REAL ESTATE INDUSTRY – YEAR IN REVIEW 2022 MONTRÉAL AND QUÉBEC CITY

The pandemic has left its mark on the real estate market, which is also coping with successive increases in interest rates. While most of the indicators were upbeat last year, we can expect strong headwinds over the next 12 months. Some segments are doing better than others. A look at current perspectives as we review 2022.

In late 2021 and early 2022, a return to normalcy was beginning to take shape after several months of turbulence. With a very active market and growing investor confidence, things seemed to be returning to normal after a forced pause.

The Canadian economic outlook quickly deteriorated, however, due in part to successive interest rate hikes set by the Bank of Canada. In order to fight inflation the Canadian central bank initiated a bullish cycle, which led to a rapid rise in interest rates and a correction in housing markets.

In addition, rising construction costs and labour shortages (both already present) continued to grow. As a result, dark clouds gathered in a sky that had been clear at the beginning of 2022.

OFF TO A GOOD START… THEN THINGS GOT WORSE

Thus, during the first six months of the year the dollar volume of sales indicated that the 2021 levels could be reached and even surpassed, despite the rise in interest rates since March 2022. In fact, when comparing the first two quarters (Q1 and Q2) of 2021 to those of 2022, the increase was 48% in Canada and 68% for Greater Montréal. Sales volume for Québec was historically high, at approximately 450 million, but that was nonetheless a decline compared to 2021, when 620 million sales were recorded in two quarters. During the same period, sales volume for office spaces increased from 5% to 14%, and sales in the industrial sector from 22% to 24%. On the other hand there was a decrease in volume for all other types of assets, even for multi-residential buildings and land.

There has also been a rebound in long-term Canadian bond yields, compressing the real estate premium from 339 points to 179 points between Q3-2021 and Q3-2022, the lowest level in the past 15 years.

At the same time, average yields for the four Canadian asset classes trended upward. The two additional increases in the interest rate during the last quarter of 2022 will certainly have an additional effect on the returns required by investors.

Construction costs also continued to rise in the first half of 2022, following a sharp increase in 2021. Strong demand, long procurement times and labour shortages have been major contributors. Ultimately, this presents an additional challenge for developers, especially when costs rise during construction, making pro formas more difficult to achieve.

Let's take a closer look at how 2022 played out in the Montréal and Québec City real estate markets.

MONTRÉAL – A ROLLERCOASTER RIDE

Multi-residential, New Condos and the Resale Market

Housing starts in the Montréal census metropolitan area (CMA) peaked at 32,000 in 2021. For 2022, it was expected that volume would be equivalent to that of 2019-2020, i.e., approximately 26,000, a decrease that will most likely continue in 2023.

In terms of rental unit starts (traditional plus private seniors' residences), they broke records in 2021, accounting for over 60%. Given the rising cost of financing, construction and land prices, however, that proportion is also expected to diminish in 2023. Some multi-residential projects may even be converted to condominiums.

Multi-residential remains an asset in demand. Investors are mainly attracted to new buildings with at least 80 units of good quality, both on and off the Island. But an expected increase in yields of at least 25 to 50 points on the overall discount rate (ADR), due to the increase in interest rates, could change the game.

The good news? Buildings are showing vacancy rates below 3%, despite the many new construction starts in recent years. In midtown and the suburbs, the market is still very tight. In the downtown core, only 25% of projects still offer incentives of free months of rent for a two-year lease. In September the recovery was solid, helped by the return of students. Average rents for new projects have increased by about 5% annually for the past two years.

As for new condos, the inventory available for immediate occupancy is very low, as low as five and seven condos available for immediate possession on the North and South Shores! The same trend has been observed for several quarters in all markets with the exception of downtown, where there are only 103 new units available, which is still very low compared to overall volume.

As regards prices, new projects in the downtown west area range from $1100 to $1200 per square foot, which is about 10% higher than 2021. The North Shore has the lowest prices, followed by the South Shore and the rest of the Island of Montréal.

As for land prices, for the past two years they experienced a strong increase of about 15% annually. But with the tightening of the market, that trend will be reduced and we could see a decrease in the volume of sales.

COMMERCIAL SECTOR –VERY LITTLE MOVEMENT

There has been very little investment activity in shopping centres. In 2022 there were only four transactions of $20 million or more in Greater Montréal, three of which were shopping centres with a supermarket.

Nonetheless, it is clear that despite the closures, the 2020 lockdowns and the various constraints imposed afterwards, retail sales in Québec remained fairly stable in 2020 (-0.1%) and jumped dramatically in 2021 (+13%). Data for the first two quarters of 2022 are consistent with this. However, consumer confidence remains fragile, especially in light of inflation and rising interest rates.

Office Space Rentals Still Uncertain

In 2022, there was a decline in the volume of office transactions in Greater Montréal. The uncertainty surrounding the use of space due to teleworking is weighing on this market segment. As a result, availability steadily increased to 17.5% in Q3-2022 in Montréal. The largest increase was in Laval, followed by downtown Montréal and its 50 million square feet of office premises. Availability there since the start of the pandemic has reached nearly 4.4 million square feet, a worrying increase. Nevertheless, prestige buildings and new construction have fared better than other categories.

While teleworking is here to stay, one wonders what impact it will have on the office market. As things stand now, buildings are effectively

30-40% occupied, and we have seen several recent leasing deals involving a reduction in square footage. Therefore, increases in availability are to be expected at lease renewal time.

This also puts downward pressure on effective net rents. While some landlords are trying to keep them as high as possible, they now have to provide more incentives to rent.

Industrial Sector Booming

With very little availability and high demand, the industrial sector is a very hot market, a situation observed in almost every major urban centre across Canada.

Rising rents, rising costs and a scarcity of available product have driven unit values to record levels, more than doubling in the past five years. Land prices are also on a dramatic upswing, with available, well-located space becoming scarce in all regions, especially as the supply of municipal industrial land is now virtually depleted.

That lack of inventory is exacerbated by the large land areas required for mega-distribution centres and the new requirements for industrial buildings in the technology field. Rents are steadily increasing given the limited space available for lease, with single-tenant rent rising 21% in 2022 compared to the previous year.

However, the surge in rents may be slowed by the City of Montréal's new 2023-2025 assessment roll. It could generate a 50% tax increase over three years in the industrial sector on the Island of Montréal. In addition, the Court of Appeal's decision on the inclusion of additional equipment (generators, refrigeration units, batteries, etc.) in the municipal assessment could change the situation.

QUÉBEC CITY – A CONTRASTING PICTURE

As in Montréal, in early 2022 the forecast for the Québec City real estate market looked bright and promising after two years of pandemic gloom. By autumn, however, the situation had changed radically.

MULTI-RESIDENTIAL ON A ROLL

For the past four or five years, the multi-residential market has been leading the way in terms of development. After a record 5,000 housing starts in 2020, more than 7,000 rental units were built in 2021, an increase of 40%!

Compared to Montréal, the number of new condo units is still relatively insignificant in Québec City, although it is experiencing a slight resurgence in popularity due to rising rents in new rental projects. Activity was strong throughout the territory, even in the areas far from the centre, and there were several major transactions.

The many projects underway create demand for land to be developed. Fortunately, there are still opportunities to densify the territory, which tends to stabilize prices.

However, the impact of rising construction costs and interest rates is being felt, even in the multi-residential market, a niche that has been growing strongly for several years. For the moment, the vacancy rate remains very low and demand is still high.

This is reflected in rents, which rose in 2022 and are expected to continue to do so in 2023. As for yields, they began to rise from the beginning of the year, a trend that has been observed throughout the year and is expected to continue into early 2023.

All Quiet On The Retail Front

Like Montréal, Québec City has experienced spectacular growth in retail sales. But here again, consumer confidence is beginning to be seriously eroded by rising inflation and interest rates. Buildings offering local services fared best during the pandemic and continue to be popular.

The market saw little movement in 2022, other than the sale of the Cominar portfolio and the sale of two other commercial properties. As for yields, they are rising and could continue to do so in the months to come.

OFFICE SECTOR – BETWIXT AND BETWEEN

Public service and institutional occupants have been a major asset to Québec City's office market, helping to stabilize it. But the way space is used has changed dramatically since the pandemic, and the effect of teleworking is still difficult to measure. There is a desire to occupy less square footage, but without sacrificing performance and a sense of belonging, especially in a context of labour shortages. At the same time, employees are not ready to return to the office five days a week.

Large institutional occupants account for almost 23% of total leasable space, and their square footage decisions will necessarily influence the market in a significant way. If the square footage occupied by these major occupants were to be reduced by 20-25%, the office market in certain areas of the city could suffer, particularly around the National Assembly and in St. Foy.

However, with unused space not yet back on the market, the availability rate remained stable until the first quarter of 2022. The situation worsened thereafter, with a one percent jump to an average of 9.2 percent, with a higher rate in the downtown area. Another harbinger of a likely increase in vacancy, the percentage of total available space

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Unsurprisingly, effective net rents are down which, combined with rising construction costs, leaves little room for new office tower projects.

These conditions are also having an impact on investment, as the volume of transactions in the office segment was quite low in 2022. Consequently, the office market is expected to remain sluggish for a few more years.

INDUSTRIAL – AN OVERHEATED MARKET

The industrial market is on a roll, supported by low availability, lack of land and rising rents. The conditions are ideal for new construction, but there is a shortage of available land, and land at reasonable prices is located too far from the central core. The labour shortage encourages many companies to stay in the central areas to remain attractive, which pushes up the prices of buildings located in that zone.

The scarcity of product has also meant that transaction volumes have been relatively low in recent years. As for yields, there has been no recent increase.

In conclusion, for both the Québec City and Montréal markets, several factors could have an effect on real estate. Among them are the significant increase in financing and construction costs, the anticipated demographic growth that could accentuate the housing shortage, teleworking and hybrid work, strong pressure on the industrial market and the probable arrival of a recession. All of these factors will be on our radar in 2023.