CRE and Covid-19: lessons from previous corrections

This is the third installment of a three-part examination of the effect of the Covid-19 correction leading to a bear market as it affects the commercial real estate market.

The first installment dealt with seven ways the Covid-19 correction is the same as other corrections. The second installment dealt with how Covid-19 is different than the other corrections. This last installment looks at seven lessons learned from previous corrections causing bear markets that help those in commercial real estate markets to suffer less on the inevitable road to recovery and expansion.

1. There is only so much rent tenants will pay

In times of an oversupply of office space or retail space or industrial space, the new market ceiling is total gross rent. That number can get applied to every market across the country. In the 1992-1995 real estate recession in Canada, the magic rent number for office space was $20 per square foot gross. The tenant had no concern about whether it was basic rent or operating costs or taxes or where the building is located, it was only going to pay $20 per square foot gross per annum.

What made inter-market comparisons difficult and perhaps misleading then was that what was a $0.00 per square foot per annum net effective rent in Toronto was a $6.00 net effective rent deal in Ottawa for exactly the same deal as far as the tenant was concerned, but only because operating costs and taxes were close to $20 per square foot per annum in Toronto and $14.00 per square foot per annum in Ottawa.

Take care to use the market metric that drove the transaction and did not just emerge from the transaction. You can always calculate a cap rate, but that does not mean is was a cap-rate buy.

2. The late stage expansion period leaves some industry segments with way too much space

Examples of late stage expansion ending up with prolonged pain in the commercial real estate leasing markets include: the energy segment for Calgary in the mid to late 2010s; the tech segment for Ottawa in the tech wreck of 2000-2002; the financial segment in London and New York after the Lehman correction of 2008-2009; and the GTA industrial segment after the 1992-1995 real estate recession as the new norm for clear heights was 24 feet as opposed to 18 feet.

Tougher economic times deflate tenant demand for accommodations and that makes for tougher leasing markets. Tougher leasing markets mean every opportunity to lease space to any firm be chased aggressively. The silent killer is the cost of vacant carry, and that cost does not seem to make it into the explicit calculation of any deal analysis. The status quo is not cost neutral.

3. The leasing market can be opaque and mask what is really happening

There is a submarket here in Ottawa most identified with the tech wreck. Kanata went from being a suburban office submarket of about 2 million square feet in 1995 to about 6 million square feet by 2001. Nortel did ½ of its research and development worldwide close to this submarket, and that was US$ 2 billion annually just in Ottawa back then. Demand for new space was driven by tech companies, all of whom compensated for anticipated firm expansion over time by committing to leases that allowed for that expansion. When the tech wreck started, there was way too much office space available.

Here is how the office market became opaque here. At the time I worked in a brokerage office that was very active in the Kanata submarket completing subleases for brand new attractive and inexpensive office space on behalf of tech companies. The weird part is the availability (as opposed to vacancy in direct space) rate did not decline despite all my colleagues completing this leasing activity. The availability rate stayed stubbornly in the 20%-25% range for 12-15 odd quarters. What gives – lots of activity and no change tot the availability rate?

We dug deeper to find that the sublet space market was subject to a controlled release of new availability by the firms looking to off-load space. Every quarter as sublet space was taken off the market others brough sublet space to the market to capture the next wave of firms looking to secure space.

Eventually the availability rate in Kanata began to drop dramatically by about 2006. What happened was that rather than having an increase in leasing activity to drive the availability rate lower, it was that the inventory of sublet space that could come to market dried up. This submarket had been experiencing 300,000 – 400,000 square feet of absorption since the start of the tech wreck, it just got masked in the net absorption calculation.

3a Now you find out if you really are a tech market

The struggle in my office was for the guys working on behalf of the tech firms with too much space post tech wreck was their clients wanted reports on the progress being made in unloading that surplus space. My colleagues were sometimes embarrassed to report as little activity as they did. To their surprise, the Ottawa report was the one the firm was most interested in, as it was about the only market with any activity for any of their surplus leases in North America.

You find out a market’s street cred for talent with tech firms when times are bad.

4. Get ready for the flight to quality

The market expects this will be hard on every business. There will be less revenue, and that means cutting costs, and some of the costs to be cut are for the real estate they occupy. As reduced tenant demand and increased business bankruptcies and restructurings affect the leasing markets, the really good product becomes less expensive. That allows some firms to look at improving their premises by relocating to buildings they previously could not afford. The lower quality buildings in less desirable locations eventually suffer the most.

The same happens for property for sale. There will be very good assets that were previously never being sold that will come to market. There will be great assets to buy for those willing to “catch a falling knife” and upgrading their portfolio for the next decade.

If you are leasing space at the lower end of the quality and desirability scale, get ahead of flight to quality temptations.

5. Those guys with no financing can do really cheap lease deals

In the commercial real estate recession of 1992-1995 most of the affected properties had mortgages. By the time of the tech wreck of 2000-2002 there were more institutional investors. There was a meaningful difference in how owners with mortgages could compete with institutional investors for any leasing activity.

The constraint for the owners with mortgage financing is they had to secure lease terms that more than paid the necessary debt coverage ratio for their loan. The constraint for the institutional owners was to generate a minimum sufficient cash flow return from the lease, and that amount could be far less than the owner with mortgage financing could accept.

The institutional owner had the luxury of living with sub-optimal cash returns until the recovery took hold and then they could increase the rents. The owner with the mortgage could not. It can be very difficult to compete with institutional ownership when times are challenging, and they want to land that particular tenant.

A corollary is that institutional owners are far more motivated to secure credit tenants. It will be painful for private investors to retain those firms who best survive challenging economic times if the institutions set their sights on securing that tenancy.

6. Boy, why does price discovery mean pricing gets worse and worse?

As far as owners are concerned, yes, the bid does get worse and worse until it doesn’t. The “discovery” part for the owner is that usually by the time the bid is prepared to live with the ask it would unacceptable previously, it “discovers” the ask is worse.

Part of the change is that there are fewer buyers prepared to invest now. The diffusion of innovation helps illustrate what is going on, as it is a good proxy for the approach of the investment cohort.

The investment market used to have early majority, late majority and laggards in the mix. There will be no laggards and late majority investors again until the recovery is fully underway. The only investors for sure now are the innovators and the early adopters. It is still too early for the early majority. All the buyers who are late majority or laggards are waiting for some transaction to clear the market. We are down to perhaps 16% – 34% of the investor universe who will be active in the correction and the trough.

The other part is technical. With less inexpensive debt both in terms of quantum and interest rate, there is more of that increasingly expensive equity in every deal, and that alone would have the same net operating income capitalized at a higher rate. Add in an additional risk premium because the market is not sure how and when this will land, and that adds to less attractive pricing for owners.

Now, add in a return of the quality premium. The pricing for “best in class” assets is likely the same or maybe even better for owners as all investors look for the security of the assured income those assets can provide. It will be harder to attract buyers for not best in class property, and that additional return expectation makes the ask worse for the owner.

7. Debt is the thing that trips up the deal

Debt is the thing that trips up many owners and deals.

In the 2008/2009 Lehman correction to bear market event, there were two instances in which debt unavailability tripped up the borrower.

In the first instance, a developer was looking to secure take-out financing in order to secure the construction financing for its proposed development. What transpired was a forward buy of the development and not take-out financing. The developer had such little interest in providing take-out financing that this was the only way to get the project completed.

In the second instance, a Canadian pension fund looked to secure debt for a prime office building at the start of 2009. It had one bid from a lender. By the end of the year when it went to get debt for a similar building it got 8 bids. The pricing for the debt at the end of the year was 300 basis points cheaper.

In the commercial real estate recession in 1992-1995 owners got tripped up on loan expiries. The problem was that the lender wanted a principal pay-down in order to do a renewal. The property no longer qualified for the quantum of the outstanding principal. Lenders were being more conservative on all its property valuation criteria as the value of the property had declined since the origination of the loan, and both loan-to-value and debt coverage reduced the principal of the loan being offered. The issue that tripped them up was not that they were not current in their mortgage payments, it was that the lender could not provide the same quantum of loan at renewal.


These are some of the lessons and observations and experienced lived through the past three commercial real estate corrections somewhat equivalent to the impact of Covid-19 I have experienced.

What about you? Care to share a war story or two to help those who have yet to experience terror and anger and eventually capitulation, and then all of sudden the recovery is full on?

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