Office vacancy crisis could open the door for more affordable housing
Office vacancy rates remain stubbornly high despite the push to get the employees back into offices, but this apparent trend could be an opportunity to convert surplus space into residential units to help speed up the need for much-sought-after affordable housing.
This opportunity has been in the works for a while. A report by the Urban Analytics Institute at Toronto Metropolitan University in May 2020 warned of the expected decline in the demand for office space and suggested that “commercial landlords may want to initiate contingency planning to see if commercial buildings can be partially or wholly transformed into different land uses, such as residential.”
Three years later, such voices are gaining traction as the demand for office space dries up. The office vacancy rate in Canada was 17.7 per cent in the first quarter of 2023, according to a recent CBRE report. For the past 12 straight quarters, more office space was added to the market than leased to tenants, resulting in a negative absorption rate.
Vacancy rates are even high in coveted downtown offices, and occupancy levels for tenanted spaces are much lower than pre-pandemic levels. But the CBRE report said uninspiring older buildings will struggle to attract tenants that would likely gravitate to “well-amenitized modern spaces.” Hence, buildings with inflexible floor plans, slow elevators and dated heating, ventilation and air-conditioning systems might experience even higher vacancy rates than the local average.
Financial markets are also showing signs of pain as office demand declines. The “prices of bonds backed by commercial mortgages have recently dropped to levels not seen since the early days of the pandemic,” according to the Wall Street Journal. Its story highlighted the resulting risk to banks, which hold 46 per cent of all commercial real estate debt in the United States.
Office real estate investment trusts (REITs) in Canada appear to be showing similar stress markers. Many of their unit prices tumbled at the onset of interest rate hikes, with some dipping even further in March 2023.
Are falling bond and REIT values indicative of even deeper troubles? Data maintained by the U.S. Federal Reserve’s board of governors show the delinquency rate for commercial real estate loans, excluding farmland but not restricted to office properties, was 0.68 per cent in the fourth quarter of 2022, which is significantly lower than the almost nine per cent recorded in the first quarter of 2010. Hence, pronouncements of an imminent debacle are likely exaggerated.
But the long-term outlook for office real estate is far from certain. Hybrid-work practices could further increase vacancy rates when leases renew in the next few years. Could this push vacancy rates in Toronto to 30 per cent or more, as is the case in Calgary? The answer depends upon the pace and size of the economic recovery and the increasing demographic footprint.
Rising interest rates have restricted access to capital, thus inflating risks for commercial real estate. But some believe these risks are manageable. For example, UBS Global Wealth Management recently said commercial real estate “exposure at banks is currently manageable with potential loss levels even in a hard landing scenario likely causing earning pressure rather than capital depletion.”
Perhaps one reason for that view is that vacant office buildings present a unique opportunity to address the housing affordability challenges in Canada that have resulted from an undersupply of housing over the past five decades. With one million more people added to the population in 2022, the odds of housing supplies catching up with demand are discouragingly low under the business-as-usual scenarios.
Some out-of-the-box thinking, namely repurposing a surplus asset into something in short supply, is what Canada must consider. Calgary is already leading the charge for office-to-residential conversions. The city reported a slight decline in office vacancy rates, but that’s not necessarily due to a higher demand for corporate space, but because offices are being converted to residential uses.
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For example, an 82-unit affordable housing building called Neoma now stands in downtown Calgary instead of an office building. HomeSpace, a charity that builds, maintains and manages affordable housing for vulnerable people, purchased the vacant office building for $4.7 million, and PCL Constructors Inc. renovated it for $30 million.
Avison Young (Canada) Inc., a commercial real estate firm, estimates that 30 per cent of the office buildings in Canada, representing roughly 3,000 office towers, can be converted to residential use. It warned, though, that conversions are not a straightforward process. The shape of the floor plate, the location and number of elevators, plumbing and other considerations can add to the cost.
“Never let a good crisis go to waste,” Winston Churchill quipped during the Second World War. The office vacancy crisis can open the door for more affordable housing, but it will require the public and private sectors to collaborate by leveraging their assets and resources.
Murtaza Haider is a professor of real estate management and director of the Urban Analytics Institute at Toronto Metropolitan University. Stephen Moranis is a real estate industry veteran. They can be reached at the Haider-Moranis Bulletin website, www.hmbulletin.com.
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