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'Darkest before dawn': Another tough year for office REITs but opportunities may lurk

As we step into 2024, the forecast for office real estate investment trusts (REITs) in Canada remains stormy. Michael McNabb, a portfolio manager at Purpose Investments Inc., describes the situation as a 'darkest before dawn' scenario. Despite their attractive pricing, office REITs are grappling with a myriad of challenges.

Before the pandemic, office REITs were the darlings of the real estate market, offering investors lucrative monthly payouts. However, the landscape shifted dramatically with the COVID-induced work-from-home trend. Employers reevaluated their need for physical office space, leading to a reduction in real estate holdings as a cost-cutting measure in the face of economic uncertainties.

Maria Benavente, vice-president and real estate-focused portfolio manager at Dynamic Funds, notes a significant shift in demand due to remote work trends. She estimates that 10 to 15 percent of office space demand has been permanently eroded. The national office vacancy rate rose to 14.1 percent in the third quarter of the previous year, up from 13 percent in 2022's third quarter, according to a report from Colliers Canada.

Despite the rising vacancy rates, average asking rents for offices reached a near-record high of $21.08 per square foot. This increase is attributed to the removal of older office buildings and landlords offering concessions beyond lower rent, according to the report. John Duda, Colliers' president of real estate management services in Canada, anticipates a slow uptick in office space absorption by the end of 2024. However, he doesn't foresee a radical turnaround, underscoring the ongoing imbalance between employer and worker preferences.

The disparity between what employers want and what workers desire remains a key challenge. Duda emphasizes the employees' power in the current job market, stating that the busy levels in downtown cores are picking up significantly, signaling a potential shift back to the office.

The market sentiment towards office REITs is fairly negative, with units in major REITs like Slate Office REIT, Allied Properties REIT, True North Commercial REIT, and Dream Office REIT witnessing substantial declines since March 1, 2020, ranging from 62 to 85 percent.

Maria Benavente advises caution in approaching the sector, noting that office REITs are value investments that require patience and tolerance for volatility. Several office REITs have been forced to cut dividends, emphasizing the need for investors to be selective, focusing on factors like balance sheet strength, liquidity, and dividend coverage.

While the near-term outlook is challenging, some money managers see opportunities for long-term investors. McNabb suggests that commercial real estate, including office REITs, operates on the basic economic principle of supply and demand. Currently, the supply far exceeds demand, contributing to the sector's struggles. However, McNabb remains cautiously optimistic, suggesting that longer-term investors could find value in high-quality companies as the economy recovers.

In conclusion, the Canadian office real estate sector faces headwinds, but there may be opportunities for savvy investors willing to navigate the turbulence with a patient and selective approach.