The negative sentiment surrounding office space is over-exaggerated, driven by media narratives that focus on extreme cases in primary markets rather than the broader fundamentals and the future outlook of the sector.
We've seen similar scenarios before—like with Airbnb, which was thought to completely replace traditional hotels. Yet, quality hotels in prime locations continue to thrive. The same is true for well-located office real estate. While demand may decrease for lower-quality spaces, well-located and affordable office buildings remain attractive to tenants.
Many large companies are reversing their work-from-home policies, recognizing that in-person collaboration is crucial for productivity, innovation, mentoring new staff, and maintaining company culture. These companies are bringing employees back to the office, signaling a strong belief in the enduring value of physical office spaces.
Office real estate isn’t obsolete; it’s evolving. The key is to focus on quality properties in prime locations—assets that will continue to be in demand. As populations and businesses grow, so does the need for office space. However, we’re witnessing a shrinking supply of office buildings, with many being demolished or converted into residential units, and very few new developments coming online. We've reached a tipping point where the costs to build new office structures are so high that new construction is an uneconomical decision given the market rents achievable in existing buildings. This further restricts future supply growth.
This creates a perfect storm—existing inventory is shrinking, demand is rising, and new supply remains flat. While others retreat from the office sector, we see an opportunity to secure valuable properties at favorable prices, attract strong tenants, and benefit from rising rents and stable cash flows. Investing in office space now is a strategic move that may offer stability, and growth potential.
On the other hand, the risks associated with residential real estate are largely political. Issues like rent caps, rent moratoriums, and the negative sentiment vilifying residential landlords are being used by politicians to secure votes. In contrast, the commercial real estate sector operates on business-driven, less emotional transitions between tenants and landlords, effectively sidestepping the politically motivated challenges and risks in residential.
Commercial real estate could offer more stable and predictable cash flow due to long-term leases and significant tenant improvements, resulting in lower turnover rates and potentially less volatile cash flows compared to residential properties.
Moreover, residential real estate is currently the hot topic in Canada. Many investors, including those with little to no experience, are rushing into the development space, often relying on the MLI Select loan program to get projects and loans approved. We see this as highly risky, the achilles heel of the strategy as the business model depends on a single lender—CMHC, the government—who can change requirements at any time, just as they did during COVID by preventing equity take-outs on refinancings.
Additionally, we expect a significant increase in residential supply to hit the market over the coming years. While vacancy rates are currently at record lows, signaling an undersupply, we believe that the residential market is priced to perfection and therefore is not aligned with the direction of the cycle we prefer to enter—especially when returns are projected based on the speculation of future values and construction costs, which are beyond our control.
It's no secret that office space is currently a contrarian investment in real estate, but for the reasons mentioned, we’re bullish on the long-term potential of well-located, stabilized office properties purchased well below their replacement cost, which offer strong, in-place cash flow.
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