Don’t get Vincent Chiara wrong. Like many investors in the real-estate industry, he still has doubts about the future of office buildings.
But as Chiara snaps up these properties, rapid-fire, in cities across Canada, he’s convinced he’s caught onto something that everyone else has missed: Prices have now plunged so much that in many cases they’re actually below the value of the land itself.
Buildings on the shore of Lake Ontario in Toronto. Bloomberg
To Chiara, whose Montreal-based firm Groupe Mach has shelled out more than $C1 billion ($1.1 billion) on this bet since March 2020, this makes for a classic buy-and-knock-down trade. The gap between the price tag and the value of the land, he says, helps cover the cost of the demolition and paves the way for the construction of something – primarily, apartments – that is in hot demand in Canada and, more broadly, across much of the world.
“If there’s enough buffer between the price I paid and the value of what this property is sitting on, then I’m land banking,” he said. “If some of these office assets go sideways, then we’ll redevelop them.”
The reason this might work is because Canada’s big cities, like many others around the world, have a housing shortage. That means land that can be used to construct new homes carries a premium.
Chiara uses a visit to Groupe Mach’s most recent purchase, a 1980s-era campus of blue glass towers and green courtyards in Toronto’s suburbs, to explain. Mach paid $C165 million for the property, but not before checking how many apartments could be built on the land. With the potential for 2.5 million square feet (232,260 square metres) of residential space, Chiara estimates the empty land would be worth $C250 million – a premium to his purchase price, which he says could cover the cost of demolishing the office buildings entirely.
It’s what’s driven Mach to become the second-biggest buyer of office buildings in Canada since the start of the pandemic, according to Altus Group data. The dozens of office buildings the company has bought put it second only to Blue Owl Capital’s Oak Street Real Estate Capital, which spent $C1.2 billion on just one marquee property in Calgary.
Putting a floor under office values
If more developers start to make the same calculation as Chiara, it could put a floor under office values. It’s just a question of how much of a discount is needed to make those redevelopment deals worthwhile. And though quirks in the Canadian office market may mean the math starts to work there first, a similar process could be what helps a bottom start to form for such assets around the world.
“This whole strategy of redevelopment, I don’t think it’s just a Canada strategy. You can also employ that on a global basis,” said Raymond Wong, a vice president of data solutions delivery at Altus in Toronto. “If this really works in other countries, other institutions and developers might look at having a more proactive strategy.”
A lawyer by training, Chiara founded Mach 23 years ago when one of his clients, Montreal’s wealthy Lieberman family, said that if he could find properties worth buying, and manage them after, they’d invest alongside him. Since then, other wealthy families – notably Quebec’s Saputo clan and more recently a family based in Saudi Arabia – have partnered with Mach.
Chiara says the firm also does deals on its own, and when it does have a partner, it typically owns at least 30 per cent of the property, and often more than 50 per cent.
Chiara said Mach has also managed to get loans from Canada’s major banks, at interest rates around 5 per cent or 6 per cent, not far above the overnight lending rate. He says that’s an indication the lenders don’t view the loans as particularly risky – unusual at a time when lending against office buildings has ground to a near halt in the US. He says that’s because the banks also ultimately believe in the value of the underlying land, as well as Mach’s track record as a property manager and developer handling such projects.
“Because we do our own construction, because we’re more vertically integrated, we can control costs,” Chiara said. “If this was a pure office play, the banks wouldn’t do it. But I think they like our strategy, the plan B, and that’s what we’ve sold them.”
Tough times for offices
Still, the bad news for office buildings keeps coming. Though there’s been some recovery, many markets are seeing office tenants come in at 30 per cent below pre-pandemic levels, vacancy rates are at multi-decade highs, and most investors and forecasters expect valuations to fall further as the market continues adjusting to higher interest rates.
In the US, one estimate from Capital Economics predicted that office values will plunge 35 per cent from the peak by the end of 2025. They’ll take another 15 years to recover from there, the forecasters said. That repricing has seen the amount of distressed office buildings in the US balloon to $US24.8 billion ($37.6 billion), with billionaire Barry Sternlicht’s Starwood Capital Group becoming the latest high-profile landlord to default on a mortgage this year, joining the likes of Blackstone, Pacific Investment Management and Canada’s Brookfield Asset Management.
But Chiara believes at least some of the bearishness on offices is overdone. He says leasing activity in his properties is showing signs of recovery, and many of the buildings he’s buying will continue as work spaces.
The Toronto campus, for instance, is still 83 per cent leased with major tenants like American Express and Canadian telecom company Rogers Communications.
Mach’s first order of business will be to update the buildings in the hopes of getting that leasing rate above 90 per cent. It’s only if occupancy craters that Mach would think about tearing a building down.
And if that happens, Chiara said he expects city officials would make the necessary rezoning a breeze, given the need for housing and the burden of empty office buildings on municipal finances.
“When we need to rezone, it’s going to be because offices are in the shithole,” he said. “And if that’s the case, the city is going to play ball.”
When it comes to building housing, starting from scratch typically makes more sense. Kyle Bass, the founder of Dallas-based Hayman Capital Management, said back in April that demolishing old offices would be a more practical option than redevelopment because, “you have to jackhammer rebar and concrete. You have to re-plumb everything.”
That’s a sentiment Chiara agrees with, saying most of the office buildings he’s buying couldn’t be economically turned into housing without first being torn down. But he’s become more confident in the prices he’s paying because, unlike the US, Canada hasn’t seen a wave of defaults.
That’s because stronger loan covenants that tend to favour the lender are much more common in Canada. Lenders can typically seize borrowers’ other assets to make themselves whole when payments aren’t made, in turn making borrowers less willing to default or walk away from a property. In the US, for some types of debt, the most a lender can do is seize the mortgaged property itself.
Canada’s commercial real estate business is also concentrated enough to make it in both the lender’s and borrower’s interest to avoid a default. That’s because property tends to be owned by a few big pension funds, insurers and real estate investment trusts, so lenders have a greater incentive to come to the table for fear of losing business elsewhere. Similarly, lending is concentrated among roughly six big banks.
“In Canada, you can’t just hand back keys on most of the loans,” said Gwen Roush, a senior vice president at credit rating firm DBRS Morningstar. “It’s just a different environment in Canada. Brookfield is dropping keys on office buildings in the US, but we haven’t heard big headlines of them doing that in Canada, for example.”
The relative lack of distress this has resulted in makes Chiara think Canadian office values may not have much further to fall, and why he’s prepared to offer an out for owners who want it.
“That’s obviously precipitating our acquisitions: we’re at the bottom,” he said. “It may get worse before it gets better, and I recognise that, but a lot of institutional players want out. And there’s not a lot of players with the appetite we have for the size deal we can execute on.”
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