What can your commute tell you about investing in commercial real estate?

For many of us, the ability to work from home during the pandemic was one of the few positives to emerge from a time we’d rather forget. The flexibility of hybrid work served as a salve for weary workers at a time when it was needed most.

Some days it can seem like the office sector is getting back to normal, but the hybrid work environment has created big challenges for the commercial real estate sector and the investors who hold publicly listed Real Estate Investment Trusts (REITs) that own these buildings. McKinsey and Company, a consulting firm with a focus on long-term business strategy, published a report looking at nine cities in the U.S. and found that falling demand for commercial real estate could wipe out US$800 billion in value by 2030.¹ In Canada, CBRE, a global real estate investment company, found that Canada’s national downtown office vacancy rate hit a record high of 19.5% in the first quarter of 2024, nearly double the typical 10% rate.²

Meanwhile, an increasing number of Canadian companies are mandating a full or partial return to the office. Naturally, not everyone is thrilled: Productivity research by the Integrated Benefits Institute found that 47% of employees would either quit or start looking for a new job if their employer made them return to the office.³

While it is not yet clear how stay-at-home staff and return-to-office executives will establish a new equilibrium, some investors may sense opportunity in uncertainty: Corporate tenants who see half-empty offices consider retaining less space whey they renew their office lease, or they may relocate to a less expensive building.

To get a better sense of the outlook for commercial real estate, we spoke to Colin Lynch, Head of Alternative Investments at TD Asset Management. One thing he pointed out: If you want to figure out where the interesting opportunities may be, consider looking at how far people need to travel to get to work.

What does commuting have to do with investing in commercial real estate?

There’s some interesting research that shows that cities with shorter commutes have lower vacancy rates than cities with longer commutes. A recent report by commercial real estate company Colliers Canada found employees in the prairie cities of Saskatoon, Regina and Winnipeg spend an average of 35 hours per week (or about 4.5 days) in the office, with Calgary and Edmonton checking in at 31 and 28 hours, respectively.⁴ Larger, more congested cities with longer commutes, such as Toronto and Montreal, were at the opposite end of the spectrum, with 24 and 23 hours (or about 3 days a week), respectively. For every extra minute that was added to a commute, an employee would spend 12 fewer minutes in the workplace.

“Office sentiment, from a vacancy and leasing perspective, is much more optimistic in some of those smaller centres than the larger ones, such as Toronto, Ottawa or Montreal,” says Lynch. “In Vancouver, we still have a bit of hybrid, but there are a lot more people living amidst office towers who don’t have materially large commutes. We see a bit more of a return to the office there as well.”

So, you’re saying buy commercial real estate in Winnipeg?

Well, not exactly, but vacancy rates in different cities may be one metric to consider. You may also want to think about looking at portfolios that hold newer buildings with new amenities that are located near transit and are surrounded by places to shop and eat. Lynch points out that within Toronto, the area of Yonge and St. Clair has seen lower vacancy rates, in part because it’s in an affluent community with easy access to transit and a lot of new restaurants moving into the area.

Greener buildings are also in more demand, says Lynch. “Say you’re a tenant in a Class B space that’s a little older, not well connected to transit and not as great from an environmental, social and governance perspective,” he explains. “If you’ve got an opportunity to move into a brand-new building with great amenities that’s connected to a subway station — guess what? You’re going to do that.”

Why would I want to consider adding commercial real estate to my portfolio anyway?

Investing in commercial real estate, which many people do through REITs, gives you exposure to assets that tend to be less correlated to the broader stock market. That’s because stable, rent-paying tenants allow REITs to generate income, some of which  gets passed on to REIT unitholders through dividends.

What else can you tell me about REITs?

REITs are a common way for investors to get access to commercial real estate. Sure, if you have a lot of money, you could potentially buy a building yourself, but it’s a lot easier to purchase units of a REIT. While some REITs own a wide range of buildings across multiple asset types, others focus on specific areas of the market, like office, warehousing / industrial, apartments or retail.

“REITs are a liquid way for investors to access this type of asset class,” said Sam Damiani, an analyst with TD Securities, on a recent podcast. “Traditionally, income-producing real estate has been the purview of wealthy families or just pension funds, life insurance companies and the like. The REIT structure was basically created about 25, 30 years ago to enable public market investors to access that type of asset class in the same way that an institutional investor would. So, it’s a unique and attractive way for many investors [to get exposure to real estate].”

What are the risks?

Well, you’ve seen some of them unfold over the last few years. If some event causes people to suddenly stop going to the office, putting rental income at risk, then the REIT you hold might have to cut its dividend. Rising interest rates have also hurt the sector. Just like with your own home, mortgage costs on these buildings have increased, while sale prices have softened. These factors may contribute to REIT managers considering selling some properties at a loss, or at least not at the gain they had anticipated.

If interest rates start to fall, what could this mean for commercial real estate?

A decrease in interest rates could make commercial real estate a more attractive investment because borrowing costs would come down, but that all depends on the reason for the reduction. If rates fall because the economy is sputtering and people lose their jobs, then that could put even more pressure on the office space sector. But another school of thought, suggests Lynch, is that worries over the economy could elevate office occupancy as employees may want to show their faces during tumultuous times.

The best-case scenario is that rates come down without any major economic calamity. “Investors have many things they can choose to invest in — not just real estate,” Lynch says. “If rates are coming down, that almost makes the bar for competition for real estate lower. This means that well-performing offices that produce income and, therefore, cash flow, become more attractive to investors looking for yield.”

So, bottom line— what does this all mean?

It’s important for investors to remember that not all office space is created equal. “You have to find buildings with good fundamentals that are earning income. What is the leasing? What are the incentives?” Lynch continues, “When you have economic dislocation, those incentives grow larger and larger, which means that even though the top-line rent is constant, the actual rent the landlord is receiving is going down.”

Still, while the year ahead could be another challenging one for the commercial real estate sector, flattening construction costs, strong population growth and the possibility of lower interest rates might be reasons for cautious optimism. It appears hybrid work will continue to be the new norm, but employers aren’t about to abandon their efforts to get as many employees back into the office any time soon.