While the overall national office market climate remained strong in 2008, some cracks are beginning to be seen. The global financial crisis will continue to play out in 2009, particularly in the Finance, Insurance and Real Estate sectors – key drivers of demand for office space across the country. The steep pull back in oil prices from the record peak reached in July 2008 is having negative implications on the demand for space in Calgary, and to some extent Edmonton, markets not unaccustomed to the effects stemming from the volatility of the oil market over the decades. National office vacancy rates declined 80 basis points to 6.2% in 2008, with average Financial Core Class A space registering 2.9%.

Market conditions remain tight across the county – for how long?

For tenants and landlords alike, it is important to measure vacancy change in the context of where we’ve been as well as where we may be headed. A ‘balanced’ market is said to typically be in the range of 8.0%. Most markets across the country ended 2008 well below this level.

Financial Core Class A vacancy in Toronto continued a downward trend throughout most of 2008 but hit a wall by the end of the year, ending 2008 at 4.1%. Large block opportunities increased over the course of the year; however, many of these opportunities were for future, not immediate occupancy. This trend of moving from forward into neutral was echoed for the overall Greater Toronto Area as well.

In Calgary, overall vacancy came close to doubling once again this year, up 250 basis points to 5.5% as a result of the injection of new supply to the marketplace. Downtown Class A vacancy remains tight at 2.2%. Vancouver continued to experience tight market conditions in their downtown core (1.9%) leaving tenants little option but to explore suburban market offerings to accommodate growth. Overall vacancy in Vancouver ended the year at 5.9%. Despite the addition of new inventory to the Edmonton market, vacancy continued its declining trend ending the year at 4.0% overall with very few large contiguous blocks available. Activity in Montreal continued to show improvement at the start of the year but the delivery of new supply offset the market resulting in vacancy levels remaining flat for the year at 7.7%. Vacancy levels increased overall in Ottawa to 6.7% as election activity temporarily slowed the public administration sector’s appetite for space and the economic downturn softened private sector demand.

Most secondary markets across the country remained well leased with rental rates experiencing steady growth. Markets such as Regina and Saskatoon, as well as secondary markets in the interior of British Columbia are extremely tight for space for tenant expansion or new tenant activity. New construction delivery is conservative and typically only enough to meet existing demand, thus keeping supply at a bare minimum.

Declining demand and rising supply will have an impact on the market for 2009 but this impact will vary from city to city. With the economy facing recessionary conditions in 2009, we have already begun to see growing amount of sublease space across the country as many companies look to rightsize their operations and discard any surplus capacity. For example, in Toronto, sublets represented 20.9% of total vacancy in the downtown market, up from 15.6% at the start of the year. A similar trend is being seen in the downtowns of Calgary and Vancouver where sublets accounted for roughly 26% and 45% respectively.

While it is expected that the national office vacancy rate will rise in 2009, the solidity of Canada’s financial system should continue to provide some insulation as compared to what has been experienced south of the border. Layoffs in the financial sector have not been significant to date. However, any negative changes to the stability of the financial services sector would certainly have significant effect on office leasing fundamentals, particularly in Toronto but echoed throughout the country.

The dynamics of new supply

2009 will be a dynamic year for new supply delivery as over 3.2 million square feet will be delivered to Downtown Toronto, the most significant injection of new development since the early 1990’s. An additional 1.1 million square feet is underway for 2010-2011 delivery. This new supply in itself will certainly have implications on both vacancy and rental rates over the near term. Add to it the uncertainty of the current economic climate and there becomes some cause for concern. However, these conditions do not spell a downturn for the Toronto office market. The ownership structure is far more institutionalized and concentrated in fewer hands than during any other “correction” experienced in the past three cycles. Therefore the owners’ pockets today are deeper and thereby better equipped to weather periods of higher vacancy. While much of this new supply has been pre-leased, it is instead the demand for the backfill space that will determine the ultimate health of the market over the near term.

A similar dynamic is at play in Calgary where over 2.9 million square feet was delivered to the market in 2008, 28% of which was located downtown. An additional 4.5 million square feet will be delivered through the course of 2009, with 3.1 million square feet slated for 2010-2011. Demand for space will be impacted by the pull back in oil prices and corresponding slowing of business activity in the energy sector.

Other primary markets have new supply deliveries on the horizon but not to the same extent as Toronto and Calgary. This includes Vancouver (867,000 square feet), Montreal (614,000 square feet), Ottawa (383,000 square feet) and Edmonton (960,000 square feet).

Is today’s economic climate and development cycle reminiscent of the early 1990’s?

Case in point – Toronto. During the period 1989-1991 over 22 million square feet of new office supply was delivered into the Toronto market, 7.8 million in downtown alone. This, combined with an economic recession, pushed overall Toronto office vacancy from 10% in 1989 to 22% in 1991, and downtown vacancy from 7% to 20%. In contrast, we expect to see 3.2 million square feet delivered to the downtown Toronto market in 2009 which will push vacancy from 4.6% to roughly 10% at the end of 2009 and with additional supply coming on in 2010-2011 vacancy will creep higher, to what extent will be determined by how long the downturn in the economy lasts.

Developer over-exuberance in the 1980’s led to oversupply going into the 1990’s. Financing was easy to come by in the previous cycle, reflected in the amount of building taking place within the more entrepreneurial ownership landscape that existed. Oversupply drove net effective rental rates in some cases to negative numbers as landlords competed aggressively to attract and retain tenants. Today, lending is far more conservative, property is held in fewer hands by well-funded institutions, and stronger pre-leasing is required before breaking ground on construction. As a result we have not seen any significant new supply since the early 1990’s in downtown Toronto. While we expect to see rents in some specific incidents to drop possibly 15-20% in 2009, this is due to the economic malaise that is being experienced in the overall market not oversupply of new product.

Interest rates were far higher in 1990, hitting 14% forcing independent developers to re-think their developments plans, putting them on hold as the market softened or shelving them completely. The original Bay Adelaide Centre was one such victim. In addition, some lenders became owners of real estate when developers fell away. By comparison, interest rates today are at historic lows, however the credit crisis has put the ability to obtain financing in question. The marketplace is definitely waiting to see if any of the large scale development projects underway across the country will experience a slowdown or delay in construction activity or a temporary hiatus given the current climate. To date there has been much speculation but the only major project on temporary hold is Phase ll of the MaRS development in Toronto. Financing issues will likely defer proposed developments to the next building cycle, unless significant pre-leasing commitments can be obtained.

What is different in today’s market is that “force majeure” or “act of God” has taken on new meaning in construction and pre-leasing. Is the inability to secure financing in this economic environment enough to justify a breach of contract? Certainly something better left for the courts to decide, however, savvy tenants are looking for greater protections to ensure that delivery timelines are met and lease documentation contains stiff financial penalties if delivery time elapses. These protections are also being written in for tenants seeking to backfill space of tenants exiting for new construction supply as any delays to the exiting tenant impact move timelines for the new tenant as well.

The rental rate dilemma – deal or no deal?

Rental rates continued to hold in some but not all of the national office markets in 2008, driven by low vacancy and conservative new supply delivery. Tenants in Calgary and Edmonton, who faced “sticker shock” in 2007, received some relief in 2008 as rents began to stabilize. Tenants in Vancouver continued to face record high rental rates and with little new downtown supply forecast, rents will remain elevated over the near term. In Ottawa, overall net rental rates softened in 2008 with rising vacancy and are expected to stabilize for 2009. Toronto rents increased marginally in 2008 but with new supply delivery in 2009 it is expected that rates will stabilize or soften slightly in response to market conditions. Rents in Montreal remained relatively stable.

In general, rental rates are expected to stabilize or trend downwards in 2009 as slowing economic conditions and new supply delivery impacts the market. However rents will need to be looked at on a situational basis. Landlords with strong occupancy levels will feel little pressure to concede on rental rates while those with more significant vacancy may need to adjust their rent levels to achieve their occupancy goals. In lieu of rent decreases, expect some landlords to increase inducements and free rent periods as a means of attracting tenancy.

How will tenants react?

There are different ways tenants will react in the market. With softened rental rates we may see a flight to quality, as some tenants take advantage of deals in the market and upgrade their space location by perhaps moving up the Building Class scale, by moving from the fringe to a more prominent location or changing sub-market completely. However, where companies are rightsizing their organizations in ‘survival mode’, any move may be looked upon unfavourably and ostentatious in light of other cost saving measures. Tenants that do not have an immediate need to move may choose to risk waiting on the sidelines for the market play out in 2009. The current economic climate makes it increasing difficult for tenants to get an accurate handle on how much space may be required if uncertainty surrounds the health of their organization.

Similar to the investment and industrial markets, a pricing disconnect does exist between tenants and landlords where tenants are looking for “fire sale” pricing and landlords with quality offerings and low vacancy are reluctant to discount.