Get Ready for Lower Property Valuations Amid Higher Interest Rates … – CoStar Group

By Garry Marr
CoStar News

One of Canada’s big five banks expects higher interest rates, tighter lending conditions and a mild recession to depress rental revenue and lower property values across commercial real estate.
A report from Sal Guatieri, senior economist at the Bank of Montreal, noted even the once-red-hot industrial and multifamily markets had been impacted by falling valuations. Still, the apartment sector will have the benefit of strong population growth in Canada.
“These headwinds will translate into less lending and higher default rates, mostly in the beleaguered office market,” said the economist in a note.
Gautieri said the failure of a few U.S. regional banks would impact the commercial real estate market primarily through tighter lending conditions because smaller banks provide about 70% of total bank loans to the sector.
“Commercial property owners could have difficulty refinancing, as the Fed’s latest survey of loan officers found that lending conditions for this group have tightened further,” he said, noting U.S. property prices have fallen 15%, back to pre-pandemic levels, led by a 25% plunge in office values.
For Canada, the economist noted a moderate increase in capitalization rates suggests commercial real estate prices are also under pressure north of the border.
“The upturn spans all major segments, with offices leading. Cap rates, however, have risen less than interest rates, resulting in below-normal spreads between the two returns,” said Guatieri in his note.
“If interest rates stay high, further price declines will likely be required to attract investors.”
Real estate firm CBRE said last month that Canadian cap rates rose in the first quarter, but capital is expected to return later in the year as interest rates and financial systems stabilize.
South of the border, the economist noted the 0.7% delinquency rate on CRE loans from banks in the fourth quarter was only slightly above recent record lows.
“While this rate should return to the long-run median of 1.8% in a mild recession, even that would pale against the near 9% peak reached in the Great Recession,” said Guatieri, noting office delinquency rate was higher at 2.61%. “Lengthy leases are holding it down.”
The economist paints a dim picture of the office market and says it will remain the most depressed commercial real estate segment for some time.
“A mild recession will compel companies to reduce headcounts and space, aggravating the secular challenge arising from the adoption of hybrid work. Earlier rapid growth in the tech industry had buttressed landlords during the pandemic, but a recent wave of layoffs is causing a surge in subleasing,” said Guatieri.
He noted Toronto’s office occupancy rate was 47% of pre-pandemic levels as of April 15, according to the Strategic Regional Research Alliance. A U.S. 10-city average was 49%, compiled by Kastle System’s access-card swipes as of May 10, the BMO report said.
“Remote work could do to offices what e-commerce did to malls— make them far less essential to our daily lives. Still, the direction of office occupancy rates is unclear,” said the economist.
“Many workers, some of whom have seen their daily commutes shrink from three hours to three feet, prefer a hybrid option. But employers are more actively coaxing them back to in-person work, either with carrots (free food and gourmet coffee) or the stick (lower bonuses and fewer promotions). Unresolved is the impact of remote work on productivity.”


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