Canada’s Road To Recovery: What Lies Ahead

WRITTEN BY ZACH SCHENKER & GREG PEACOCK

After 14 months of lockdown restrictions and a crippling third wave, it definitely has not been the spring that Canadians were intending. Case counts and hospitalizations are at peak levels, and to many, the recovery prospects appear very bleak while we watch our neighbours to the south return to normalcy. With that being said, we believe there is strong reason for optimism as the math toward herd immunity in Canada is encouraging. The most recent modelling by Public Health Canada has showed that restrictions could be lifted when 75 per cent of adults have received their first doses and 20 per cent have received their second doses of vaccines.

This will require Canada to administer 80 doses per 100 people (approximately 30 million doses). As of May 2, Canada has administered just over 13 million doses. At our 7 day rolling average of 262,857 doses per day, it will take 64 days to reach this Public Health target. This is an extremely conservative estimate as U.S. Pfizer shipments are set to increase over the coming weeks alongside the rollout of the one dose Johnson & Johnson vaccine.

For Canadian CRE investors, the world and human behaviour has changed dramatically over the last 14 months. In the midst of such uncertainty, capital allocation is very challenging as it is unclear whether these changes to human behaviour are temporary or permanent. Fortunately, there is emerging data from other developed economies that are well ahead in the vaccine race, which can reduce uncertainty and provide capital allocators with some guidance.

Return to Office

The zoom revolution has resulted in prognostications regarding a major decline in metropolitan office space demand. The theory suggests that companies and employees have adapted to working from home without significant productivity impairments. This provides companies with cost savings and more flexibility for employees.

Since office restrictions tend to be the last in line when it comes to reopening, Israel, who leads the world in vaccinations with 121 doses per 100 people, is the most informative data point for examining return to office trends. Surveys in Israel’s largest city, Tel Aviv, demonstrate that office occupancy rates have risen to relatively high levels and local news outlets have reported that office parking garages “look about as full as ever”. Despite this, the larger tech employers such as Google and Microsoft appear to be operating differently. Google Israel employees have adopted their own practice of coming into the office at most one or two days a week and working at home the rest of the time. Office occupancy hovers around 30% on any given day as many workers are demanding they be allowed to continue working from home at least two days a week. Similarly, Microsoft Israel continues to use a hybrid model in a way that is adjusted personally to the needs of workers.

The conclusion from this information is that most organizations will eventually return to office. However, for those organizations that require extraordinary human capital (e.g. Google and Microsoft), work from home flexibility will likely be offered as a form of attracting and retaining top-end talent. We believe this is likely to create some softness in the Toronto, Waterloo, Ottawa, Montreal, and Vancouver office markets where tech concentration is high. These effects will manifest in the longer-term as companies cannot immediately exit existing leases. Luckily, Canada’s conservative financing when it comes to office developments has acted as a constraint on new supply, which is why we believe absorption and occupancy will only be mildly impacted by these trends.

Retail

It is fair to say that main street retail has been hit harder than anything over the course of the pandemic. Some have forecasted that COVID-19 has accelerated the retail apocalypse as brick-and-mortar shops continue to lose market share to Amazon and other e-commerce platforms. While there is no doubt that many Canadian consumers have migrated toward e-commerce channels during the pandemic, it remains unclear whether these are temporary or permanent behaviours.

 To answer this question, we analyzed footfall traffic data from the United Kingdom, a county with similar consumer spending that has administered 72.6 doses per 100 people. Footfall traffic is a useful indicator for examining consumer sentiment and retail vibrancy. On April 12th, footfall across all destinations in the United Kingdom was up by 516% year-on-year, with shopping centres seeing the largest uplift (+657%), followed by high streets (+544%) and retail parks (+308%). These figures are encouraging and largely consistent with the crowded scenes at Canadian retail shopping centres when restrictions were eased throughout the pandemic. Despite the surge in footfall traffic following mass vaccinations, there is a more sobering picture to be told when comparing this data to pre-pandemic levels from two years ago. Footfall across all destinations was down -15.9% (Shopping Centres -16.5%, High Streets -26.7%, Retail Parks +7.8%).  

According to this data, it appears that the road to recovery for retail may be slower and more painful than expected. While Tier A shopping centres should benefit from the months of pent-up-demand, there is a large subset of consumers that have permanently altered their purchasing habits. Retailers who fail to provide a more experiential component for their customers will struggle to recapture market share that was lost to e-commerce and changing behaviours. Consequently, we believe that street-facing retail real estate will continue to face headwinds even after widespread vaccinations. This presents a unique opportunity for adaptive reuse projects in well located neighbourhoods.

Housing and Inflation

A few months ago we issued a stern warning regarding inflation risk. Since then, the prices of raw materials used to make almost everything has continued to skyrocket. From steel and copper to corn and lumber, commodities are surging to levels not seen for years. While the U.S. Federal Reserve has been quick to dismiss this inflation as “transitory”, prominent investors including Warren Buffett at the annual Berkshire Hathaway shareholder meeting have sounded the alarm. This inflation poses a particular risk for the housing industry as the price of lumber has increased over 380% from a year ago.

Lumber Spot Prices (USD)

Home builders have been quick to pass on these costs to buyers, contributing to the soaring home prices in Toronto and other markets. Buyers have been willing to accept such price increases for the time being, however, a change in interest rates to combat rising inflation presents a serious margin risk for home building companies that have incurred higher construction costs.

In conclusion, life as we remember will mostly return, and it will likely happen much quicker than Canadians expect. However, as we can glean from other countries, there will be some behavioural and economic consequences from the pandemic which should not be underestimated by investors. Those that utilize this emerging data to revise and reshape their worldview will possess an informational advantage and be better positioned to generate strong returns in Canadian CRE.