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Keeping You Informed – Q4 2022

The commercial real estate investment market seemed on track to deliver record-breaking sales volumes in 2022, with most sectors in a strong position coming out of the pandemic.  Office assets, although perhaps less in favour than most other asset classes, were still transacting.  As the Central Bank continued to increase interest rates in the second half of the year, difficulties in funding and pricing transactions emerged.  As we enter 2023, there is uncertainty regarding the potential for a recession, its severity, and the future of interest rates and inflation.

According to the most recent CBRE Canadian Cap Rate Report, cap rates have been on the rise in 2022 for our core office markets of Toronto and Ottawa. The average office cap rate for office properties in these markets increased by 56-100 bps. This is the first notable annual increase in yields in 14 years, however, the average yields are still below the peak seen in 2009.  In the case of private real estate funds, property valuation reductions haven’t been as apparent as the immediate drops in listed REITS.  However,  the decline in quarter-by-quarter performance seen in the MSCI/REALPAC Canada Quarterly Property Fund Index suggests that we may see similar trends when the Q4 2022 results are released on January 31, 2023.

This quarter also highlighted the continued widening of the gap in terms of cap rates for top tier assets versus Class B assets.  This flight to quality is expected to continue, as tenants seek amenity-rich buildings to attract and retain top talent.  The office is a primary place for meaningful sustainability efforts, and many employees expect their companies to make good environmentally-friendly choices.  This is reflected by the fact that net zero targets and sustainability are now a top priority for most commercial real estate decision makers per a recent global JLL client survey.

We believe that a significant part of the best-in-class theme revolves around investing in ESG upgrades, such as decarbonization efforts.  It not only reduces asset risk, but it also creates meaningful value.  Data from analytics firm MSCI identifies a 26%-35% gap in sales prices of buildings with sustainability ratings compared with those without in London and Paris.  This foretells the extent of importance of such upgrades.

Continuing to overlay our decarbonization plans with our broader repositioning strategies will be our main objectives for 2023 and beyond.  Our role as an active investor will continue to help mitigate the long-term risk in these markets while maximizing risk adjusted returns.