The worst may be over, but office real estate still faces an uncertain future

Office vacancy in Canada was about 18% in Q4 2025 (vs ~10.9% in 2019), with downtown Toronto at 15% and top-tier 'trophy' buildings at 3%; leasing improved in 2025 for the second straight year driven by return-to-office mandates. Pipeline activity has fallen as developers paused projects, but older/obsolescent buildings face repurposing challenges and conversion economics are often poor. Public office REITs remain under pressure—Allied Properties trades around $9/unit, down ~45% year-over-year and ~80% from its 2020 peak, after a dividend cut and equity raise—while investors stay cautious amid higher borrowing costs and AI-driven demand uncertainty.

Analysis

The market is bifurcating into a small, structurally advantaged cohort of assets that capture scarce corporate demand and a large stock of secondary assets that face secular obsolescence. That split creates two distinct return regimes: rapid cap-rate compression and rent growth for buildings with modern infrastructure and ESG upgrades, versus prolonged value erosion, forced capital expenditures, or distress sales for the rest.

AI is not an instantaneous demand destroyer; its near-term impact will be concentrated and complementary — accelerating demand for buildings with heavy power/telecom capacity, latency-sensitive floorplates, and enhanced environmental controls while reducing routine administrative occupancy. Over a 12–36 month horizon this will skew tenant mix toward firms that pay a premium for “tech-ready” space and increase the economic infeasibility of generic conversions for many owners.

Public-market illiquidity in Canadian office creates a tactical arbitrage: private institutional holders can hold through a long glide path while public REITs trade on financing and sentiment mismatches, amplifying drawdowns on leveraged listed names. Key reversible catalysts are: visible deleveraging (quarterly debt paydowns), sustained positive leasing spreads for 12 months, or a tightening in regional bank CRE credit that forces asset disposals — any of which would re-rate segments in 3–18 months.

Key Decisions for Investors

• Short selective secondary office names (e.g., D.UN / AP.UN) via 6–9 month put spreads sized as a portfolio hedge — target 30–40% downside if leasing momentum deteriorates; stop-loss at 20% loss off entry. Use options to control borrow/financing risk.
• Go long real-estate services and transaction beneficiaries (e.g., CBRE) via outright equity or 9–15 month call spread to capture fee growth from higher leasing/asset-turn volumes — R/R: asymmetric upside if transaction activity accelerates; downside capped to equity move. Size as 2–3% of portfolio with a 6–12 month horizon.
• Long data-center/industrial landlords (e.g., DLR/EQIX or Canadian data-center proxies) and short a basket of office REITs as a pair trade (equal notional) — thesis: capex and tenancy reallocation toward compute/tech spaces. Horizon 12–24 months; expect 20–50% relative outperformance if AI-driven tenancy reallocations continue.
• Event-driven long on beaten-up office REIT equity (e.g., Allied/AP.UN) conditional on demonstrable balance-sheet repair: enter tranche 1 if management announces >10% asset sales or quarterly debt reductions and trailing 12-month leasing spreads turn positive; take profits on a 30–50% recovery and keep subsequent tranches opportunistic.