Vancouver has become the scene of a bidding war zone for commercial properties, forcing buyers to accept lower returns on their investments, say real estate industry insiders.

"I've been in this industry for 23 years," says Tony Quattrin, vice-president of investment properties for CB Richard Ellis Ltd. "This is definitely the most aggressive I've seen the market in commercial real estate."

Quattrin and other industry players say an unprecedented abundance of investment capital and a shortage of inventory have sparked bidding battles for income-producing commercial space - including office, retail and industrial buildings.

"Basically, under the new rules of the market, we're taking assets out that are unpriced and we're asking bidders to come in and make bids on those properties," said Quattrin, after speaking at a National Association of Industrial and Office Properties (NAIOP) breakfast meeting in Vancouver.

Bayne Stanley, Business Edge
Tony Quattrin, vice-president of investment properties for CB Richard Ellis Ltd., says the market has never been hotter.

From 2003 to 2005, Quattrin told NAIOP members, Vancouver's investment sale transactions values doubled - from $800 million in 2003 to $1.2 billion in 2004 and $1.6 billion in 2005.

Institutional investors are driving the activity. Pension funds, including the Canada Pension Plan, topped all buyers, followed by real estate investment trusts (REITs), foreign investors, private buyers and syndicates.

Although investors are paying more for properties, the tight market is forcing them to accept a lower return. Put-off purchasers are either heading to Vancouver's suburbs or leaving the market altogether.

"Investors are just going to have to pay a lot more for real estate (in 2006)," says Quattrin, adding Vancouver's situation is part of a national trend.

The bidding wars, which have developed over the past year, are occurring while construction costs are rising rapidly. Investors usually decide whether to buy or sell according to a building market capitalization, or cap, rate that refers to a property's rate of net income relative to its purchase price.

Expressed in the form of a percentage, the cap rate incorporates a property's selling price, gross rents, non-rental income, vacancy rate and operating expenses. It is considered more reliable than other measurements, such as gross rent over the term of ownership.

Cap rates have fallen to six per cent on some commercial buildings, notably office towers, and Quattrin predicts they could fall further.

"We haven't seen (cap rates) below six in Vancouver yet, but I don't doubt that it will come," he says.

Stuart Wells, a lawyer with Clark Wilson LLP, says some pension funds are willing to accept as little as four per cent. Eager purchasers will take whatever properties they can get, no matter what sector it's in.

"Certainly, there's no concern about the availability of capital," says Wells. "We have clients who are sitting with piles of money and are worried about finding ways to deploy it."

Similar to the way residential developers hold pre-sales on future condo complexes, commercial developers are pre-selling shopping centres and institutions such as seniors' centres before putting a hole in the ground, says Wells.

When a buyer shakes hands with a seller on a deal, adds Darren Donnelly, head of Clark Wilson LLP's commercial real estate group, he wants the terms in writing "extremely quickly."

As a result, lawyers on both sides have less time to conduct due diligence, buyers are not placing any restrictions on purchases, and deals are closing quicker.

"Most (companies) just don't have enough experienced staff, so it's a real challenge for us sometimes to get good instructions from the client ... You have to live with the idea that your client is taking more risk," says Donnelly.

The downtown Vancouver office market is feeling the pinch more than other commercial sectors.

"I predict there will be a rise in office rental rates in the next 12 to 24 months," says Quattrin. "Vacancy rates will really start to drop."

He forecasts rental rates will jump 20 to 25 per cent to approximately $40 per sq. ft. from $20 to $30 per sq. ft.

According to the CB Richard Ellis end-of-year 2005 office market view report, downtown Vancouver's overall vacancy has dropped to a four-year low of 7.8 per cent, while vacancy is at a record low of 5.8 per cent on the Broadway Corridor - a medical-office hub considered the most high-end area outside downtown.

Meanwhile, rental rates have increased between 15 and 25 per cent in the downtown and Broadway corridor markets as 87 per cent of rentals occurred in B- and C-class buildings, primarily because they were more available.

"It means that the growing tenant base, going forward, will be struggling to find office space downtown," says CB Richard Ellis analyst Chris Clibbon. "And, it means someone is going to have to step up and build an unusual office development in downtown Vancouver with a good, high rent, or you'll see more suburban office development - which is probably very likely."

Clibbon adds his office developers will build suburban "office parks" before building downtown. "It's just easier (to build) in the suburbs."

He predicts Burnaby, where the vacancy rate has dropped nearly 10 per cent over the past 24 months, will become the next office development hotspot. Burnaby's vacancy rate dropped to 14.7 per cent at the end of 2005 - its lowest level in 41/2 years.

David Podmore, CEO of Concert Properties and president of the Urban Develop-ment Institute's (UDI) Pacific region, says it is becoming increasingly difficult for developers to justify building office towers downtown.

"One of the concerns, of course, is finding a suitable site at an acceptable price, and the problem we have in Vancouver is the conversion of commercial space to residential has driven the price of commercial land so high that it really is difficult to make an office-commercial building work - because the land prices are inflated," says Podmore.

Concert would like to build an officer tower at the right site for the right cost, says Podmore, but high residential land values are constraining office development.

Podmore says the City of Vancouver has been wise to impose a moratorium on commercial-to-residential conversions in the central business district in order to protect commercial opportunities. The moratorium is expected to last at least another year while civic planners study the issue.

"If we continue to look at all commercial sites as though they could be residential, the cost is going to make it very difficult for anybody to think about building a commercial building," says Podmore.

During the UDI's recent annual development forecasting luncheon, he chastised developers for making "silly" large land purchases at inflated prices.

He anticipates some new development firms will fail because they do not have an understanding of costs. Over the last year, prices of steel, concrete and labour have escalated rapidly.

Avtar Bains, executive vice-president of investment with Colliers International, says high prices prompted investors from Israel, the United States, Germany, England and China to look elsewhere for properties in 2005.

"They're still interested in Canadian properties, but when we set a price expectation that was so high, buyers from those countries said, 'Thanks, but no thanks.' " Only 13.5 per cent of downtown Vancouver buildings have offshore owners, he told UDI members. Most are owned by Canadians. "The market across Canada is driven by Canadians, and it's very important to understand that."

Kevin Meikle, vice-president of investment sales for Cushman and Wakefield LePage Inc., also forecasts cap rates will shift downward, adding the Vancouver market has a differential of one per cent.

"When you're getting 10-year money for under five per cent and you can buy a long-term yield (in real estate) at 6.6 (per cent), people are going to continue to flood the market," says Meikle, suggesting real estate is more attractive than bonds. "So there's not going to be pressure there for cap rates to go up."

According to CB Richard Ellis analyst Clibbon, the average price of serviced industrial land rose 10 to 25 per cent in Greater Vancouver, depending on the location.

Meanwhile, the industrial vacancy rate dropped to 1.6 per cent by the end of 2005, just shy of the record 1.3 per cent at the end of 2000.

Last year, developers built three million sq. ft. of new industrial buildings - a record high for annual completions and well above the five-year average of 2.1 million sq. ft.

Clibbon predicts industrial construction activity will remain strong as 2.3 million sq. ft. of new supply is under construction and another 4.3 million sq. ft. is in the planning and pre-construction phases.

(Monte Stewart can be reached at monte@businessedge.ca)