What surprised Ryan Henry, vice president, investment sales and leasing, RDH Group, Royal LePage Commercial about the pandemic is how quickly it reverberated in commercial real estate space.
Typically, real estate lags the broader changes in the economy by at least six months, not immediately. As we all witnessed, however, shutting down the economy put immediate pressure on all areas of real estate. Houses were pulled off the market, condos forbade showings and the retail sector boarded up. All but the retail sector, and now the office sector, rebounded enthusiastically. Investors, renters and landlords are left wondering – now what?
The new model of working – that is, not in the office – was heretical to almost any white-collar employer. Employees, frankly, weren’t trusted by their employers to be productive without their supervision. As many analysts have now concluded, however, we are actually just as or more productive working from home than in the office. Since the data now proves the work from home model can work, this trend, or a variation of it, is here to stay.
Most of my colleagues in the legal and finance sector are not returning to the office until 2021, if at all. We also all know about Apple, Shopify and Twitter’s proclamations about abandoning their leases. Such abandonment, however, was only recently evidenced in our market by the surge in subleases in the Toronto office core. They have tripled.
Scott Mulligan, real estate veteran and partner/broker of record of Ellington Partners, Corporate Real Estate Advisors, says vacancy rates in the Toronto core may reach up to the mid-teens. These vacancy rates will hover around the mid-teens notwithstanding that companies unaffected by COVID-19 will replace those that were. Having said that, today’s gloomy picture isn’t nearly as bad as in the ’90s when vacancy rates soared to almost 20 per cent and landlords, unlike today’s landlords, built towers on spec with no tenants or cashflow in sight. This isn’t Toronto’s first real estate rodeo and history dictates a rebound. The question is when and how much? Experts such as Anthony Scilipoti, president and CEO of the multi-award-winning think tank Veritas Research, believe the when is years and the how much is marginal. Scilipoti anticipates a more dramatic fall before the rise, especially with older buildings that are less appealing than newer tech-enabled ones. The fall, he anticipates, will come as government subsidies come to an end and the economy is no longer in what he calls “suspended animation”.
He says working from home was already in play as prescient leaders uncovered the benefits of transferring the costs of a lease from the business to the employee. COVID-19 simply acted as a steroid. This permanent shift will have a long lasting and devastating impact not only on the office sector, but also ancillary services such as restaurants.
Scilipoti’s concern is echoed by many. Restaurant after restaurant in the world’s largest underground path closed their doors for what could be forever.
While few are going back to work right now, Mulligan, citing various sources, believes this won’t last forever. He concludes that about 10 per cent of all businesses will likely convert to a 100-per-cent remote model. Another 20 per cent will work part-time remotely and part-time in the office. The remaining work force will return back to business as usual, thereby stimulating the resurgence of Toronto’s office and restaurant industry. Henry echoes this perspective. In fact, during the deepest throws of COVID-19, his clients in the services and tech space didn’t skip a beat. They signed leases and worked with designers to create a pandemic-friendly work environment.
Given that each back-to-work model still requires some in-person meetings and since square footage per person will likely go up to meet government-mandated health regulations, office space demand will rebound in 2021, say Henry and Mulligan. Regardless of when the rebound occurs and to what level, tenants will require a lot more flexibility in their leases, such as unencumbered permissions to license out space without landlord approval. Tenants will also want to be able to give back space or be able to reduce their rent payments if they find that their usage has gone down. Finally, tenants will want a more expansive force majeure clause that allows them to not pay rent should an event prevent them from operating.
In return, landlords will likely want to be released and indemnified by tenants should any outbreaks in their buildings occur, regardless of the reason for the outbreak. Both parties will also want to dig deeper into their insurance policies and clearly determine if they have coverage for their business for such hazards.
Many anticipate that the additional cleaning costs and increases in insurance costs may prevent more businesses from returning to the traditional office space. As such, tenants that proved viable during the pandemic may demand caps on operating cost as it relates to cleaning or paying for the landlord’s insurance or any future increase due to an outbreak.
The management of future pandemics will be especially troubling for enclosed shopping malls. Scilipoti anticipates that malls may be revitalized by reimagining the purpose of going to the mall: shopping will be an experience-driven event, not an event to buy new shoes. Rather than going to the mall to determine what you want to buy, shoppers will be entertained by their brands and experience the brand’s offerings and then buy the product at home. Canada Goose and Lululemon are two brands that have already done this in an exemplary fashion; Canada Goose puts you into a freezer to try out their cold-resistant jackets and Lululemon hosts a variety of health-related events such as yoga while displaying their latest yoga gear. Shoppers at Lululemon or Canada Goose may order custom clothes in-store, which is shipped at a later date. Alternatively, as most typically do, the shopper goes home and orders the product online.
If we are able to lure people back to malls to experience products and brands, but not purchase anything, a change in how landlords will collect rent is coming – namely per cent rent. This is typically calculated as a portion of a tenant’s in-store sales. As sales move online, however, landlords will likely demand that per cent rent takes a portion of the tenant’s online sales, as opposed to in-store sales. This, for obvious reasons, may be unfair as online sales may have nothing to do with the in-store experience. Per cent rents calculated on online sales may also eat into the retailer’s already thin margins, forcing them to fold or abandon malls altogether. Either way, retail tenants will have to pay extra attention to their per cent rent clauses and ensure that per cent rents aren’t unduly expansive.
In the midst of the chaos caused by COVID-19, Henry, Mulligan and Scilipoti all witnessed opportunities. Those in the office planning space experienced a boom in work requests. Construction, likewise, is in high demand as now defunct office and retail space is being repurposed for other uses such as storage. While industries that used to underpin the health of our office market, such as Canadian banks, are giving up their downtown offices, other previously unknown companies are swooping in.
For example, wealth management companies, government and tech companies are all expanding their footprints and making up a large portion of the shortfall in demand from banks. While we are likely entering an economic crunch, as anticipated by Scilipoti, Henry remains hopeful that Toronto will rebound at a much faster pace than other world economic hubs. He doesn’t look far to reach this conclusion. As a recent father and caregiver to his own father, he is “way more comfortable having (his) family here,” he says. So are many overseas investors who watched Canada’s comparatively positive handling of the pandemic. Investors, and Henry, also laud our healthcare system, stable government and both our diverse population and economy – all reasons for Toronto’s longstanding growth to continue.
Notwithstanding the slightly divergent perspectives of Scilipoti, Mulligan and Henry, all agree that COVID-19 has created permanent changes in how we live and work. I take this one step further and believe that COVID-19 has further changed what we deem as important in our leases.