Thanks to Sandy McNair at Altus InSite for providing this chart to put the Kanata submarket in context from a Canadian perspective.  The following is a list of the 10 biggest office leasing suburban submarkets:

What has struck me for a while is that the vacancy rate for Kanata is not necessarily a good indicator for whether that market favours landlords or tenants.  The casual observer may be surprised to find that a basic negotiation assumption – the market favours me or the other side –involves more than just the market vacancy rate. There are more forces at play.

Dave Pridham of Bentall Kennedy raised this comment in a recent blog of mine about PWGSC securing space in Ottawa.  Dave’s contention is that the vacancy rate for the federal government is not that of the overall market, but only the space that is both big enough to house them and meets their standards for accommodations.  These criteria eliminate some (or most) of the available space that makes up the vacancy rate, and implies a (much) lower effective vacancy rate for the federal government as they survey the market for options.

I want to use the Kanata marketplace to illustrate how the vacancy rate alone may not be a good indicator of the market dynamics for a particular tenant.  I have relied on the good folks at Altus InSite for this data.  They track 66 buildings totaling 5,056,291 square feet in this submarket with a vacancy rate for Q1 2012 of 17.2%.

The following chart summarizes the availability of space to lease by area for Kanata, e.g. up to 5,000 sf, 5,000 to 10,000 sf, etc.  A tenant rep broker will produce a list of these options for consideration as alternatives for a particular tenant. I used the Altus InSite web site http://altusinsite.com/.

For example, if you are a tenant looking to lease 10,000 – 20,000 square feet, your initial search shows 13 choices: 9 available directly from landlords; and another 4 options as sublets.  There is 168,000 sf of this sized spaced available.  The competition amongst landlords is less fierce than you might expect, as there are only 4 landlords competing for this business.  What the vacancy rate glosses over is multiple offerings from the same landlord.

Kanata Sub-Market April 2012

source:  Altus InSite

In this size range, a single landlord accounts for 5 of the 9 direct options.  This high proportion of the vacant units is not surprising, as this landlord owns 2.4 million sf in a market that is 5.1 million sf, for a market share of roughly 41%.  What is notable is that a factor in the determination of whether the market favours landlords or tenants may have as much to do with how many landlords are competing for a tenant, in addition to the number of options available to the tenant.

A second element that is revealed in this vacancy rate dissection is that for any particularly sized tenant, the availability of options is further narrowed when you remove those vacancies that are either too large or too small for the respective tenant.  For example, users looking for more than 50,000 sf have 3 options.  They do not benefit in their negotiations if there is lots (or little) space available in the less than 20,000 sf availability.  In this situation, 980 basis points of the vacancy rate of 17.2% is immaterial to their market niche.  Similarly, it is highly unlikely that the space that is suited to users for more than 50,000 sf will be marketed to users looking for less than 5,000 sf, and that makes 528 basis points out of the vacancy rate of 17.2% immaterial for that market niche.

A third element that is revealed is just how few landlords compete for tenants of more than 5,000 sf.  There may be 23 direct options available to tenants looking for 5,000 – 10,000 sf, but there are only 6 landlords competing for the business.  There are at most 4 landlords competing for the remaining size breakdowns.  This is not the competitive landscape many tenants would expect.

Clearly other factors, beyond the vacancy rate, also need to be considered, such as:

• the quality of the space available;
• the extent to which the existing leasehold improvements are a match with the intended use;
• the quality of the existing leaseholds and their further economic life;
• the leasehold improvement costs to be incurred by the landlord and tenant to make the space work;
• leasing velocity;
• covenant strength.

The Kanata office leasing submarket is less favourable to many tenants than a vacancy rate of 17.2% seems to indicate.  The balance between it being a market that favours landlords or tenants depends in part on the size of the requirement.  Lastly, the Kanata market effectively gets made by only a small number of landlords because of their dominance in terms of their control over supply.

What other factors affect the balance of the landlord market versus tenant market?

I like hearing the US viewpoint on real estate, because their market is so much bigger, and because for years they were 2-3 quarters ahead of us in the real estate market cycle  It used to be simple to predict the market in Canada – just describe the current conditions in the US (cap rate (de)compression, trends in vacancy rates, trends in absorption, etc.) and that would be the conditions in Canada in about 18 months.  With the differences in employment growth, that linkage between the two real estate markets broke in 2008, and does not seem likely to return anytime soon.

See the entire presentation here.

The Economist ran a recent article that dealt with the US in more detail. Unmired at last: America’s recovery is neither robust nor dramatic. But it is real.

More importantly, I like to hear yield expectations from the US because their biggest markets set the floor for yields for most asset classes.  For example, most people would expect the NY or London CBD office to set the floor for yields in that asset class and every other market priced off of those ones.  You would think that eventually there is leakage of yield expectations from these biggest markets to all other markets.

Rexall – Ottawa – 6.9% cap

Walgreen – Memphis – 7.9% cap

For example, the Canadian market was  dominated by German investors in the mid 2000s as the Germans took advantage of yields unavailable to them in their domestic market for equivalent-quality real estate  The example above illustrates a difference in yield for notionally similar investments that the market will eventually minimize.

I also enjoy the other market research made available in presentations, and at this year’s forum, one slide in particular struck me as relevant. It helps to explain my confusion.  It is from the presentation by John O’Bryan from CBRE.  You can find a link to his speech and his slides here.

This slide tracks the yield for the 10-year Government of Canada bond (notionally the safe rate for investment) and compares that to the national cap rate for all property classes excluding hotels.  The decline in the yield of the 10-year bond is pretty much continuous for 20-odd years, and not surprisingly cap rates have declined pretty much continuously over the same period.

The slide shows that while cap rates continue to compress to historical lows, the gap between cap rates and the safe rate have not compressed more recently.  In this slide, John O’Bryan suggested that there is room for additional cap rate compression as the cap rate – bond rate spread narrows back to historical averages.

This spread highlights the premium that investors demanded for real estate to compensate for its  inherent additional risks versus the safe rate I have guessed at the bond rates for each of  the highlighted spreads and extracted the information below:

The first four columns are CBRE information, and I have added the multiple.  I keep hearing about multiples for the stock market, so I thought I could add a multiple for this discussion.  For example, to invest in real estate in 1998, investors wanted a multiple of 1.74 times over 10-year Canada bond rate.  By 2011 investors wanted a yield 3.2 times greater than the safe rate by this measure.

With this multiple in mind, the shocker for me was hearing the US panelists talk about the yields they expect.  One guy is doing mezzanine debt and getting a yield of 10-12%, or about 5 to 6 times the safe rate.  Another guy is targeting IRRs in the upper teens for some value-add deals, or returns 8 to 9 times the safe rate.

It is these yield multiples that cause me grief.  They struck me as really high.  If I worked backwards, mezz debt in 2003 would have been priced at 22.5% – 27%, and IRRs would have been 40.5% – 45% for value-add deals.  Clearly this was not the case (at least for the deals I was aware of).

Then I figured out that I did not appreciate the risk profile for the investment they were describing.  I wondered what the risk profile is to get these yields.  I wondered what probability of failure was implicit in the yields they were targeting, and what impact failure had on the investment.

I was reminded of a pension fund that securitized their US commercial mortgages in the mid 2000s and sold off the “A” piece, because they liked the increased yield of the “B” piece.  That strategy worked really well until the events that justified the higher yield in the first place for the B tranche – increased risk – kicked in and some of the loans failed.

What struck me was that the cap rate compression for core assets (the best buildings in the best markets with the best tenants) has not affected the yields being targeted further up the risk curve.   It seems like yields for risk were set in concrete maybe 20 years ago and have not changed.  It sounded like that US guy had to get high teen returns because he always aimed to get high teen returns without regard to its premium relative to the safe rate.

What is an adequate premium to do riskier real estate deals?

There are three trades happening around the end of 2011 and early 2012 that are good illustrations of the source of this confusion for me.  They are the Chambers Building, the Telus Building and the EDC Building.

They point to how the investment market was affected by the Lehman Brothers in September 2008.  I am using the Lehman collapse as the “line in the sand” between the very aggressive investment market up to 2007 (for the US) and into 2008 (for Canada), versus the very tight credit conditions in 2009 that loosened starting in 2010.

The Chambers Building

The Chambers Building is a 211,000 sf Class A office building in downtown Ottawa combining three heritage buildings fronting Confederation Square on Elgin Street with a 14-storey tower built in 1994.  It is leased on a long-term basis to the National Capital Commission (70% of the building) and is subject to a land lease.

The Chambers Building was bought by Allied REIT November 2011 for something less than $100 million, say $95 million and a cap rate in the mid-6% range.  The sale is scheduled to close in February 2012.  It is convoluted, as there is a land lease to the National Capital Commission, and the lease participates in total gross rent.

The seller came to market in 2006 with the same agent, had pretty much the same rent roll and rental income growth, and no sale was concluded.  The agent said they had the right buyer, but not at a price the owner would vend at.  2006 – no sale; 2011 sale effected.

What is notable is that prior to the Lehman collapse the market saw this as expensive pricing and a little unusual with a convoluted land lease.  It is trading at $450 psf (without any value for the land and no value for the building at the end of the land lease) and a cap in the mid-sixes, so is not inexpensive by any measure.

My confusion for this sale is that it had been in the market prior to the Lehman collapse and the sale did not clear the market.  It is odd that the Lehman collapse has made this property more liquid.

What is it then that changed?

The Telus Building

The Telus Building sold in January 2012 for $60 million.  The sale price is equivalent to a cap rate of 6.3% and is about $550 psf.

The Telus Building is Class A 111,000 sf LEED Gold office building in downtown Ottawa.  It is fully leased by Telus for a fifteen-year term, and was completed in 2007.   Morguard managed the building for DEGI and effected a sale to Greystone Managed Investments, its largest client.

DEGI (Deutsche Gesellschaft fur Immobilienfonds mbH) bought the building in 2007 at about the height of the real estate markets worldwide for $66 million.  The investment metrics at the time were a 5.75% cap and about $605 psf.  DEGI has incurred a loss of about 10% on the purchase price, had a gain on the C$-Euro exchange of about 7.5%, and, factoring in some principal repayment on the existing first mortgage, likely means they about broke even on the trade.

The DEGI purchase stood out at the time for the price per foot of building.  It has declined from about $605 per foot to $550 per foot.  What is notable is that the pricing differential from the top of the real estate market pre-Lehman collapse to the post-Lehman recovery is about 55 basis points.

What is confusing for me it that the first sale was described at the time as an anomaly and maybe as illustration of the market at the top.  If that is the case, is a 55 basis point correction sufficient?

Export Development Corporation Building

The new EDC Building closed January 24, 2012 for $165,450,000.  Manulife bought this from Broccolini and Canderel. It is a Class A 472,000 sf LEED Gold building in downtown Ottawa leased to Export Development Corporation for 20 years.

Broccolini/Canderel contracted to build this for EDC in 2009, and was caught in the credit squeeze post-Lehman collapse.  Unfortunately for Broccolini/Canderel, they started to need capital to complete the development at a time that capital was generally unavailable, particularly with real estate at this early stage of development and in this scale of development.

The difficulty they encountered was little debt financing available for construction.  Lenders were uncomfortable with loans in excess of $30 million, and they were insistent on a clear exit for their debt investment.  Broccolini/Canderel struck a deal with Manulife for its sale about 2 years ago.

The cap rate is reported to be about 7.0% – 7.25%, or fully 70-95 basis points higher than Telus with a longer lease at a lower rent with a stronger covenant.  The gain at closing from cap rate compression since the purchase was struck is a minimum of $27 million.   This is likely the best buy of the three.

The confusing signal for me was how quickly the credit markets closed, and how small the window was in which the credit markets struggled.  I continue to wonder if this magic combination of low bond yields and tight spreads will continue to provide liquidity for the investment markets, or more importantly, what event could return us to the tight credit period that Broccolini/Canderel experienced.

Stephen Jarislowsky described this as a balance-sheet recession.  He said they last a decade.  We are about 4 years in to it.  What trends do you anticipate for the next while?

The subject was the impact of the federal government’s plan to change its occupancy.  In a market in which it has contracted for 4 million sf of new supply, it is talking about reducing the scale of its operations.  This link takes you to a summary of the debate.

Sandy said the sky is falling.  He argued that the reduction in federal government personnel in conjunction with a reduction in space allocation per employee combined with new office building supply the feds have contracted to create a perfect storm for existing owners.  He predicted a (startling) reduction in PWGSC demand for office accommodations of 10.5 million square feet.   Sandy got everyone’s attention when he outlined the impact of all this vacancy on private landlords in the Greater Ottawa market.

Nathan said there would be no change from what we have known for the past decade.  He took the opposite approach:  the reduction in numbers of employees will be less than anticipated;  the reduction in space demand will take a long time to flow through to occupancy in buildings; and, we have heard this plan before and it usually does not shock the local office leasing market as much as predicted, if at all.  Nathan provided the reassurance that this will likely not have much impact, if any, as the plan will not be executed as described. It felt like they had set up the session to be confrontational, they took opposing views on purpose, and argued both well.  The good news is that at least someone said something to spark discussion.  The divide in the reaction to the session became:  who was being controversial?

The conclusion that Sandy came to was shocking in its magnitude, however the methodology employed is pretty sound.  He relied on three factors to get there: the new supply that PWGSC has contracted for and that exists (Nortel campus) or is being built (3 buildings in Gatineau, one in CBD Ottawa and one in east-end Ottawa) and everyone agrees to that; a planned reduction to the size of the federal workforce that Nathan conceded could be 5% while Sandy modeled 10%; and, the impact of PWGSC reducing the space allocation per employee.  It was this third part of Sandy’s analysis that met with most resistance to acceptance from the audience.

It was odd (for me) that Nathan played down the plans for the federal government to reduce the size of its operations.  The press has reported on various occasions that pretty much every department is going through an exercise to reduce its operation by both 5% and 10%.  The government has hired Deloitte to oversee the program savings each department is proposing.  This link reviews that mandate.

The slide from the Conference Board earlier in the day illustrated that the government is already getting smaller:

More recently, the Ottawa Citizen ran an article this past weekend reviewing the DND plans to revamp and occupy the Nortel Campus.  It helps in shedding light on what one major department is considering.  This is a link to that story.

The article describes how DND is located in 48 buildings in the Greater Ottawa region.  DND expects to take 5-7 years to complete its move to the Nortel campus, and remain in occupancy in 5 other buildings: its existing headquarters on Colonel By Drive; the Louis St. Laurent Building; the National Printing Bureau building; the Hotel de Ville building; and the building on Star Top Road.
“As far as other DND locations throughout Ottawa and Gatineau, the government will allow leases to run out.”

DND HQ

The National Printing Bureau

Star Top Road

Based on the Ottawa Citizen article, there are 43 locations DND will vacate.  The owners of these buildings will need to replace the use by DND with that of another federal government department.  If Nathan is correct, that should be straightforward and pretty much business as usual.  If Sandy is correct, there will be owners looking to secure PWGSC occupancy in an environment of reduced real estate requirements.

The question that faces owners of office buildings DND occupies in Ottawa is:  which approach to this controversy is prudent for my investment?  Funny how the status quo may turn out to be the controversial prediction.

Where do you sit on this debate?

The tricky part in the inventory above is that it consists of office buildings in the “competitive” market.  The “competitive” market is a subset of all office buildings, some of which really do not compete for tenants, and so get excluded when trying to determine the options available to tenants.  I like to think of the competitive market as buildings an office tenant rep agent can earn a commission at.  That excludes buildings that are owned by a firm and occupied by it.

Why am I bringing this up? I contend that the shadow supply, that supply of office buildings not captured in the “competitive” market, residing in the Gatineau market and in PWGSC owned real estate, has a material impact on how tenants make accommodation decisions.  This shadow supply is fundamental as to how PWGSC executes its real estate strategy.  It is significant.

The overall size of the market is important as it gets factored into demand – 3% growth is way more demand on 65 million sf versus 45 million sf.  Too often this “shadow supply” is forgotten because it is not reported on.  My suspicion is that “shadow supply” is a larger proportion of the office market universe in Ottawa than other markets and as a result is a bigger concern.  This is an aspect that is important to the investment side, and not as much to the leasing side.  Its impact is material.

Gatineau

The Gatineau Market

The Gatineau, Quebec office market, part of Greater Ottawa and home to roughly 25% of the people here, is rarely reported on.  It is a market of roughly 9,000,000 sf and is 80% occupied by the federal government (according to PWGSC).  It gets ignored in the Ottawa statistics because real estate brokers are licensed provincially and the Ottawa brokerage community does little business in Gatineau.  Only 20% of the market is occupied by non-PWGSC, so that makes it a pretty small submarket for tenant reps to farm for activity.

None the less, there is 9,000,000 sf of space that may or may not have been included in the “Greater Ottawa” stats above.  Altus InSite tracks 28 buildings providing 4.7 million sf in the competitive inventory that is ignored by the brokerage houses as they report on Ottawa.  The remaining 4.3 million sf is owned by PWGSC or is a lease-purchase.

The Gatineau marketplace is important to PWGSC as it has a policy guideline to have at least 25% of its inventory (owned or leased) in the Gatineau.  It has struggled to achieve that ratio, and will struggle to maintain it if it wants to upgrade the quality of office space it occupies as it migrates towards modern, green efficient facilities.

It is odd that this important submarket isn’t included in brokerage reports.

PWGSC in perspective

As of June 2009 PWGSC had an inventory of 102 buildings, totally 18,300,000 sf, the federal government owned.  It leases another 21,500,000 sf in 241 locations.  What is noteworthy is that the vacancy rate that PWGSC confronts is different than that of the competitive market as it has an additional 18.3 million sf in occupancy to factor into the calculation.  PWGSC has been running with a vacancy rate of less than 3% in the entire National Capital Region for years (made up of owned and leased premises).

The following chart outlines the PWGSC inventory of office accommodations:

All figures in million sf
Contracted means projects currently under construction for occupancy by PWGSC.

Back to my contention.  It is important to know the office building universe because that is the way PWGSC looks at it.  It is doing its strategic planning and making tactical decisions on the basis of an office market that is 18.7 million sf larger than that tracked by the brokerage houses, plus another 4.7 million sf of competitive supply in Gatineau.

The market they play in for space is not the market described by the competitive market reports.

Now for the nuances that give the market reportage headaches:
1.  L’Esplanade Laurier is a 1,000,000 sf office complex occupying a city block in the Central Business District in Ottawa.  It was counted by PWGSC as “lease-purchase” as their lease allowed them an option to purchase the building.  They exercised that option.  If one is rigorous about the definition of competitive space, this building should have been removed from the competitive inventory as of Q3 2010.

L'Esplanade Laurier

If the federal government goes to tender for redevelopment by the private sector, the building could go back into competitive supply.  The building is always there.  The question is, will it appear and disappear in the competitive inventory?

2.  The Nortel Campus was its world R&D headquarters for decades.  Nortel built its first building in the early 1960s, and as of the time of the high tech downturn in the early 2000s, the campus totaled 2.35 million sf.  It did not appear in competitive inventory. During the late 1990s and early 2000s, Nortel vacated the competitive inventory to absorb expansion at the campus.  That counted as negative absorption for the competitive inventory with no off-setting increase in supply.  It was as if demand for office space vanished.

Only when Nortel made space available for other firms to rent did 1,000,000 sf get added to the competitive inventory.  Nortel sold business units to Ericsson, Ciena, GENBAND and Avaya in 2010, and as they leased back space from Nortel the space they leased should be added to competitive inventory.  Given that the federal government bought the campus in Q4 2010, the competitive inventory will decline as these firms relocate to new premises.

To recap:

• the campus is not added to inventory as it is built;
• 1,000,000 sf is added to inventory and vacancy when Nortel makes space available to lease;
• 1,000,000 sf is removed from vacant space and inventory when the feds buy the campus;
• 1,300,000 +/- is added to inventory and occupied space at the campus to incorporate the areas leased to Ericsson, Ciena, Avaya and GENBAND as the business units are sold by Nortel; and
• the inventory and space occupied is reduced as these leases expire.

Please keep in mind scale – the campus is 2.35 million sf or roughly 10% of the competitive suburban office market.  These changes are material and dramatic.

3.  Some buildings start out in the competitive inventory and never get removed.  Canderel built three buildings for Cisco in Kanata that they eventually sold to Cisco.  Cisco subsequently sold one to RIM.  RIM is building another building for itself of 120,000 sf.   The first three buildings are counted in the competitive inventory although (to date) they do not compete for tenants.  The new RIM building should be included in the competitive inventory if the other three are as well.  I feel that by excluding the RIM buildings, we are not getting an accurate picture of the significant growth in demand.

4.  Some buildings are added to the competitive supply long after they are built.  For instance, the JDS Uniphase campus (1,000,000 sf) was not counted in supply at completion; but was added in increments as they made space available for lease through the early 2000s; and, was added to supply in its entirety with the sale to Minto.  Absorption and new supply were not representative of building construction, but of “competitive supply” definition.  The market missed out on 1 million sf of absorption at the time it occurred.

5.  Changing measurement standards.  Building net rentable area increased with BOMA 96. The federal government calculates rentable area less generously than BOMA standards.  Floors within a tower have a smaller rentable area when leased to PWGSC that when leased to private-sector tenants.  Buildings get smaller or larger as the proportion of space leased to the feds changes.

6.  The PWGSC statistics are for PWGSC and not for the federal government in its entirety.  PWGSC represents the federal government in most lease and purchase transactions, but not all.  For example, Canada Post headquarters on Heron Road are not included in the PWGSC count for owned and leased space.

There are some additional demands on the office market in Ottawa from the federal government that is not tracked by PWGSC reporting.

So what?

There is a fundamental disservice to investors by not taking into account the office market universe for Ottawa, i.e. taking into account the office buildings not counted in competitive supply, because it is such a large proportion of the office market here.  As well, consideration of the competitive supply plus the PWGSC owned portfolio is necessary to understand the PWGSC view of the market.  They are the 900 pound gorilla in this market, so it helps to see things from their perspective occasionally.  They have a lease in about half the office buildings in town.

For PWGSC, there is 46.7 million sf of competitive supply including Gatineau plus 16.8 million sf they own plus 4.0 million of lease-purchase buildings (using the Altus numbers).  That results in a market of 62.7 million sf.

That changes Ottawa’s rank in terms of size of office market according to CBRE Q1 2011.

How do you feel about the descrepancies in reporting? How does it affect your decisions? I’d like to hear from you.

I sure hope it is no big deal. My fear is that this market is accustomed to growth by the feds, and pretty consistent growth at that.  The last time the federal government went through an exercise to reduce the size of its workforce was the Chretien government, and they undertook that exercise in their first term in the early 1990s.   The civil service here contracted until about 1997 and has been growing ever since.  The following chart illustrates federal government employment in Greater Ottawa from1990 (column 1) through 2010 (column 21).

Federal Government Employment in Greater Ottawa

The last government rationalization program reached its goal in 1997 with a low of 97,000 employees here.  By 2010 the number had increased to 136,000.  That is growth of about 3% per annum for 12 years.  It generated a need for additional accommodations for about 3,250 people each year, and that is equivalent to demand for 650,000 sf of office space every year.

My contention is that the Ottawa office leasing market is so accustomed to this level of growth that it does not even notice this level of demand, and now feels that it is ‘natural’ or ‘unremarkable’ or ‘to be expected’ because the feds never get smaller.  My contention is that PWGSC has been taking space it might not otherwise choose because it had no options.  My contention is that Ottawa has benefitted from a combination of market forces – little new supply and consistent employment growth – for more than a decade.

My contention is that is over.  PWGSC has supply options, and its level of demand is about to decrease.

The new majority government is working to reduce the size of the federal government.  Before and during the election they suggested that attrition – retirements and people leaving – could provide the savings they want to capture.  The budget of June 2011 suggests that attrition will not get them the cuts they want, and that job losses may be more severe.

The attrition rate for the past few years has been running about 5,000 people per year.  The Conference Board of Canada recently estimated the federal government will downsize by 7,000 people over 2 years.   The Conference Board estimate is equivalent to 1.4 million sf in negative absorption over 2 years.   Attrition is equivalent to 1.0 million sf in negative absorption per year.   The majority government plans to look for savings for a year and announce them in next year’s budget.  That has implementation starting near (?) the end of 2012.

What the leasing market here is used to is growth, not contraction.  The ‘double whammy’ of new supply and a reduced need for accommodation will hit some buildings hard.  Check out the direction for their initiatives for accommodations from the 2010 Ottawa Real Estate Forum.

I think that a problem for PWGSC is just how many leases they have for at most 41 million sf.  It is hard to imagine that they find 448 leases in 235 buildings as ideal.  It is reasonable to expect them to consolidate into larger premises.  It is reasonable to expect themto reduce the number of firms they contract with for leased accommodations.

I expect that this slide will soon show a decline in the number of buildings they lease here, and a decline in the number of leases while at best maintaining the size of the portfolio.  If you have big, LEED compliant office buildings with good access to the public transit system you are good.  Renewal negotiations may be very tough, however those buildings are preferred.  Buildings offering smaller space in older physical plants will be a different matter.

At a minimum, PWGSC will be a “price maker” in all its lease negotiations.  The ownership community will be “price takers” in an environment of increased supply and decreased or negative demand.

Welcome to the new normal.

This blog deals with supply for the government.

The good news for figuring out what the government wants to do in Ottawa is that Public Works and Government Services (PWGSC) makes a presentation at the Ottawa Real Estate Forum each year and they describe their plans.

PWGSC announced that they had concluded lease-purchase deals in Gatineau for:

• 455 boulevard de la Carrière for 395,000 sf with Broccolini;
• 300 rue Victoria for 451,000 sf with Multivesco;  and,
• 22 rue Eddy for 451,000 sf with Broccolini

22 rue Eddy

300 rue Victoria

455 de la Carriere

The three new buildings in Gatineau get PWGSC to its goal of a distribution of 25%/75% occupancy by the federal government between Gatineau and Ottawa.

Since the October 2010 Forum PWGSC has completed two additional deals:

• East end build-lease for 240,000 sf with Controlex; and,
• Redevelopment of 90 Elgin Street for 516,700 sf for the Department of Finance with GWLRA and Arnon.

90 Elgin Street

These five projects provide PWGSC with 2.053 million SF of new supply.  In addition to the achievements PWGSC outlined above, the federal government purchased the Nortel Campus in January 2011.  This campus adds 2.35 million SF +/- in new supply to the PWGSC.  The campus is currently partially occupied by Nortel Networks and firms that bought Nortel division – Ericsson, Avaya, GENBAND and Ciena – and these firms have leases to remain at the campus for about 2 years.

The change to the Ottawa commercial real estate market is that the federal government takes delivery of 2.053 million SF of new supply in a period of about 6-9 months in 2014.  The Nortel campus adds another 2.23 million SF, and once again for their occupancy in the 2013-2014 period.

This slide from the 2010 PWGSC presentation outlines the scale of federal government occupancy in Ottawa.  The result of the new additions to supply we identify is that the federal government is adding roughly 10% to its inventory of occupied space in Greater Ottawa in 2014.

That is a supply shock that PWGSC is incorporating into its lease negotiations now.

What helps mitigate the new supply shock is that PWGSC will have deletions from its supply inventory.  We estimate that the 39 crown-owned office buildings provide about 12 million sf of office space.  These facilities can be older and in need of significant repair.

Two examples include the Sir John Carling building, formerly occupied by Agriculture Canada, and L’Esplanade Laurier, the current home to Finance and Treasury Board.  The Sir John Carling Building has been emptied and is slated for demolition.  L’Esplanade Laurier is in need of capital repair, and the previous owner estimated these repairs at $150 million circa 2009.

It points to three distinct trends affecting Ottawa now; the massive investment by PWGSC in acquiring new buildings to occupy; the interest in securing buildings occupied by PWGSC here; the end of the Nortel era as the bastion of all things high tech in Ottawa. I expand on each of these as follows.

PWGSC was very active in securing properties for its own use in 2010 (see the following chart that the presented at the 2010 Ottawa Real Estate Forum).

(note: They do not mention the purchase of the Nortel campus in this slide because the presentation happened a month before they closed on the campus.)

In addition to buying the 2.35 million sf campus, PWGSC ran a process by which three office buildings of 400,000 – 450,000 sf are currently under construction. These are commissioned under their lease-purchase program: they enter into 25-year leases for buildings to be constructed, and they have the right to buy them on expiry.

In addition, PWGSC awarded a 15-year lease for a new building in the east end and mostly completed the process of determining whether GWLRA or Morguard would redevelop 90 Elgin Street. As well, PWGSC closed on its acquisition of L’Esplanade Laurier by exercising its right to purchase at the end of the 35-year lease.

That represents projects totalling 5.3 million square feet, and a significant investment by the federal government in the property it acquired. It is a significant investment by the private sector in providing 2.0 million sf for PWGSC occupancy (including 90 Elgin).

Noteworthy office building sales in Ottawa in 2010 include:

PWGSC is the dominant tenant in all these buildings except for 81 Metcalfe and 150 Metcalfe. Some of the sales were completed before the Nortel campus came to market, and some during its marketing. What was notable is that buyers invested in PWGSC leases with remaining lease terms that were as little as 12 months and at most 6 years.

The last longer-term trend emerging from 2010 is the dismantling of Nortel. Ottawa was its principal research and development facility world-wide representing 50% of Nortel’s R&D. At the peak, Nortel was investing $4 billion annually in R&D and half of that was in Ottawa. By contrast, RIM currently invests $1.2 billion per annum world-wide on R&D.

Nortel was a great engine training R&D talent and launching many high tech firms in Ottawa. It will be missed as an employer, a magnet for talent, and a spawning ground for high tech ventures.