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.