The Connection Between Oil Prices and Ontario’s Industrial Real Estate
WRITTEN BY ZACH SCHENKER & GREG PEACOCK
The COVID-19 pandemic has catalyzed a challenging era in Canadian commercial real estate (CRE) highlighted by destabilizing rental prices, capitalization rate expansion, increased credit spreads, and development project delays.
Given these impacts, many in the industry are relying on more data and information regarding the pandemic to inform future investment decisions and portfolio strategies. Although this health crisis will certainly deliver unique opportunities in Canadian CRE for forward-looking developers and landlords, there is an equally important crisis, which has been accelerated by the pandemic with the potential for equally significant ramifications. Since 2015, the price of global crude oil has entered a deep tailspin, which has been greatly advanced by declining demand due to the complete or partial shutdown of many global economies. In Alberta, the relationship between oil prices and CRE is clear even to the most casual observer. With over 241 acres of vacant space in Calgary’s downtown market, the vacancy rate at the end of the first quarter this year stood at 25.48%. This is a stark contrast to the Vancouver and Toronto downtown office markets, which have 1.7% and 2.2% vacancy rates, respectively. While this relationship is obvious in the province of Alberta, there are more obscure, yet equally important, linkages between the price of oil and the success of CRE as an asset class in other provinces, such as Ontario.
In order to understand these more conspicuous relationships, Western Texas Intermediate (WTI) oil price data was compared against capitalization rates from 2008-2020 across different CRE asset classes in Ottawa, London, and Toronto. The WTI oil price is often used as a world reference price, which is generally quoted in the media. Despite Canada’s dependence on the oil sector as a major driver of economic activity, the capitalization rates across most asset classes in Ontario are not correlated with the WTI price of oil. With that being said, there is a clear outlier when it comes to the industrial real estate asset class. In Ottawa, London, and Toronto, a correlation exists between the price of oil and the capitalization rates of industrial real estate. In these markets, as the price of oil decreases, all else being equal, the value of industrial properties increase.
This may come as a surprise given the fact that there are many businesses and industries in Ontario that support the oil and gas sector in Alberta and are therefore reliant on strong oil prices. However, the data indicates that in Ontario, different manufacturing activity becomes more attractive as the input price of oil declines. Of the three Ontario cities that were examined, London’s industrial real estate has the strongest relationship with oil prices, which is consistent with the high concentration of manufacturing activity in that region. Conversely, Ottawa has a weaker correlation, as much of the industrial real estate is more technology focused, which is less exposed to oil prices. Meanwhile, the Greater Toronto Area’s (GTA) industrial real estate exhibits a strong correlation, as there are many warehouse and distribution facilities that are dependent on trucking and transportation, which are fuel intensive activities.
When regressing these capitalization rates by the price of oil in the previous year, the London industrial market delivered a strong R squared of 0.67, indicating that 67% of the variance in London industrial capitalization rates can be explained by the price of oil in the previous year. In regressing Ottawa’s industrial real estate against oil prices, the correlation was not strong enough to establish a statistically significant and quantifiable relationship. Meanwhile, the GTA’s relationship was robust as 39% of the variance in industrial property capitalization rates can be explained by oil prices in the previous year. Ultimately, the WTI price of oil can be used as an independent variable to predict the future capitalization rate of industrial real estate in London and the GTA. Based on the August 10th, 2020 WTI price of oil at $41.94 USD per barrel, the capitalization rate of industrial real estate in London is expected to average 7.56% in a year. When simulating this model to understand the range of potential outcomes based on current oil prices, the 90th percentile of outcomes features a 7.94% capitalization rate and the 10th percentile of outcomes exhibits a 7.19% capitalization rate. Ultimately, this model suggests that capitalization rates should remain similar to the 7.5% rate over the last few years with the potential for mild expansion in the next year. Meanwhile, the capitalization rate for industrial real estate in the GTA is expected to average 4.91% in a year based on the current WTI oil price of $41.94 USD. For this market, the 90th and 10th percentile high-low scenarios are 6.06% and 3.75%, respectively. The average scenario of 4.91% is greater than the capitalization rate for industrial properties in the GTA for Q1 2020, which averaged 4.62%. This suggests that there will likely be some capitalization rate expansion and pricing dislocation in the next year, presenting opportunity for investors.
While this model is informative for investment decisions regarding industrial real estate, it relies on a volatile independent variable that is surrounded by a complex macroeconomic environment. Global oil demand is expected to fall by a record 9.3 million barrels per day (mb/d) in 2020. Even in December, demand is expected to be 2.7 mb/d less compared to 2019. Despite output reductions from OPEC+, Canada, and the United States, such reductions are not expected to offset the sharp decline in demand for 2020. Consequently, lower oil prices are expected to persist, suggesting that industrial real estate capitalization rates will remain higher for the foreseeable future. For those investors with a longer-term focus, Deloitte projects that WTI prices can climb to $50 per barrel in 2022 when global demand recovers from the COVID-19 pandemic. This is likely to raise industrial capitalization rates in London and Toronto to approximately 7.68% and 5.21% in 2023, respectively. Ultimately, as the price of crude oil rebounds from this historical demand shock, patient investors looking to purchase industrial real estate in Ontario should be able to enter the market at more affordable prices.