An interview with Mark Rose, Chairman and CEO; and Jennifer Rosenak, Director of Market Intelligence, Avison Young
Jen Rosenak: Mark, you’ve seen several cycles in commercial real estate. How is this downturn different?
Mark Rose: While in some ways this cycle is familiar, I see a few complex factors leading us into unique conditions. From the dramatic change in liquidity, rising climate-driven pressures on the built environment, and evolving shifts in office utilization, we are in an extraordinary confluence of events. Yet the long-term fundamentals of the commercial real estate industry are neutral to positive, and there is a rising awareness that our enduring pursuit of vibrant cities, thriving workplaces, and innovative work is moving us into an era of new opportunity and strategic optimism.
You mentioned the impact of liquidity on financial institutions and the real estate sector. Is this different from past cycles?
Since the hyperinflation era of the 1970s, prices have remained relatively low and stable in most Western economies due to central bank policies working in conjunction with various broader factors, such as the globalization of trade and capital markets. These factors have resulted in the long-term downward trend in interest rates and government bond yields – the benchmark for the cost of debt and the pricing of almost every investment asset, including real estate.
30 years of inflation
Following the Financial Crisis of 2007-9, central banks around the world lowered interest rates to zero and flooded the capital markets with liquidity through quantitative easing (QE), creating an environment of easy real estate returns fuelled by cheap debt and falling cap rates. Great investors were made to look even better and riskier bets were supported by this accommodative policy, but as historic context shows, these unusual conditions would eventually end.
Let’s talk more about that. What was the trigger?
Further liquidity injected to stave off the impact of the Covid pandemic proved to be the trigger for an inevitable correction. As the global economy rebounded from its contraction during our months of lockdown, supply chain issues – coupled with tight labour markets and Russia’s invasion of Ukraine – caused a surge in inflation which has persisted longer than expected, in part sustained by rising wages. Inflation hit double digits in many countries, forcing central banks to raise interest rates sharply, and reverse QE via “quantitative tightening”, to prevent a return of the paralysing “stagflation” of the Seventies.
Inflation = Interest rates
Central banks have signalled that more rate hikes are likely. What will the impact be?
The era of pure financial engineering based on ultra-low interest rates is over. Or, in the simplest of terms, money has a price again. That means the price of every investment, from long-term government and corporate bonds upwards, will be reassessed—real estate included. How this impacts different markets, sectors, and individual assets will vary widely, but investors will demand an appropriate premium for investing in riskier assets like real estate.
Switching gears to climate and the built environment; we see regulations and occupier requirements putting pressure on assets to meet higher environmental standards. What does this mean for investors?
In many cases, we see that the current realities of rents, capital values, and retrofit costs mean the work required is not cost-effective. Funding, which is currently in short supply from the banks, is desperately needed and the public sector needs to step in to help. In the U.S., the Inflation Reduction Act provides welcome incentives for investment through grants and tax deductions, but this alone will not be enough. They provide the carrot, but the stick will come from the increasing price differential between upgraded “green” properties and discounted “brown” ones. This will cause inevitable pain for many existing owners, but there is a huge opportunity for those with the knowledge, skills, and capital to acquire and improve assets to reposition them for the future. Greater innovation in funding models will be required, but fundamental real estate skills will carry the day. The key, however, will be an appropriate adjustment in the pricing of challenged assets to provide sufficient incentive to make the necessary improvements.
Earlier you mentioned that real estate fundamentals are largely intact, but the office sector is undeniably beleaguered. To share some statistics, Central London’s 7.8% vacancy is the highest it’s been since 2009, the 53.2 million square feet of US leasing activity in Q2 was the lowest reported since at least 2000, and Canada’s vacancy continues to climb at 13.1%.
I think the pendulum will swing as we stop talking about the death of the office. From an occupancy standpoint, we are starting to see signs of optimism. In Canada, our data shows VECTOM office lease term lengths are on the rise from a historic low of 82 months in January 2022. We’re now closer to 85. In the US, the average lease length climbed to 82 months in January of this year compared to a low point of 76-month lease terms in July 2021. While still shorter than the pre-pandemic average of 90-100 months, it is a show of confidence from tenants in their commitment to office space. In fact, our recent interview with FastCompany highlights the rise in lease activity and reiterates favourable conditions for many tenants reinvigorating their workplace experience.
Hundreds of years of development in the way we work – and millions of years of human evolution – will not be turned on its head by one pandemic and the invention of video conferencing. Humans are social and at their most innovative and creative when they collaborate. Technology will aid that interaction when in-person contact isn’t essential or cost-effective, but it is not a complete substitute. It may take time, but office culture will eventually reassert itself. It will be different and less “9-to-5”, but an essential part of our working life, nevertheless. Safe, accessible, vibrant towns and cities are an amenity, and sustainable, well-located assets that support and enhance the workplace experience will thrive.
How do you envision this recovery phase? Any specific areas of interest?
Overall, the best positioned will be strategic investors who are innovative, experienced, and well-capitalized to focus on the opportunities created by fundamental realities.
This will certainly be true of distressed assets that can realize new value through repositioning, renovations, or adaptive reuse conversions.
For “green” assets, acting sooner rather than later offers the best opportunities for capitalising on the mismatch between supply and demand. Entry price will be key, so identifying exactly which assets are best placed for repositioning and being ready to act when market pricing fully adjusts – as it inevitably will – is critical. This will require confidence, patience, and decisive action, as well as continued reliance on the public sector for the success and funding of green retrofits and development.
Additionally, housing and the multifamily market remain critical drivers in most of our cities – including near-term priorities focused on affordability and supply.
Finally, the Industrial sector continues to be bolstered by overall GDP, population growth, increasing demand from the rise of AI, energy storage and renewable infrastructure, and the fast-approaching transition toward electric vehicles. Some of the biggest innovations shaping our way of life come with profound demands and dependencies as we continue to activate the built environment.
Sounds like we will still need some patience. Are you feeling positive?
Yes, we’ve seen this before. Cycles have troughs and peaks, and right now we are at our weakest at cyclical troughs. When all looks dire and narratives true or perceived fill our thoughts, the strong and strategic invest and capitalise. The interest rate cycle is close to peaking and the outlook is starting to become clearer. Frustration and confusion will begin to subside as we transition to a thriving recovery phase. Warren Buffet famously said that investors should be “fearful when others are greedy, and greedy when others are fearful.” For those with vision and the confidence to back themselves, we are approaching the point where peak uncertainty will transition into peak opportunity. The coming years will undoubtedly be challenging, but they will also be some of the most exciting and rewarding that we will ever see.