Holding Its Own: Canadian industrial market outperforms

Compared to the U.S. industrial real estate market, Canada’s industrial real estate market looks quite strong. But as the global recession lingers, it is beginning to show signs of distress, and industry experts are worried that fundamentals will weaken.

“Canada has a very high export/import relationship with the U.S., and a drop-off in demand from the U.S. has a negative impact on things here,” says Doug Auchterlonie, CEO of ING Real Estate Canada, one of the country’s largest industrial real estate owners. “Likewise, we are heavily exposed to the auto sector, which also has a negative impact on the market.”

Canada’s gross domestic product (GDP) began contracting in October 2008, and since then, job losses have mounted. Earlier this year, the Bank of Canada acknowledged that the recession in Canada will be deeper than anticipated; in an effort to resuscitate the economy, it took unprecedented measures on April 21, 2009, and cut its Overnight Target Rate to 0.25 percent, which is effectively the lowest it can go.

The manufacturing, warehousing and logistics, and construction sectors have experienced the brunt of job losses, but contraction also is occurring in the financial, real estate, professional, scientific and technical services sectors as well. Employment growth is expected to stay negative until 2010; however, the economy is expected to return to positive GDP growth by late 2009.

Even with all these challenges, Canada’s economy has held up better than the U.S. economy, contends Kathy Lee, managing director of GE Capital Real Estate Canada. Its strength is rooted in the continuing stability of the Canadian banking industry, which has not suffered from the level of insolvency and bankruptcies seen in its southern neighbor.

Climbing vacancies

The strength of Canada’s financial sector has prevented the industrial real estate sector from experiencing dramatic decreases in occupancy, rental rates and property values, Auchterlonie says.

The countrywide vacancy rate continued to climb during the first quarter of 2009, increasing to 6.7 percent – 110 basis points higher than in the first quarter of 2008, according to CB Richard Ellis. The global brokerage firm says this jump is the result of fewer deals being done, large spaces coming on the market as companies cut costs, and 4.1 million square feet of new supply that was delivered to the market in the first quarter.

Vancouver, Edmonton and Toronto experienced the largest increases in availability (see chart below). Even so, these markets still reported vacancy rates between 5.5 percent and 6.1 percent. Some Canadian markets experienced decreased vacancies. London, for example, saw its vacancy rate decrease by 80 basis points to 11.5 percent, while Ottawa’s vacancy rate dropped a whopping 210 basis points to 6.1 percent.

“The occupancy slippage here in Canada has been less dramatic than the U.S.,” Auchterlonie says, adding that ING Canada’s industrial portfolio, which consists of 34 million square feet of space, is still more than 90 percent occupied.

Likewise, Lee says GE Capital Real Estate Canada’s industrial portfolio is 94 percent occupied. “It’s holding its own,” she adds, pointing out that the industrial market, while not as strong as the multifamily market, is “still in good shape.”

Yet, weak demand is obvious: Net absorption in the first quarter 2009 was negative 4.9 million square feet, according to CBRE. This represents the second consecutive quarter with negative absorption, which has not happened since the third quarter 2002.

Southern Ontario, which has been hard-hit by the downturn in the manufacturing and automotive-related sectors, experienced the brunt of the negative absorption during the first quarter, with the Waterloo Region recording negative 418,833 square feet. Likewise, Vancouver and Edmonton are suffering, with negative absorption during the first quarter 2009 of 1.2 million square feet and negative 646,541 square feet, respectively.

Meanwhile, Toronto, the third-largest industrial market in North America with about 800 million square feet of space, recorded negative 4.2 million square feet of absorption – the largest amount of negative absorption recorded since the third quarter of 1991, according to CBRE. The negative absorption was largely attributed to 1.5 million square feet of new supply, much of which remains vacant, and other large spaces that became available.

Some large leases were inked during the first quarter, according to CBRE. UPS Canada Ltd., for example, leased 216,122 square feet in Vaughan, Ontario, while Agility Logistics leased 145,000 square feet in the O.R.E. Business Park in London, Ontario.

But these deals are few and far between, says Fraser Plant, senior vice president of Jones Lang LaSalle. He contends that vacant space is languishing on the market for more than a year; previously, it was available for only four to six months before it leased.

“Landlords are not bullish,” Plant says. “There is a lot of sublease space because of right-sizing and consolidation.”

Decreasing rental rates

Their concern about the market is evident in the lack of speculative construction. Across the country, Canada’s industrial market added 4.1 million square feet of new supply during the first quarter 2009, down considerably from the 6.7 million square feet delivered on average in each quarter of 2008.

The amount of new supply this year is expected to be down considerably from the 26.7 million square feet delivered in 2008 due to the absence of speculative building and the abundance of available space.

Construction activity in the eastern markets has dropped significantly. Historically, Toronto has added 10 million to 12 million square feet of new space annually, Plant says. Today, there is little, if any, speculative space under construction, he notes.

According to CBRE, Toronto only had 2.8 million square feet of industrial space under construction during the first quarter 2009 compared to the 7.2 million square feet that was under construction in the first quarter 2008. The decline has been caused by the recession and the slumping manufacturing industry.

Conversely, Vancouver is experiencing near-record construction activity with 5.3 million square feet currently under construction. The majority of these projects commenced in the third and early fourth quarter of 2008 and are all expected to be completed by the end of 2009.

While this excess space has created a predictable result on rental rates, the economy also is putting pressure on rents. “Tenants are beginning to feel the stress of the economy, and we’re starting to see some of that stress in the NOI,” Lee says.

CBRE says Canada’s average net rental rate for industrial space was unchanged at $5.87 per square foot. However, six out of the 10 markets it tracks experienced rental declines. The western markets, which have the highest rents and until recently have had the lowest availability rates, had rents fall the most.

Calgary’s net rent fell $0.60 per square foot to $8.90 per square foot, while Vancouver was down $0.29 per square foot to $8.04 per square foot, and Edmonton remained unchanged at $9.40 per square foot.

Eastern market net rents have generally remained within a tight range and are not expected to fall very much; however, this may change if large amounts of sublet space come to the market or there are large bankruptcies.

In the east, Toronto’s net rent was unchanged at $5.22 per square foot, Montreal increased $0.08 per square foot to $5.34 per square foot, and the Waterloo Region decreased by $0.10 per square foot to $4.79 per square foot.

“The drops in rent are not sharp … they’re not plummeting to levels seen in the 1990s,” Auchterlonie says. “Our industrial markets are relatively sound.”

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