA, class-A, and class-B office spaces experienced a rise during the quarter. Downtown office properties saw a slightly greater increase compared to their suburban counterparts.

Industrial Sector

While industrial leasing continued to exhibit strength, it has eased off from the unprecedented boom of the past few years, marked by rent growth exceeding 50% YoY in certain markets. Cap rates for both class-A and class-B industrial assets saw an increase, with class-A assets rising at a higher rate.

Retail Thrives Despite Challenges

Basic retail, including grocery-anchored retail, remained resilient in the face of inflation and interest rate hikes, attracting investor interest. Additionally, retail redevelopment potential is becoming a key consideration for investors.

Housing Market Impact

The pressing demand for housing, coupled with government decisions to relax zoning regulations in major markets, may introduce extra value for low-density assets like suburban malls.

Multifamily, Seniors Housing, and Hotels

In the multifamily sector, a strong housing market, driven by Canada’s record-breaking population growth and unaffordable homeownership, has kept investor demand high. Cap rates rose slightly but steadily, remaining lower than other asset classes.

Seniors housing investment activity continued to involve distressed assets and/or owners, aligning with buyers who see strategic value in these properties. The sector recorded substantial rent growth, minimizing the impact of interest rates on cap rates for well-positioned assets.

The hotel market has experienced significant momentum, particularly due to the return of leisure travelers and the utilization of hotels for refugees and social lodging. Preliminary hotel investment volume in H1 2023 exceeded previous years.

Regional Insights

Across various regions in Canada:

• Vancouver: The office market is expected to improve with more employees returning to offices, while industrial and retail sectors perform strongly. Industrial lease rates remain at record highs, while retail sectors exhibit average cap rates well below the national average of six to seven percent.
• Calgary, Edmonton, Winnipeg: Multifamily and industrial assets remain sought after. Office investments vary, and the retail market mostly targets anchored assets. Low industrial vacancy rates drive higher lease rates, and limited supply contributes to a tight market for owner-user facilities.
• Toronto, Kitchener-Waterloo, Ottawa: Industrial properties are in high demand, while office investments face challenges. Multifamily investments continue to attract interest, and retail and office markets exhibit mixed trends. Industrial leasing remains strong, with rates supported by low vacancy.
• Montreal, Quebec City, Halifax: Montreal sees increasing activity in short-term leased industrial properties. Office investments face limited financing, and the retail market remains strong, with interest from both institutional and private capital. Multifamily assets remain appealing, with upward pressure on rents. Halifax witnesses active multifamily and land transactions.

Higher interest rates are casting a shadow over the Canadian commercial real estate market, impacting various asset classes and regions differently. While challenges persist, certain sectors, such as basic retail and multifamily housing, continue to offer opportunities for investors.