Capital Markets

Sentiment has been improving and momentum is building towards a recovery in the Canadian commercial real estate investment market in 2025. Stronger investment activity is expected as more capital is drawn off the sidelines. Cap rates for some asset classes are likely to start modestly compressing in 2025, but subject to global bond market conditions.

Trends to Watch

1. Investment market sentiment is improving and activity is expected to recover in 2025 with volumes steadily returning to levels closer to the average pace of recent years.
2. Some price discovery is likely to continue to play out in early 2025 as the market looks to establish its new pricing levels and narrow buyer and seller expectations.
3. Real estate spreads are roughly in line with their long-term historical average and cap rates are on track to start modestly compressing in 2025, but global bond market volatility poses some risk.

Investment market to recover in 2025 as sentiment continues to improve

Momentum in the commercial real estate investment market has been steadily building in the latter half of 2024, with transaction volumes and activity notably trending higher since the recent low recorded in Q1 2024. The stronger levels of capital formation and market optimism was driven in part by the Bank of Canada interest rate cuts. With each decrease to the policy interest rate, investors grew more confident that the market was shifting back into a stable and more accommodating financing environment. As a result, Canadian commercial real estate investment volumes for 2024 are on track to total $45 billion. This would be the third consecutive annual decrease in investment volumes since the record high in 2021, but also represents what is expected to be the trough before a recovery in 2025.

While some real estate asset classes are contending with sector headwinds, market fundamentals are mostly still relatively healthy and supportive of the long term appeal of Canadian real estate as an investment. In particular, alternative assets will see robust investor demand in 2025 given their comparatively stronger fundamentals. Combined with a more accommodative financing environment, investment capital will continue to be drawn off the sidelines in 2025. Institutional capital is also expected to make a material return and inject significantly more liquidity into the market. Overall activity is expected to be stronger in 2025 as the quarterly pace of investments steadily rise to levels closer in line with the average seen in recent years. If the investment market recovery progresses as expected, volumes could total nearly $48 billion in 2025. As well, the possibility for significant merger & acquisition activity presents further additional upside potential to the forecast.

Some price discovery likely to persist in early 2025 but will then largely stabilize

With the investment market recovery in its nascent stages, price discovery for some asset classes is expected to continue over the early months of 2025. Asset classes that saw limited transactions over the past two years and that may not have undergone enough of an adjustment yet will be monitored closely as the market looks to establish its new pricing levels.

As momentum in the market continues to build, each new completed transaction will provide fresh pricing datapoints that should help narrow buyer and seller expectations. Once new price floors and ceilings have been solidified, likely over the first half of 2025, this will give investors greater confidence in pursuing their real estate strategies and become a catalyst for even more transaction activity.

One notable exception is with Class B office assets, where pricing is expected to take a much longer time to stabilize. The office sector as a whole is beginning to see cash flows come under pressure as a result of increased spending on tenant inducements, amenities, insurance, base building build-outs and decarbonization. For Class B offices in particular, these assets are also facing additional headwinds from weaker leasing and investor demand. Altogether, it could take a couple years for Class B office pricing to fully stabilize.

Cap rates expected to start modestly compressing, but subject to global bond market conditions

Following more than two years of continual increases, Canadian cap rates generally appear to be peaking and are on track to start modestly compressing over 2025. Yields in some markets and select asset classes have already marginally decreased and this trend is expected to grow over the coming quarters.

The compression in cap rates is supported in part by a projected easing in the Canada 10-year bond yield in 2025, which is forecast to drop about 15 bps according to the median forecast of the major Canadian bank economist groups. However, volatility in the global bond markets will pose some risk. Real estate cap rate spreads have also widened and are roughly in line with the 20-year historical average of 384 bps over the Canada 10-year bond yield, which should relieve some of the upwards pressure on cap rates.

Cap rate movements will vary between asset classes as some segments like office still contend with softer valuations and others, such as multifamily, face pressure for wider spreads which may buoy yields in those cases. Meanwhile, cap rates for some assets, such as anchored retail, have risen to rather attractive levels and drawn increased investor interest. The stronger demand and competition for these highly sought-after properties will provide further support for modest cap rate decreases in 2025.