The Toronto office market is being shaped by trends which have both near-term and long-term impacts. While economic indicators such as GDP and employment growth will always remain important demand drivers, these are largely cyclical forces. There are, however, secular forces at work which sometimes receive less attention. At LaSalle Investment Management, we have grouped three of these forces into what we call DTU: Demographics, Technology and Urbanization.
DTU has been a key investment theme in our Investment Strategy Annual publication for the last two years, but it continues to shape the real estate landscape today and will continue to impact it for the next several years. Furthermore, Toronto is certainly not alone; many cities around the globe are being shaped by DTU forces. We believe an investment strategy focused on DTU provides an excellent opportunity for real estate investors.
Collectively, the DTU theme continues to drive demand for space within major urban markets. In Toronto, the secular shift caused in part by DTU will continue to create office investment opportunities for years to come, particularly for investors who identify suitable assets, have an experienced and nimble team, and the ability to execute strategy.
The Impact of DTU on the Toronto Office Market
Using market data, LaSalle examined office absorption levels across the Greater Toronto Area office market over the last five years (mid-2010 to mid-2015). During this time, close to 4.4 million square feet of space was absorbed, with all of that occurring in the Class A and Class RC (renovated and converted) segments. Class B and C space absorption collectively was negative 204,000 square feet.
Indeed, this ”flight to quality” in Class A absorption occurred largely in newly built towers in and around the downtown area. However, the RC segment had over 300,000 sf of absorption over the last five years (and an even more impressive 1.3 million square feet or 16 percent of stock over the past 10 years), yet no new supply was built in this segment as it is mostly converted “brick and beam” space. Vacancy in the RC segment has plummeted from over 14 percent at the end of 2005 to 5.5 percent today.
Demand for new office product in Toronto, and indeed other Canadian markets, is being driven by a number of considerations including:
- A desire by larger tenants to consolidate operations in one central location;
- A flight to quality by some tenants that have long existed in older Class B and C buildings and now require the features of a new building, including LEED certification;
- Organizational restructurings which require tenants to maximize efficiency and consolidate into less, but more functional, space;
- A replacement of obsolete stock;
- And, most importantly, a desire among millennials to live, work and play in a singular urban environment capable of satisfying a variety of diverse needs.
The aggregate of these demand drivers, but particularly the flight to quality trend, has prompted developers to commence numerous new projects in recent years. LaSalle believes tenants will continue to vacate existing buildings (including older Class A buildings) to move to the newly built product. This will be the continuation of a pattern of the last few years, as several larger tenants occupying space in multiple Financial Core locations moved to new space in the South Core.
We also believe that the positive demand for RC class space will continue, as this type of space fits well with the DTU theme. Today’s younger, well-educated office workers have shown a preference for emerging technologies and being able to use them in buildings and locations which were once alternative and are today becoming mainstream. Downtown West and Liberty Village are two good examples in Toronto. With a shift to flexible, open-concept office layouts in buildings that are close to transit and other amenities, it is no surprise that the downtown and downtown fringe areas have accounted for the bulk of Toronto’s space demand over the last five years.
Strategic Office Investment Opportunities
This shift in the market presents an opportunity for mid-sized investors. LaSalle sees substantial opportunity in acquiring well-located, antiquated office stock and deploying strategic capital to significantly enhance the functionality and quality of these assets. This strategy is supported by the type of office demand currently in the market and LaSalle’s belief that the DTU theme will continue to play out over many years. This will create long-term demand for well-located and maintained office space in Toronto.
In recent years, Downtown Toronto, which historically has relied on the finance and professional services sectors to drive space demand, has had a number of technology sector tenants lease space in both new and existing buildings. Notable names include: Google, Twitter, LinkedIn and Amazon. The flight to quality exhibited by tenants presents opportunities for investors to acquire “core-plus” properties in various nodes within the Downtown Toronto market. Not all properties will respond to the DTU themes equally. Aging office properties will be negatively impacted relative to newer buildings unless they are renovated and modernized to meet current tenant requirements.
From an investment perspective, LaSalle believes investors can treat this threat as an opportunity to reposition older buildings properly to meet the demand that exists. Location coupled with a strategic deployment of capital aimed at enhancing an asset’s performance – including a strong focus on sustainability elements – are key to the successful execution of such a strategy. If executed properly, such a strategy should produce risk-adjusted returns that outperform the relevant benchmark.
Sam Barbieri is the Senior Vice President, Asset Management with LaSalle Investment Management. He can be reached at Sam.Barbieri@lasalle.com.