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What will influence the commercial real estate market in 2014?

Cranes dominate Toronto’s skyline as construction work continues on condominiums in the Canary District east of the downtown.

Peter Power/The Globe and Mail

It has been an interesting year in commercial real estate markets: rising long-term interest rates took some of the wind out of the sails of the real estate investment trusts, which had previously been doing deals at a fast clip, but office development boomed and pension funds became even bolder outside of Canada's borders.

As the new year unfolds, some of the top players at this country's brokerages offer their predictions on major themes in the year ahead.

Brett Miller, president of Jones Lang LaSalle Canada, had three wishes for Santa this holiday season:

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1. "I would ask for low interest rates. And I'd say that if you look at the Bank of Canada indications and what's happening south of the border it will be pretty steady-as-it-goes with possible minor increases, so I think Santa's going to deliver that gift. That means that cap rates will stay roughly at the same level, yields will be maintained, and there won't be any shocks in the REIT market."

2. "I would ask for strong leasing demand. I think the retail industry is still adjusting to the entrance of some of the U.S. retailers, to Target, and I think generally the landlords are fine because the leases are in place, but I think there could be some pain amongst the tenants.

I think the office sector has to be watched carefully, the impact of new development will starting taking a bite in the Class B markets nationally and older Class A buildings in core properties. Towards mid- to late 2014 some of the landlords are going to get fairly nervous, and we may see some rental rate erosion.

On the industrial side I think the Greater Toronto Area, Calgary and Vancouver will be strong markets – both from a distribution perspective and a slight re-emerging of manufacturing – if there's more offshoring and as the Canadian dollar settles to a 90-cent level. I think elsewhere in the country it's going to be really tough."

3. "I would ask for discipline in new development – both condo and office. I think Santa's going to disappoint me there, because for the most part I think developers are myopic, if they can get their returns on the individual project they're promoting they'll go ahead. Yet you may have three or four taking that position and then creating some volatility in the market. So I think we need a bit more discipline with regard to new construction."

As far as commercial real estate deals or transactions go, he expects next year to be a continuation of the second half of 2013, "which was definitely quieter."

"I think if the REITs settle down to this new reality of slightly higher borrowing rates, they may start buying again," he says. "But I don't think it will be the same kind of volume as we saw in 2012."

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David Bowden, chief executive officer of the Canadian operations of Colliers International, sees three major groups influencing the commercial property sector in 2014:

1. The first is tenants or occupiers. "What we're going to see is a continued move to more uniquely designed and created work places, so that organizations can distinguish their brand even more," he says. "We're seeing it with organizations like Google and Facebook and others that are already well along in that. The competition will continue for the best talent, and that will cause groups to rethink what their workplace is like so that they can attract and retain the best employees. I think that will be a trend that will magnify in 2014."

2. The second is developers. "I think we're going to see more speculative development because there's lots of capital that wants to get into the commercial real estate marketplace, and it can't find what it wants. So it's more likely to build it and take the leasing risk. But where that development will occur will be around very significant transit hubs, because the ability for employees to get to work is absolutely critical. And I think we're going to see more mixed-use developments, in part to meet the needs of live-work-play all in one. I think that trend will magnify."

3. The third group is investors. "I believe that 2014 will be an extension of what we've seen for the last three years, which is that investors are hungry for good investment opportunities," he says. "There is going to be continued pressure from new entrants, from investors from Asia, investors from Europe, and also Canadian pension funds that have yet to buy commercial real estate for their portfolios. And clearly there's more capital available than there are good opportunities to buy."

Scott Chandler, president and CEO of Cushman & Wakefield Ltd., Canada, sees three trends ahead in 2014:

1. New downtown office supply. "Historically high new supply in downtown Toronto and Calgary, as well as Vancouver and Montreal, will put upward pressure on downtown vacancy rates over the next few years," he says. " While absorption during the last development cycle was surprisingly strong coming out of the financial crisis, it may be optimistic to hope for similar strength of demand once again so soon.  While the new buildings appear to be leasing well, there may be some fallout among existing buildings, especially older, less desirable locations.  Overall, vacancy rates are expected to rise (albeit not to historical highs) and the leasing market will likely become more fragmented."

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2. Suburban recovery. "The U.S. recovery now appears to have a foothold, finally," Mr. Chandler notes. "The suburban office market and industrial markets, which heretofore were largely affected by slow U.S. economic growth and lack of decision-making south of the border, should now benefit from this growth. A cheaper Canadian dollar should also help. While the domestic economic may cool, look for a more sustained recovery from these sectors in 2014."

3. Impact of rising interest rates. "The May-June increase in bond yields quickly put REITS [real estate investment trusts] on the sidelines after representing the majority of investment property demand," he adds. "Pension fund advisers, private equity and private investors have so far picked up much of the demand slack. There remains an abundance of capital ready to invest and lend but focused on primary assets and locations.  But how will this be affected by an inevitable increase in interest rates and will tapering accelerate this increase in 2014?  Real estate investments generally still maintain a strong spread over risk-free returns and there is still positive leverage available at current debt rate levels but how the investment market prices real estate in this environment will be a key story to watch in 2014."

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