A look at fi­nanc­ing in to­day’s mar­ket

Ottawa Business Journal - BOMA Magazine - - A Look At Financing In Today’s Market -

No dis­cus­sion about how the over­all eco­nomic pic­ture is af­fect­ing the com­mer­cial real es­tate in­dus­try would be com­plete without a look at fi­nanc­ing. While the world of lend­ing and bor­row­ing has been volatile through­out late 2008 and the first half of 2009, the in­di­ca­tors are looking quite pos­i­tive for the year ahead.

Dave Arnt­field, a part­ner in the Ottawa of­fice of Mon­trose Mort­gage, one of the lead­ing mort­gage bank­ing com­pa­nies in Canada, de­scribes the fi­nanc­ing pic­ture as both evolved and evolv­ing. From about 2003 to 2007, the lo­cal mar­ket was at its very best - well be­yond rea­son­able and his­toric norms in re­spect to liq­uid­ity (avail­abil­ity of cap­i­tal), loan pric­ing and loan amounts based on value. Since then, how­ever, there has been a pen­du­lum ef­fect over the past eigh­teen months. Sim­ply put, this means we have ex­pe­ri­enced the best and gone through the very worst but the good news is we are now in the process of swing­ing back again.

Prior to last year’s slump, we were in an ab­nor­mally strong sit­u­a­tion. De­spite this, and rather sur­pris­ingly, Mr. Arnt­field notes that there was not as much danger­ous risk tak­ing as might have hap­pened, or as was seen in the US, with most Cana­dian bor­row­ers and lenders, par­tic­u­larly here in Ottawa, tak­ing a longer term, and thereby safer, ap­proach.

As ex­pected, the dol­lars in­volved in com­mer­cial mortgages can be sub­stan­tial. A com­mer­cial mort­gage is de­fined as a loan greater than $500,000 CDN that is se­cured by in­come-pro­duc­ing real es­tate and ex­cludes sin­gle-fam­ily res­i­den­tial. While there are sev­eral pri­mary sources for com­mer­cial loan funds, in­clud­ing banks, pen­sion funds, credit unions and life com­pa­nies, the plight of con­duit lenders has been a key el­e­ment in the shift­ing fi­nanc­ing land­scape. The big­gest con­duit groups fun­neled money into com­mer­cial real es­tate loans in im­pres­sive vol­umes un­til 2008, with the largest play­ers be­ing U.S.-based or­ga­ni­za­tions who moved into the Cana­dian mar­ket af­ter en­trench­ing their po­si­tion south of the bor­der. Serv­ing quite lit­er­ally as a con­duit for bor­row­ers to ac­cess the cap­i­tal mar­kets, se­cu­ri­tized lend­ing is the con­duits’ spe­cialty.

Con­duits are not in­her­ently bad, but they are tak­ing the heat for much of the liq­uid­ity cri­sis. In sim­plis­tic terms, the U.S. lenders mixed well un­der­writ­ten con­duit loans with too many risky loans which, com­bined with un­re­al­is­tic rat­ing agen­cies and un­con­trolled fi­nan­cial mar­kets, led to the fi­nan­cial im­plo­sion that many feel trig-

gered the re­ces­sion. Here in Canada, play­ers were not tak­ing th­ese same dra­matic risks so the con­duit busi­ness re­mained sound, how­ever, cap­i­tal dried up be­cause of the U.S. ex­pe­ri­ence. As a re­sult, con­duit funds have dis­ap­peared from our mar­ket. Given the vol­ume in­volved, which Mon­trose has tracked to be up to $2 bil­lion an­nu­ally, their ab­sence is be­ing felt strongly. In ad­di­tion, the con­duit loans that have yet to ma­ture will con­tinue to im­pact the na­tional mar­ket over the next five years, with ap­prox­i­mately $50MM to $100MM an­nu­ally of that tied into the Ottawa mar­ket. As Mr. Arnt­field notes, this money still needs to find a home so liq­uid­ity is­sues will con­tinue un­til all this money turns over or is re­placed in the mar­ket.

Pen­sion funds have tra­di­tion­ally been keen to in­vest in mortgages but when their eq­uity hold­ings nose­dived last year, they had to re­duce their mort­gage hold­ings to main­tain a bal­anced port­fo­lio. Thank­fully, over the past while the eq­ui­ties have been slowly climb­ing back, so pen­sion funds are now get­ting back into the mort­gage busi­ness. In ad­di­tion to lend­ing money, some pen­sion funds are also mort­gag­ing prop­er­ties they own and us­ing those funds to rein­vest in the eq­uity mar­kets.

Life com­pa­nies were sim­i­larly skit­tish for past 18 months but have started to wade back into the mort­gage pool over the last three months, with credit unions and banks also com­ing back into the mar­ket with a lit­tle more vigour. As Mr. Arnt­field ex­plains, ev­ery lender has be­come a bit more cau­tious and se­lec­tive, but most are loos­en­ing their purse strings now as the re­ces­sion ap­pears to be wan­ing.

To un­der­stand both the past and the fu­ture of fi­nanc­ing, it’s help­ful to take a look at the swing that’s hap­pened to in­ter­est rate spreads. Th­ese are, for the most part, based off of Canada Bonds, which are gov­ern­ment guar­an­teed and there­fore con­sid­ered the safest, most se­cure in­vest­ment you can make. Loan risk is then priced as a mar­gin or spread over Canada Bonds to re­flect the deemed risk of the trans­ac­tion. The Canada Mort­gage and Hous­ing Cor­po­ra­tion (CMHC) guar­an­tees loans for multi-unit res­i­den­tial mortgages and while th­ese loans carry some risk, be­cause they are backed by the gov­ern­ment, the risk is less­ened. As a re­sult, CMHC spreads are cur­rently in the range of 1.3% to 1.6% over Canada Bonds. How­ever, at the real peak of the real es­tate mar­ket, the spread was as low as 0.4% on CMHC loans.

Con­ven­tional spreads at the height of the mar­ket for a qual­ity non-CMHC mort­gage were as low as 0.8%. In the past 18 months, as a re­ac­tion to the volatil­ity in the real es­tate mar­ket, the spread has climbed as high as 4.50% over bonds, set­tling down over the past few months to around 3.00% with this down­ward trend likely to con­tinue. This is a fur­ther in­di­ca­tor that we have weath­ered the storm and are mov­ing into a more bal­anced mar­ket.

A pos­i­tive de­vel­op­ment has been the in­crease in se­cu­ri­ti­za­tion of CMHC guar­an­teed loans. His­tor­i­cally it took 7–12 years for the rate ben­e­fit of a CMHC loan to cover the cost of the in­sur­ance pre­mi­ums charged by CMHC. To­day, be­cause of the fact that a se­cu­ri­ti­za­tion mar­ket re­mains for CMHC in­sured loans and the higher spreads charged on con­ven­tional loans the pay­back is as low as 1–3 years so peo­ple are flock­ing to th­ese loans. This move­ment has helped free up some cap­i­tal to off­set the drop in the con­ven­tional mar­kets.

So what can you ex­pect from a lender to­day ver­sus three years ago? It’s help­ful to first take a look back at mort­gage spreads over the past 40 years, which ac­cord­ing to a Mon­trose study have av­er­aged about 1.8%. The spread has gone as low as the 0.8% men­tioned ear­lier to a peak as noted of 4.50% re­flect­ing the lack of funds for mortgages and the in­creased risk at­trib­uted to them. The 0.8% is con­sid­ered by many to have been an ab­nor­mal­ity as it truly was not re­flec­tive of the risk as­so­ci­ated with the in­vest­ment, nor was the 4.50%, which il­lus­trates the pen­du­lum ef­fect men­tioned ear­lier (mean­ing that the mar­ket was, quite sim­ply, out of whack in both in­stances). With spreads set­tling back down now closer to the tra­di­tional av­er­age, the mar­ket will re­main more sta­ble. Sim­i­larly, the value of fi­nanc­ing should also sta­bi­lize. Dur­ing the peak sev­eral years ago, one might ex­pect to fi­nance as much as 75–80% through a con­duit lender; to­day it’s more like 60–70%

from all lenders.

As we look ahead, an in­creas­ing sup­ply of cap­i­tal, thanks to more tra­di­tional lenders com­ing back into the mar­ket, should cause spreads to re­turn closer to his­tor­i­cal norms. Cou­pled with near-record low Canada Bond rates, the base which in­vest­ments are mea­sured off, over­all mort­gage rates should re­main very rea­son­able for the fore­see­able fu­ture. De­spite the ab­sence of con­duit money, we should see liq­uid­ity re­turn­ing to the mar­ket, even­tu­ally in­clud­ing some con­duits.

As Mr. Arnt­field cau­tions, to­day’s mar­ket is per­haps best viewed on its own, rather than re­flected through the lens of re­cent his­tory. Given that the mar­ket from 2003–2007 was red hot, with al­most too much liq­uid­ity, the ra­tio­nal­iza­tion across the board is lead­ing to what can best be de­scribed as a more re­al­is­tic mar­ket. Now, with the drama of the past year be­hind us, lo­cal bor­row­ers should find that there is mort­gage money out there. Ex­perts cau­tion that you will have to work harder to find it and lenders are go­ing to be a lit­tle more con­ser­va­tive in the past – both in terms of rates and how much they lend – but if you have a good prod­uct you should be able to fi­nance it. There are also an in­creas­ing num­ber of secondary lenders out there who are fill­ing some of the gaps, be it for sec­ond mortgages or higher-risk sit­u­a­tions; th­ese might be use­ful if you can­not fi­nance all your needs through a pri­mary lender. We can all take heart from the fact that there are very few, if any, prop­erty loans cur­rently in de­fault in our re­gion.

The bot­tom line for us in Ottawa is sim­ple. The strength and di­ver­sity of our lo­cal econ­omy is help­ing both cur­rent prop­erty own­ers as well as those seek­ing fi­nanc­ing. With prop­erty val­ues hold­ing their own, we have been for­tu­nate to avoid the steeper de­clines ex­pe­ri­enced by mar­kets with fall­ing val­ues and in­creas­ing va­can­cies, and should en­joy sta­bil­ity and even mod­est growth in the near fu­ture.

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