Issue #03 | Article 04 / 05
How to budget in the current inflationary period
Find out what our experts are telling clients when it comes to budgeting in the current landscape.
Last updated: December 1, 2022
Fiscal responsibility is increasingly important in today’s economic environment of uncertainty. Among our core strengths is helping find efficiencies and plan for tomorrow – not just next week or next year but many years or even decades from now. We spoke with three leading experts at Avison Young who have their fingers on the pulse, to find out more about the type of counsel they are providing to clients.
A tough environment ahead
- Securing top quality, energy efficient buildings in amenity rich locations – maybe at higher rent per square foot but taking a smaller amount of space – will remain attractive as companies look to position themselves amidst new elements of risk.
- Overall, we will see upward pressure on real estate yields which means downward pressure on pricing for commercial property. However, we expect the slowdown to be relatively shallow and short-lived.
What is the best step that can be taken by a client who is particularly budget conscious during this current economic landscape?
Nick: Given the weakening economic outlook and probability of a recession in the near future, companies will remain cautious and cost-conscious across all aspects of their activities. The most pressing challenge is to assess the impact of new elements of risk we are seeing in this current economic landscape. Some elements can be anticipated - for instance, the Bank of Canada communicates its intentions relatively clearly and in advance of the actual announcements – however, the outcomes of interest rates hikes have been harder to predict. We also see some contradicting information on market fundamentals in Canada:
- The housing market is cooling but the country is facing an acute shortage of dwellings. Demand for multifamily is strong but building affordable units has become impossible, due to rising construction costs for example.
- We anticipate some layoffs, or hiring freezes, due to recession but meanwhile companies of all sectors are facing labour shortages due to an aging population. This lack of workers will limit demand for office and industrial space. It is also causing delays and higher costs on the development side.
- Regardless of labour shortage, everyone needs a roof over their head and needs to consume retail and entertainment/hospitality.
- On the industrial side, supply chain disruptions are forcing manufacturers and wholesalers to hoard or fill up their warehouses in order to meet client demand in reasonable delays due to a shortage of 25,000 truck drivers. There is pressure on demand for industrial space while rental rates continue to rise across the country.
However, we are still seeing companies push ahead with “strategic” real estate projects. Securing top quality, energy efficient buildings in amenity rich locations – maybe at higher rent psf but taking a smaller amount of space – will remain attractive from both an operational and financial perspective as companies look to position themselves for the future.
How do you see some CRE assets performing differently from others?
Nick: The differentiators will be quality of asset and location rather than a straightforward division between “winners and losers” by sector. That said, those sectors with strong structural growth drivers—for example urban logistics and life sciences— are less dependent on cyclical demand growth and will therefore hold up better. But rising risk-free rates and finance costs are likely to feed through to impact most aspects of the market. When interest rates go up as quickly as they have in recent months in Canada, very few areas of the commercial real estate market will be immune from some degree of repricing.
How is the changing economic and financial market environment impacting commercial real estate?
Nick: Four key factors are confronting real estate investors.
1. Real estate pricing is impacted by the rise in government bond yields and is particularly highly correlated with the price of BBB corporate bonds. This will put upward pressure on yields (and downward pressure on values) in the property sector.
2. Higher rates slow the economy, impacting occupier demand for real estate at a time when the market is already having to adapt to changing occupational dynamics. The shift from in-store to online retail and higher levels of remote office work following the pandemic creates interesting opportunities for investors although, short term, the weaker economic outlook reduces the prospects for rental growth in some areas of the market, which also hits investor sentiment and pricing.
3. The costs of finance have gone up in line with higher interest rates. Many real estate investors use debt to finance their activities and enhance returns. As with homeowners, higher commercial borrowing costs make it harder for leveraged investors to justify current prices and forces some buyers out of the market.
4. Higher material costs and a tight labour market have dramatically increased the cost of construction and refurbishment. Prices change so rapidly that quotes are only guaranteed for a week or two. This makes it hard to run the numbers on investments requiring refurbishment or repositioning to enhance attractiveness, which is a key strategy for value-add investors.
Taken together, these four key factors are confronting real estate investors with a very different environment from the one they have become accustomed to in recent years. Overall, we will see upward pressure on real estate yields, which means downward pressure on pricing for commercial property. However, we expect the slowdown to be relatively shallow and short-lived.
Extra effort in examining assets can pay off financially
- Municipalities will be challenged to limit tax increase while delivering services. Owners and investors should examine each asset by refined region and property type, and not applying a broad-brush approach to all properties.
- Good corporate citizenship does not preclude owners from respectfully challenging their property assessment and taxes.
- Always seek guidance from your advisor before responding to municipal inquiries.
When it comes to your area of property tax, what is the biggest challenge your clients are facing when it comes to looking at budgets in this inflationary period?
Laurel: Uncertainty. Large Municipalities have been feeling pressure for some time to limit property tax increases. In an inflationary environment, stakeholders are only going to increase that pressure. It will be a challenge for municipalities to limit tax increase while delivering services. Additionally, inflationary periods are not necessarily aligned with higher valuation and taxes. A challenge for owners and investors is having to examine each asset by refined region and property type, and not applying a broad-brush approach to all properties, for budget forecasting. This takes some extra effort however the accuracy translates to confidence and positive performance of the asset.
What one piece of advice would you give in this economic environment?
Laurel: Whether your asset is in a robust or chronically vacant marketplace, the advice we extend to our clientele is to be diligent in reviewing every property assessment and seek our expertise any time there is a physical or significant tenancy change. Fervently pursue issues that will reduce your asset’s taxes to within the baseline of comparable properties or, even better, below competing properties. Good corporate citizenship does not preclude owners from respectfully challenging their property assessment and taxes. You only get so many chances up at the plate – and no one ever gets a hit by not swinging the bat. Our simplest advice: file an appeal and find an expert that will leave no stone unturned in trying to find savings.
What’s the most-often-made mistake you’re seeing among commercial real estate clients that you feel could be easily rectified?
Laurel: Too many real estate owners are responding to inquiries for information from municipalities without seeking guidance from a tax professional to understand the implications of providing the information. Always ask your advisor if this is the information to provide or if it should be provided in the manner that you were going to send it. Another mistake we often see is clients assuming their asset is correctly assessed, thinking that it does not have uniquely different characteristics which merit closer examination and consideration of a lower value than seemingly comparable properties.
No crystal ball for mergers and acquisitions
- The last two years have seen a strong mid-market M&A sector, but this may be impacted as the days of cheap capital are gone for the foreseeable future.
- Forecasting based on previous year performance is ineffective in this environment of swift change. Ensuring management of inflationary risk and having a well-capitalized balance sheet is key.
- A key trend is an increase in due diligence from counterparties as we face economic headwinds; having a capable M&A advisor can help secure the best transition possible.
Are you seeing any trends around how businesses are transitioning in/out of markets?
Aaron: Despite current economic uncertainty impacting transition activity, the last two years have seen a strong mid-market M&A sector with business owners looking to sell externally – rather than transitioning internally to a family member, for example. Our role as M&A advisors at Avison Young is to help business owners realize the best value for their business through an extensive and professional process. We work to have a deep understanding of the business, industry and owner motivations in order to help secure the best transition possible from both a monetary and lifestyle perspective. A key trend we are seeing is an increase in the due diligence process from counterparties as we face the current economic headwinds. Due diligence can be invasive and time consuming, another key reason why having a capable advisor is key to securing a best transition possible.
What’s the biggest challenge when it comes to looking at budgeting in the inflationary period for your clients?
Aaron: Typically, clients are accustomed to operating in a fairly stable environment where inflation-driven financial impacts can be reasonably forecast. Now, in this environment of swift change, if you’re budgeting based on the previous year, you’re going to get caught flat-footed, unfortunately. It’s especially tricky right now as some inflationary pressures are easing while others are gathering steam. While we don’t have a crystal ball, we can help business owners better plan for inflationary impacts in their business as there is an incredible amount of nuance that sits behind the headline inflation numbers. In the end, the best thing to do to manage inflationary risk – and other risks – is to have a well-capitalized balance sheet.
In your conversations, is there anything recurring -- When the phone rings, you can predict what the person is going to say because it seems to be the question of the day or the general mood?
Aaron: It’s hard to have a unique answer here – but it’s interest rates first and foremost. We have become accustomed to easy access to incredibly cheap capital and, frankly, those days are over for the foreseeable future. Central banks are in a precarious position of aggressively pushing monetary policy in an effort to push down inflation without completely crushing economic stability. Key economic indicators are showing this is starting to have an impact but we remain in uncertain times where central banks are going to keep their foot on the gas, raising rates into the slowing economy. Business owners and prospective buyers are looking toward 2023 with ample uncertainty around economic health. The market is in a unique situation where negative economic news is having a positive impact as the read-through is that central banks will ease off on their interest rate hiking plans.
With decades of experience, Avison Young’s team of professionals is uniquely positioned to work closely with clients on property conversions, supporting all life stages of a project from start to completion.
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Our experts who contributed to this article
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