What’s next for commercial real estate in 2023?

Rising interest rates and high inflation

There has been some trepidation in the market in recent months in terms of the increases to interest rates in quick succession in the latter half of 2022. Underwriting criteria have become more strict, and lenders and investors alike have become more cautious. It is unclear how long the rise in interest rates will impact the market, which has led to increased caution among all real estate players and some owners pulling their deals from the market and some purchasers pulling out of deals and not being willing to take the risk on moving forward.

A slowdown is expected for at least the first half of 2023 in light of the uncertainty in the market.  It is unclear whether rates will stabilize, increase or decrease and economists and the Bank of Canada potentially have different viewpoints as to how that looks. Investors and owners are cautious in terms of how high inflation will have an impact on their bottom line, with many companies expecting cuts to expenses and decreased revenues due to slowing consumer demand and workforce management pressures. That said, experts generally predict that the current unpredictability in the commercial real estate should stabilize in the middle of 2023. There remains a great deal of dry powder looking to be placed which bodes well for increased activity in mid to late-2023.

Changing tenant demands

One of the longer-term impacts of the COVID-19 pandemic has been a push by tenants for more flexible office space, including communal areas, ability to “hotel” employees, and robust and versatile electronic and virtual connectivity. The increasing acceptance of (and demand from workers for) a “hybrid” arrangement presents unique challenges for landlords, owners and retailers alike. How buildings and office space are used is undergoing a major shift. Tenants and landlords, especially public company tenants and landlords, are increasingly also focused on ESG considerations and related reporting to their shareholders.

These environmental and social governance matters are top of mind for landlords/investors and tenants/occupiers alike (and increasingly lenders). Many landlords are requiring tenants to adhere to increasing and more onerous sustainability requirements and associated reporting obligations. Industry players are focused not only on sustainability and governance matters, but also climate-related regulatory actions, especially foreign investors who are interested in investing in new jurisdictions. While the majority of offices in major urban centres have sat largely empty for the last two+ years, we are starting to see a return of the workforce to the office, at least on a part-time basis, with increased presence at associated retailers when those workers are returning to the office.

Lender underwriting

Given increased interest rates and more stringent underwriting by lenders, it is not surprising that there has been a slowdown in activity in the commercial real estate market in the latter half of 2023. The difficult underwriting criteria have made it more difficult for purchasers to qualify for financing which is greatly hampering deal volume. This has led to reduced competition for properties and as noted above, some owners pulling their properties off of the market until conditions are more favourable. Notwithstanding a more difficult financing environment, certain asset classes within the industry continue to remain sought after. For example, while the industrial market has seen some cooling in recent months, it still remains a very viable and stable asset class, as are data centres, storage, warehousing and fulfillment centres, multi-family residential, as well as life sciences buildings or development opportunities.

Virtual connectivity, cybersecurity and PropTech

Related to the increasing hybrid nature of the office workforce, digital economies and virtual connectivity are top of mind for all players in the commercial real estate industry. There is great demand for cloud computing and storage, which has increased interest and demand in data centres and related infrastructure. This also presents important considerations relating to the protection and confidentiality of data and cyber security.“PropTech” (aka “property technology”) remains a key focus within the industry in terms of how to best leverage new and improved technology with the “bricks and mortar” of commercial real estate. It is expected that interest in proptech will continue to be a strong trend into 2023.

Legal implications

• Pandemic’s long shadow in agreements. In real estate contracts, we expect to continue to see carve-outs from force majeure for COVID-19 given that it is now a known event, but with the expectation and focus on the fact that future pandemics or epidemics and associated government-ordered lockdowns will constitute force majeure events (but will not abate the obligation on a tenant to still pay rent, for example). Expect the language of force majeure clauses and associated carveouts to be of particular focus.
• Increasing scrutiny in securing financing. Lenders will be rigorous in their underwriting of deals as well as associated legal documentation given the tighter lending market.
• Budgetary priorities mount in development and construction. Inflationary pressures will result in developers and owners alike being focused on cost (and cost-cutting measures) to a greater degree of detail and specificity in development and construction contracts.
• Lease negotiations may continue to be protracted. Tenants and landlords will likely continue to dig in on issues of particular importance to them as highlighted in this article, with tenants likely demanding much greater flexibility in terms of flexible office space, accommodating floor plates and shorter lease terms.
• ESG focus continues. Expect to see more and more detailed and onerous “ESG” and reporting types of clauses in contracts, particularly from public-market players.
• Changing rules for foreign buyers. A legislative change that takes effect January 1, 2023 may also have the effect of cooling certain parts of the commercial real-estate market, such as multi-family residential, which act and associated regulations were passed on December 2, 2022 relating to the Prohibition on the Purchase of Residential Property by Non-Canadians Act. Certain exemptions under the Act are available and the impact of this new legislation remains to be seen, but is an important legal consideration in advising foreign buyers who are interested in purchasing a residential interest in Canadian real estate.

Conclusion

2023 is set to be an interesting and dynamic one in the real estate industry. The fast pace of change in this market demands keen attunement to many important and sometimes subtle legal considerations. Particularly amid the current broad economic volatility, knowledgeable and experienced legal counsel and other advisors who have a pulse on ever-changing market dynamics that affords the ability to negotiate “market” terms will be more important than ever.