Will We Continue to See Donut Cities?

All real estate indicators are positive, reports DBRS Morningstar, except for city center office and retail spaces. 

Yan Barcelo 29 September, 2021 | 1:50AM
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Canadian real estate has been on a tear recently. But not all real estate. DBRS Morningstar recently released a report titled ‘Canada's Real Estate Financial Risk: A Post-Pandemic Rebound’ that noted that city center office space, and retail spaces continue to be laggards.

“From an overall credit risk perspective, we expect our rated portfolio of Canadian real estate issuers to rebound from the coronavirus pandemic. We anticipate year-over-year EBITDA growth to be 3.7% in 2021 and 5.8% in 2022, compared with a 7.6% decline in EBITDA in 2020 versus 2019… Our 2022 yearly growth expectation is the highest since 2019,” the report said. By the end of 2021, growth should have overtaken the levels of 2019 and erased all losses since the onset of the pandemic.

There are two persistent weaknesses in this positive outlook: office and retail real estate. Concerning the office segment, it “is likely to continue to have higher-than-historic vacancies, continues the report. However (…), with the eventual return to in-person work and many DBRS Morningstar-rated issuer’s central business district assets supported by long-term leases to high-quality tenants, DBRS Morningstar expects some EBITDA improvements in the second half of 2021.” For retail, DBRS Morningstar “expects a longer and drawn out recovery, which will keep EBITDA below pre-pandemic levels through to 2022.”

Continuing to Work from Home?

How city centres fare hinges to a large extent on how the work-from-home (WFH) issue unfolds: how will employers accommodate workers with flexible work arrangements and how many workers will indeed return to the office?

A Stanford University research group headed by economics professor Nicholas Bloom, believes that WFH is here to stay and will definitely impact downtowns, increasing the “donut” effect – cities where the centre, or core, is hollow, or empty. “The home office isn’t about to shut down, Bloom states. In my research and discussions with hundreds of managers across different industries, I’m finding that about 70% of firms — from tiny companies to massive multinationals like Apple, Google, Citi and HSBC — plan to implement some form of hybrid working arrangements so their employees can divide their time between collaborating with colleagues on site and working from home.”

This is having an effect on city downtowns, which in the U.S. have lost about 15% of people and businesses while the suburbs of the same large cities are thriving, reports Jose Maria Barrero, assistant professor of finance at the Instituto Tecnológico Autónomo de México, who collaborates on Bloom’s research. Though the team has not conducted formal interviews in Canada, Barrero believes that U.S. numbers apply to major Canadian cities.

Barrero recognizes that REITs don’t necessarily show this erosion. “There haven’t been many lease cancellations in office rentals,” he acknowledges. But that doesn’t change the underlying current: “My guess is that this will be a fairly drawn out affair,” he notes. It could also be drawn out even more and intensified by the covid delta variant. That could prolong employees’ home office confinement even longer and further entrench the WFH aficionados.

Temporarily Returning

Joshua Varghese, co-founder of Axia Real Assets, in Toronto, agrees… in the short term. “If COVID goes away, I can see a bunch of people excited to go back to the office.” But that will not be the new norm. In the longer term, “reality will take hold and people will see how much they value the flexibility of working from home: for example, no commuting and having the kids around.”

The loss for offices shows in the gain for “peripheral residence”, which the exploding prices of housing illustrate. “I’m very bullish on secondary and even tertiary markets, those which are about an hour’s drive from downtown,” Varghese points out.

Downtown office real estate certainly won’t collapse, but it will need to adjust to the new reality and strive to become more “inspiring”, as Varghese characterizes it. “You will see a preparation of high quality platforms, he says, while the marginal landlord who hasn’t devised an attractive environment for employees will lose out.” Allied Properties (AP.UN) and Dream Office (D.UN) are two REITs already moving in that direction, the first by designing “cool spaces”, the second by “reducing its commodity office stock and concentrating on forward-thinking office projects,” notes Varghese. However, both are still quite below their pre-COVID highs by 25% to 35%.

As for downtown retail real estate, “I’m not sure I would say the same,” Varghese states. Here, the challenge is not only WFH, but even more the transfer to ecommerce, prompting even more store closures. A player like “First Capital Realty (FCR.UN) has well located stuff with convenient locations, comments Varghese. If there is pain in retail, (First Capital) should be better insulated.” That stock’s price is 20% below its pre-COVID high.


These sectors are driven by a fundamental shift in real estate that Varghese calls “decentralization”: “As we continue to be able to do most things from almost anywhere, the question arises, what type of physical space will we find valuable?”

Varghese recalls that in 2011, the top five companies in the MSCI US REIT index were what he calls “centralization-enablers”, with properties that bring people together: malls, offices, multi-residential. Today, four of the top five companies are “decentralization-enablers”, where the more they allow people to carry out decentralized functions, the more valuable they are: industrial, data centres, self-storage.

Notwithstanding the longer term trends, downtown real estate is still suffering and some REIT prices show it. Is it time to buy while prices are weak? Christopher Tsichlas, vice-president, real estate – global corporate at DBRS Morningstar, agrees that it may take time before the dust settles, but he’s still upbeat about downtown real estate. “Barring any major resurgence of the pandemic, we expect cities to bounce back, he says. He gives the example of quality multi-family properties close to downtown Toronto and elsewhere in North America that have significantly suffered during the pandemic. “Now, in New York, Miami and other places, early indicators show that people are coming back en masse to these buildings.”

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About Author

Yan Barcelo  is a veteran financial and economic journalist with more than 30 years of experience, Yan writes for many publications in Toronto and in Montreal, including CPA MagazineLes Affaires and Commerce.

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