The Decibel - A glut of office space in a hybrid work world

Episode Date: December 1, 2022

The office vacancy rates in two of Canada’s biggest cities – Toronto and Vancouver – have more than doubled since before the pandemic.The Globe’s real estate reporter, Rachelle Younglai, explains what is driving that trend and which companies are feeling the strain of managing physical offices in a world of hybrid work.Questions? Comments? Ideas? Email us at [e-mail]

Hi, I'm Mainika Raman-Wilms, and you're listening to The Decibel. The return to the office hasn't exactly been a smooth journey for some companies. And as a result, a lot of offices in those shining towers in Canadian downtowns are sitting empty. The Globe's real estate reporter, Rachel Young-Lai, is here to explain who's feeling the strain now that hybrid work has become the new normal. This is The Decibel from The Globe and Mail. Rachel, thank you so much for being here today. Thanks for having me.

So let's just start by putting this office vacancy rate into some context here. In big Canadian cities, how does it compare to pre-pandemic levels in terms of empty offices? Well, in Toronto, we're at 15%. In Vancouver, we're at 11.5%. And in 2019, they were both below 5%. And if we go back and we compare it to previous downturns, I mean, they're higher than the Great Recession, which was in 2009. And it's even higher than after the dot-com bubble burst in the early 2000s. Okay, so this is significant, though.

Of course, these vacant spaces are owned by companies. So can you just give me some examples of what type of companies are affected by this? Yeah, some of the companies that are trying to give up space right now are financial services companies like CIBC, accounting companies like PricewaterhouseCoopers, and of course, tech companies. And they range from names that you would probably know, like plenty of fish, to other ones that are less well known, like diligent and intellects. Okay, okay. So let's unpack this a little bit. Obviously, if there's an increase in vacancies, we've got a supply and demand issue here. There's too much space for companies, and not enough people in them, frankly. There's also a lot of cranes in the sky, at least in Toronto, there's there's new building happening here. So what's happening on the supply side of the equation?

Well, for a while, I would say the Toronto and Vancouver office markets were undersupplied in terms of office buildings. And that led a lot of new developments, new office buildings to be developed and built. And we always knew that these buildings would start opening in 2019, 2020, and over the past two years. And so what we've seen is all these buildings are finished, they're completed, and they're opening and their spaces open. And now these new tenants are moving into these spaces, and those tenants are leaving their old spaces behind. So in terms of supply, we're seeing a lot of supply come onto the market. Okay, so they're trying to move into new spaces and then,

I guess, sublet or sell the other space? Sublet, exactly. Sublet their old space, yes. And can you give me an example? I think the CIBC example is an interesting one here. Can you tell me what's going on with that? Yeah, so CIBC is one of the major lenders in Canada. And they are moving into a large new office tower in downtown. And it's called CIBC Square. And it's basically two 50 story towers. And that equals to about 3 million square feet, which is a lot considering that Toronto is about the Toronto office space is about 3 million square feet, which is a lot considering that Toronto is about, the Toronto office space is about 80 million square feet. So 3 million is quite a lot to add. So CIBC is moving their employees into CIBC Square.

And at the same time, they need to get rid of their old space, the space that they're currently in. Right now, I think they're trying to get rid of over 400,000 square feet in five different buildings in downtown. I guess I wonder, like, why not just break the lease? They can't break the lease without paying a huge penalty. So yeah. And these are not like when I think of like a rental lease, that's like a year or two. It sounds like these are these are different. Yes, yes, yes, yes, you're exactly right. They're multi year leases. They're not one year leases, they can be, you know, upwards of 10 years. Okay. One of the big factors here, of course, is that there aren't employees to fill these spaces because everyone's used to hybrid work now. We're not actually used to coming into the office all

the time. So how is that playing into all of this? Well, what's interesting is that a lot of companies did not really deal with the return to the office until 2022. Because as you remember, in 2020, there were the lockdowns and requirements to stay at home. And then 2021, the return to the office was constantly being pushed out because of the new waves of COVID. And this year is the first year where companies have been able to say, okay, everyone is back in the office. This one company, we saw them go through this cycle where in 2020, this company is called Intellex, they tried to give up all their space, not all the space, but a lot of their space in 2020, they put it on the sublet market. And then in 2021, they said, no, we want

the space back because our employees want to come back to the office. And then this year, they put their space back up on the sublet market. And when I spoke to them, they said, well, remote work has been here for two years and our employees, they've changed the way they work. So now they're giving their space back up. So really, companies are just figuring out how they're going to use their office space right now. This is the first year that they've really been able to see how their employees are reacting. Okay. Okay. So we're seeing some companies kind of cut down on the

space. Are there some companies though, that are getting rid of their space altogether, because they're not going to have people in the office? So no company has told me that they're getting rid of all of their space. But a lot of companies are trying to get rid of a lot of their space. And I'll just give you an example with Price Waterhouse Cooper, as I mentioned them earlier. It's an accounting firm, and their Canadian head office is in downtown Toronto. And in the first year of the pandemic, they got rid of two floors. And since then, they're trying to get rid of even more space because so much of their workforce is remote, and they just don't need it. That's one example.

Okay, yeah. And we know after, you know, being in this pandemic hybrid work environment for a while, employees tend to like the flexibility of this. But companies do tend to want their employees back in the office. I guess, why haven't we seen a fuller return to work for a lot of companies that we're talking about here? A lot of office workers are saying, if I can't have flexibility and I can't work some of the days remotely, I'm going to quit and I'll find a job somewhere else. And because the labor market has been so tight and because it's been relatively easy to find another job, or there are fewer opportunities for them to find another job. They may be forced to go back into the office full time if their employer requires them to be back in the office full time. But we're not seeing that yet.

Okay, interesting. So at this point in time, it seems like, I guess, employees do have the upper hand in a way because there's that demand for their work. Yes, yes, yes, yes. Some of the companies that are facing this as well are tech companies. And, in fact, there have been significant layoffs at some of the really big ones like, you know, Meta, Twitter, Amazon. We're hearing about this in this part of the year now. How has the tech crunch that we've been seeing lately playing into all of this? So we're not seeing the large companies give up office space yet in Canada.

We're seeing the smaller companies give up space. So Plenty of Fish, for example, or Kabam, it's an online gaming developer. They're trying to give up space. A smaller company like Finance IT, which is in downtown Toronto, they're trying to give up space. It's starting to affect the smaller companies, so smaller companies that rely on venture capital funding. So some of that funding has dried up. And so because they're not getting as much capital or getting as much funding, and because their workforce has largely told them we want to work at home, they're the first ones to give up space. And we saw that also at the beginning of the pandemic in 2020. It was a lot of the smaller companies, the small cap companies that were giving up space first. So that's what we're seeing right now. But we're not really seeing it with the larger companies. And I guess is that just because it hasn't got to that extreme level yet? Like if this trend continues, might we see it with bigger companies? Yeah, we might see it with bigger companies. Yeah, we might. We do know that some of the

larger companies have been looking for more space in Toronto, and they have kind of put that on hold. And in 2021, we saw some US tech companies were looking for space in Toronto. They too have put their searches on hold or on pause while they're trying to figure out what's going on with the economy. So yeah, we just we haven't seen the larger companies like MetaCutSpace yet. We'll be back in a minute. Okay, so we've got kind of an interesting situation here where companies are trying to juggle maybe subletting old spaces. New buildings are happening. They're moving into new buildings. They've got a lot of space to deal with here.

Employees that don't necessarily want to be back in the office. So there's a few different things that are happening here. I guess out of all of this, who is really feeling the pinch here? Who's, I guess, in a difficult place? Well, it's not the landlords, not yet, because tenants are still paying the rent. And so I would say it was the smaller companies. If they are seeing problems with their revenue then and they are not able to sublet their space, they might be facing difficulties. But the other businesses that are really affected by this slowdown in workers coming back to the downtown core are the small businesses that service office workers.

So if you think about the dry cleaner or the shop that sells, I don't know, running shoes, they're all being affected because they're not seeing the same volume of workers pass by their shops on a regular basis. So I don't think it's the more established restaurants in the downtown core that are feeling it as much as the smaller retailers, because a lot of people decide or a lot of workers when they come to the downtown core they want to make a day of it and they come to the office and they also schedule you know a lunch with a contact or they schedule a dinner or a drink or or some some entertainment with with a client and so that has not i don't think i don't think the restaurants are feeling it as much as the smaller businesses actually that's an interesting detail then because when people are coming into the office,

it's a bit maybe more of a social day in a way then. So they're actually still supporting the restaurants at least on that side. Yes, exactly. Okay, so then what's happening in terms of rents? Are new tenants scoring really great deals here or what? We haven't seen a drop in the rental rates in Toronto or Vancouver. And that's because even though the vacancy rate is up, there's still competition for places and there isn't pressure on landlords to drop the rental rates yet. All right. So, Rachel, we've gone through

a whole bunch of different factors that have caused this uptick in more empty offices in the downtown core of big cities. And I want to ask you about interest rates because this is something we've been hearing a lot this year about how different things are affected by interest rates. They've climbed from 0.25 percent to 3.7 percent just this year. So really significant increase here. And interest rate hikes always have a ripple effect on real estate. So how do they factor in here? It's harder for businesses to borrow right now. It's more expensive for them to borrow.

And because it's more expensive for them to borrow, they will spend less and invest less. And they may have to cut back on some of their expenses. And one way to do that is to maybe cut down on their real estate that they're using. So that's one way. The other way that interest rates are affecting commercial real estate is on the investment side. So investors who buy large buildings, most of them use debt and borrow to buy a building. And so we're seeing less investment. So I'm going to go back to the vacancy rates that we talked about off the top here in Toronto and Vancouver specifically. Vacancy rates above 10%, 15%, that seems significant, as we said.

But at what point do these vacancy rates, I guess, become a cause for concern for commercial real estate experts? When do they start to worry about that rate? So Calgary would be the prime example. As you know, there was a lot of building, of new office buildings in Calgary during 2013. And when the commodity prices crashed, including oil prices, a lot of energy companies scaled back.

And so now we have a lot of, we have a situation where there are a lot of office buildings in Calgary that are a third, a third of the offices, office building is vacant. And it's been like that for a while. And I guess what happens at that point? Like people who own these spaces, what do they do? So they have tried, I mean, they've had to cut the rental rates, they cut the rental rates, They try to attract tenants with other benefits. But it's been dragging on for a few years now. And so there's a lot of talk about trying to turn those office buildings into residential. There's talk about demolishing

some of the buildings, not the brand new ones, but the older ones. So there are a lot of options in the air right now. Okay, interesting. So Calgary is talking about using old towers as new residential units because its vacancy rate is up around 30% and has been for so long now. I'm wondering, would that be possible in other cities too, like in Toronto and Vancouver, if vacancies remain so high over time? That would be a nice idea, I suppose. But it's not very easy to do that because office buildings are not set up to be residential. If you think about an office building, there's a large amount of space where there's only two or three bathrooms for that entire floor. So if you imagine turning that office space into 10 apartments or 10 condo units,

every single condo unit would need a bathroom. And so you'd have to change the infrastructure of that building. So it would be quite hard. From all the reporting that you've done and the experts that you've been talking to as well, where do we think the commercial office real estate market is going to be in the near term future, especially when we're looking at the big cities like Toronto and Vancouver? It really depends on what happens with the economy and how much the rise in interest rates will slow the economy. And so if we see a lot of companies cut back on space,

we could be living with high vacancy rates for a while. I would say one thing about the Toronto office and Vancouver office market is that a lot of the buildings are owned by pension funds and very well-capitalized companies who are able to withstand downturns. And so even if there is a higher than normal vacancy rate, like we're seeing right now, a lot of them can hold their buildings and wait until the recession,

until we go through a recession or a downturn. Rachel, thank you so much for taking the time to speak with me today. Thank you. That's it for today. I'm Mainika Raman-Wilms. Our producers are Madeline White, Cheryl Sutherland, and Rachel Levy-McLaughlin. David Crosby edits the show. Kasia Mihailovic is our senior producer, and Angela Pichenza is our executive editor. Thanks so much for listening, and I'll talk to you tomorrow.