In the news | Espace | Gavin Reiff | Street Smarts: Adaption is on the Horizon for Strategic Investors and Tenants

By: Gavin Reiff, P.Eng, MBA, Vice President, Richter LLP

As originally appearing in Espace Montreal, volume 30, #2, 2021.

The cities and built-up communities in which we live are historical records.  Think about the street layouts, utility networks, the varying character of your neighborhood and downtown, along with private buildings and public institutions such as city halls and libraries.  Their location, size, built form, opulence (or restraint) all represent a physical record of the preferences of people who inhabited the area over time.  The vintage of each building indelibly casts those preferences in metal, concrete, and glass.

Each lamppost, intersection, and building has a story that historians and urban archeologists would be interested in.  Questions such as “Why is it there?”, “Why was it needed?”, “What was there before?”, “Who paid for it?”, and “What will this become?”.   We could fill many pages in exploring this, yet for the purpose of this article let’s be satisfied to know that preferences of the main characters in these stories contributed to shaping the built environment, the communities, and cities that effect our daily lives.

It’s been said that cities are one of humankind’s greatest inventions.  They provide safety, social opportunity, economic opportunity, and choice.  They also enable knowledge-transfer, economies of scale and scope, institutions, and specialization.  Cities have inherent downsides too, yet recent history suggests they are a net benefit.  The UN estimates that during 2007 more people on the planet lived in cities as opposed to rural communities, and by 2050 it’s projected that more than two-thirds of the global population will reside in cities

How Our Relationship with Cities Have Changed

As we embarked into a new decade, the 2020’s, it appeared our preference for urban environments was lasting.  Continued urbanization and the emergence of mega-cities was almost a foregone conclusion.  Then the world changed.  Every continent, every country, every city, and every citizen experienced a global health crisis that scientists had predicted but was too outrageous for us to comprehend. Instantly and dramatically the economic, social, and geopolitical factors that shape our preferences changed.  Then everything changed.  Our social attitudes towards supply chain certainty, and allocation of resources, has turned inward.  In a defensive and protective manner, our preferences for how we use and interact with people and our built environment changed.

What we previously sought out in urbanism (density, proximity, convenience, access, efficiency, entertainment) and shared-assets (co-working spaces, car-share, community assets) become factors that propagated health risk.  We become more isolated with preferences shifting towards private, single-purpose ownership.  There was an increase in demand for private transportation (cars, bicycles), and outdoor greenspace, and private amenities.  Not surprisingly this resulted in increased demand for larger living spaces with private amenities such as home offices, gyms, movie theatres, and swimming pools.

All of this added up to a reversal in our well-established migration patterns.  We moved out of our cities.  It is impossible to determine whether migratory patterns have permanently altered our pre-existing preference for urban environments.  It is, however, likely that cities will remain highly relevant.  Research suggests that people who moved did so within the same geographic and economic region, and there is more evidence of increased activity and real estate pricing in many North American cities.

Implication to Commercial Real Estate

What we do know is that our relationship to our cities will be different to that of the previous decade.  That is not necessarily a bad thing, but it’s something that commercial real estate investors, operators, and users should prepare for.

Office Sector

The office sector will be shaped by the preferences of people and organizations who utilize the space.  Tenants are weighing employee demands for increased flexibility, while some significant organizations have moved to a fully remote model.  For the organizations who elect to operate out of physical premises, something the real estate industry expects to represent the majority of employers, we are likely to see a hybrid office environment consisting of an increase in private work space, hoteling, along with satellite and short-term offices designed to bring the office environment physically closer to where employees live.

Industrial Sector

The industrial sector has benefitted from increased demand for space in all major cities and regional distribution centers.  Our recent shift in preference for enhanced supply chain security has increased demand as operators require industrial space to manufacture and warehouse product, while managing their businesses.  Against the backdrop of increased consumer dependance on logistics, from procuring goods online and limited supply, there is increased pressure on rents while tenants are challenged to secure optimal premises.

We now experience dichotomy of preference, with people seeking the benefits of cities yet with attributes of low-density environments.  With steady, and even increasing populations, this is a recipe for physical expansion and adaption of our built environment, along with higher instances of relocation.

Personal and Business Considerations in Moving

If the macro-environment has impacted your preferences, either through your business or personally, and you are contemplating a re-location there are number of real-estate related factors that should be considered.

Investment

Depending on your circumstance an opportunity may exist to acquire new premises.  Longer expected duration, availability of investment capital, and confidence in the underlying fundamentals of your new jurisdiction, are pre-conditions for investment.

As an owner of the asset you may occupy the building indefinitely and, should the market co-operate, will benefit from capital appreciation of the asset while being protected from inflationary rent pressures.  There are certainly risks in owning real estate as you will become responsible for operating costs (taxes, utilities) irrespective of occupancy, and for capital cost to repair and upgrade the asset for safety and market positioning.

Taxes & Jurisdiction

The jurisdiction that one elects to operate from has a myriad of implications for real estate investors, operators, and tenants.  Firstly, the location of your real estate is a significant driver into the asset’s tax assessment, and in turn the amount of taxes payable on an annual basis.  Furthermore, should one acquire a real estate asset the asset value and jurisdiction inform the quantum of applicable land-transfer taxes.

Through their zoning by-laws and other tools, the municipality also plays a significant role in determining whether, and to what extent, real estate may be re-purposed or redeveloped.

Capital Considerations

Well located and relevant format real estate asset generally provide reasonably consistent cash flows and inherent inflation protection.  They are also capital intensive to acquire and to operate.  In moving jurisdictions and making an accompanying real estate decision, your cash flow profile and capital needs are likely to change.

It would be prudent to review and update your short-term and long-term capital needs before finalizing your real estate decision.  Over the past months the market suggests that debt-capital is available, yet lenders have adjusted their lending criteria in favour of higher quality and more durable cash flow and security.

Leasing

Should your circumstances be more transitional, leasing new premises may be more suitable.  Over the past months that relationship, and leasing documentation that supports it, has been tested.

Tenants have demonstrated an increasing need for flexibility inclusive of shorter lease terms, broadening use of options, smaller deposits, and the right to terminate early especially related to items of force majeure and government mandated shutdowns.  All of these elements represent a transfer of risk from the tenant to landlord and is reflective of the uncertain climate to which operating businesses have become accustomed.  Their lack of visibility makes it challenging to make long-term business decisions including staffing levels, capital equipment, and inventory management.  All these business decisions ultimately inform their real estate requirements.

Our relationship to real estate, and the cities they form, is complicated in that real estate is static and durable yet both our preference and time are fluid.  Owing to this dichotomy, it’s expected that people relocate their businesses and residences numerous times over their lifetime.

We have only scratched the surface in identifying and exploring items to consider during migration and have yet to explore the unique attributes of each real estate asset.  In a similar manner to most decision-making situations there may not be a perfect solution, yet with a disciplined and informed approach you will make a better decision.