Office REITs face another tough year as work-from-home devastates market

But there may be opportunities for long-term investors.

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TORONTO – It’s expected to be another challenging year for office real estate investment trusts, but some money managers say there could be decent entry points into the sector for long-term investors.

“We’re in a ‘darkest before the dawn’ scenario heading into 2024 for office REITs; there’s no denying they’re cheap… but there are numerous hurdles facing office owners,” said Michael McNabb, managing director of Purpose Investments Inc. portfolio, via email.

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“I think a lot of investors forget that this was the most popular REIT asset class heading into 2020,” he said, when office vacancy rates were extremely tight and investors flocked to the sector for their monthly payments.

But after the pandemic, McNabb said he has noticed that pedestrian traffic on Toronto’s PATH system, a network of underground walkways in the city centre, remains very low on Mondays and Fridays in particular.

“The office is not dead, but I think it has changed.”

The COVID-induced work-from-home shift has devastated the office market, as many employers re-evaluated their office presence. Companies have also considered reducing their real estate holdings as a way to control expenses to help cope with the current weaker economy.

“It is likely that between 10 and 15 percent of demand has been permanently destroyed by (work from home) trends,” said Maria Benavente, vice president and real estate-focused portfolio manager at Dynamic Funds.

“We hope it continues to be a rich and poor market.”

A September report from Colliers Canada showed the national office vacancy rate rose to 14.1 per cent in the third quarter of last year, up from 13 per cent in the third quarter of 2022.

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According to the report, office vacancy rates have been rising for three and a half years and will likely continue to rise in the near term as remote work continues to prevail.

Meanwhile, average office rent approached a record $21.08 per square foot, driven primarily by the disposal of older office buildings and landlords negotiating concessions beyond lower rents, according to the report.

John Duda, president of real estate management services at Colliers Canada, said he expects a “slow increase” in office space absorption by the end of 2024, but does not “anticipate a radical change.”

Part of the problem is the disparity between what employers and workers want.

“What has prevented a more dramatic change in returning to the office has been the imbalance in the labor market,” Duda said in an interview.

“Employees have had a lot of power and that means they don’t just come in and say, ‘I’m not coming in.’ But that is beginning to change and we are noticing it particularly in the core areas (of the center); The occupancy level has increased significantly.”

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Units in Slate Office REIT, Allied Properties REIT, True North Commercial REIT and Dream Office REIT are down 62 to 85 percent since March 1, 2020.

Sentiment remains quite negative in the sector and it is difficult to time the recovery, Benavente said, noting how Calgary’s office market was still struggling to recover from the 2014 oil price collapse, even before the pandemic.

“Office is a value investment; value requires patience and tolerance for volatility,” he said.

“We think there is some value; However, investors should be selective and focus on balance sheet, liquidity and dividend coverage. “We saw many office REITs forced to cut their dividends, sometimes even twice.”

Slate Office REIT, for example, suspended its monthly distribution in mid-November to conserve cash. True North Commercial REIT cut its monthly payment early last year.

Office REITs will do well as the economy begins to recover and companies return to hiring mode, Benavente said. Banks must also be willing to lend more freely to office owners if activity is to recover in the sector.

McNabb said he is still very cautious about the sector and wants vacancy rates to improve. But he believes longer-term investors could start to “select” higher quality companies, which could prove to be a good investment over time.

“Commercial real estate follows the simple economic rule of supply and demand…and currently supply is outpacing demand by a very wide margin,” McNabb said.

This report by The Canadian Press was first published Jan. 3, 2024.

Companies in this story: (TSX:SOT-U, TSX:DU, TSX:AP-U, TSX:TNT-U)

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