The City of Toronto has been one of the fastest growing office markets in North America, averaging about 2.3 million square feet of new office space per year since 1980. Despite this very favourable trend, the office space created in the last 15 years is not exactly catering to a wide range of users, as it is all virtually located in Toronto’s financial district and it is almost exclusively “AAA” or “A” class space, making it very costly.
At the same time, a number of “C” class office buildings have been converted to residential uses, largely due to Toronto’s robust residential market, which has resulted in a loss of about 3 million square feet of “C” class office space since 2000. Vacancy remains very low for “C” class office space (below 5% since 2008) and there is almost no space available for sublease.
The increasing lack of affordable office space in good locations can create problems for emerging businesses and start-ups, as this can limit their viability and cause them to cease operations or leave Toronto in search of cheaper office space elsewhere.
Why is “C” class office space not being built anymore?
The City of Toronto, much like many other major North American cities experienced a huge office construction boom in the 1980s, with approximately 60 million square feet of new office space built in the City between 1980 and 1992. However, what followed in the 1990s was a period of little construction activity, due to the overbuilding experienced in the 80s. The boom period of the 1980s was ripe with speculative building, which simply means that many office buildings were built without any significant pre-leasing agreements or commitments with tenants. Developers took big risks back then and often secured lease agreements with tenants after construction of the office building was completed. Furthermore, the selection of tenants was much more wide-ranging in the 1980s, and could have included some emerging businesses, as the newly created office space didn’t just cater to one particular industry.
Nowadays, the development of a new office building is often initiated through a pre-leasing agreement between a major company and an office developer. Offices will rarely get built speculatively, unless the developer self-finances the entire project. Iain Dobson’s research with the Strategic Regional Research Alliance and Canadian Urban Institute has determined that only about 350 companies are large and strong enough to provoke the development of a new office building. These companies possess the economic and financial influence to have office space built specifically to suit them, given of course, that a significant amount of space is pre-leased (i.e., generally at least 50% of space in the entire office building). And these office buildings are often built quickly as they have to align with market and business cycles.
More regulated financing and leasing standards have shifted the focus of office development to high quality, well located office space, which tends to be very pricey. Emerging businesses and start-ups (among many other small to medium companies) simply do not have the influence, financing and history to initiate the construction of new office space, and moreover, cannot afford space in brand new buildings. They have to lease or sublease space out of already existing buildings.
Another important factor that limits options for emerging businesses and start-ups is the standard length of office space leases. Normally, office space is leased out at 5 or 10 year intervals. This is not an issue for example to TD, Apple or Wal-Mart, as there is enough confidence that these large companies will be around in 5, 10 or 20 years. However, emerging businesses and start-ups are much more susceptible to market factors and do not possess the pool of capital, resources and performance history to know confidently, whether they will be around as far as one or two years into the future. Property owners seek security and stability with their leases, and are unlikely to take a risk on new companies as they are unsure of their durability.
Why is “C” class office space declining?
The strength of the residential market in Toronto since 2000 has demonstrated that in certain locations and under particular market conditions, building residential buildings is much more economical than office buildings. Areas like Yonge-Sheppard, Yonge-Eglinton and Yonge-Bloor have experienced a surge in residential condo construction, but absolutely no new office buildings in over 20 years. One of the main reasons is that the rents charged for office space are not high enough to warrant the development of a new office building. For example, the average net effective rental rate for office space in the Yonge-Bloor sub-market should be at least $30 per square foot to justify the construction of a new office building. However, the average net rental rate for offices in Yonge-Bloor is currently at $18 per square foot. This situation is not much different across the rest of Toronto when it comes to new office space, which is why a number of “B” or “C” class office buildings have already or are planned to be converted to residential uses.
These residential conversions are also contributing to low and declining vacancy rates of “C” class space, which ultimately limits options for emerging businesses and start-ups as less space is available for lease. A healthy and balanced office market exhibits vacancy rates between 5% and 7.5%. The vacancy rate for “C” class office space in Toronto is currently at 2.7%, and has not gone above 4% since 2008. Proposals for conversions are wiping out “C” class office buildings with high vacancies, leaving only office buildings with low space availability. Figure 3 shows the declining supply of office space in the Midtown (Yonge-Eglinton) and Bloor Street sub-markets, despite overall growing office space supply in the GTA and Downtown.
Are there solutions?
City of Toronto incentives and initiatives
To encourage investment in offices, the City of Toronto provides financial incentives for new office construction that exempts developers from paying development charges for office space above the first floor in a new office building. Development charges are payable by square metre (or by unit with residential uses) across the total gross floor area proposed in a new project. For example, residential developers have to pay development charges for the entire building, whereas office developers only pay for the space on the first floor.
The City also provides incentives as part of the Imagination, Manufacturing, Innovation and Technology Program, which can reduce property taxes for an eligible office development over a 10-year period.
As well, in an attempt to adhere to business cycles, Toronto’s planning department prioritizes the processing of development applications for office buildings and mixed use buildings with a large office component during the municipal approval process. Therefore, the application will be processed at a much faster rate and developers can begin construction sooner, which saves them time and money.
The City also recently initiated an amendment to its Official Plan (OPA #231) in December, 2013 that would provide greater support for “C” class offices through land use planning policies. One of the new policies indicates that office space must be replaced in downtown or in areas well served by transit if over 1,000 square metres (or roughly 10,700 square feet) is planned to be demolished or converted to residential uses. Some in the industry refer to this is a “no net loss” of office space. This policy is focused on reversing the loss of “B” and especially “C” class office space throughout the city due to residential conversions.
The Kings Example
In the 1990s, the City of Toronto amended a zoning policy for the “Kings” area in downtown (i.e., King Street West and East) that permitted a greater diversity of uses, most notably offices, to be established in former industrial, brick and beam buildings. The zoning change led to a creation of more than 15 million square feet of very well located, relatively affordable office space that over the years met the demands of emerging businesses in the new economy. But with rapidly increasing land values in Toronto, particularly in the core, rental rates have risen to a level that is currently making it difficult for emerging businesses and start-ups to occupy space there. As well, there are fewer opportunities remaining for conversions of former industrial buildings to office uses in the “Kings”, as the supply of convertible buildings is less than 2 million square feet.
Despite the increasing rental rates in the “Kings”, the zoning change proved to be a very successful initiative that not only created opportunities for businesses in the new economy, it ultimately revitalized complete neighbourhoods, turning them into very attractive places to live, work and play in.
Co-working Office Space
Growth of the sharing economy has also led to the creation of co-working office space, with numerous examples evident in most major North American cities. Fees can be paid for hourly, daily, weekly or monthly usage and it is often very affordable. The advantages of this type of space are the low costs, generally good locations and ability to benefit from collaboration with different entrepreneurs and social innovators. Some great examples of Toronto-based co-working office space include the Centre for Social Innovation, BrightLane, Workhaus, Workplace One and iQ office suites.
Much like the need for affordable housing in large, growing and increasingly expensive cities around the world, there is also a need for affordable working space. Enormous social and economic benefits can be reaped from creating an environment conducive to emerging businesses and start-ups. The cities and developers that can foster that environment in the form of affordable office space in good locations can do wonders for the community.