Q2 2024 Commercial Mortgage Market Update

CMHC issued a series of major policy changes on June 4th which has changed the landscape for multi-family financing across the country.

MLI Select Scoring Change

The most impactful change is the revision to the MLI Select program energy efficiency qualifications. Prior to June 19th, developers were able to qualify for 100 points solely on energy efficiency (achieving amortization of 50 years) by hitting a 40% improvement on a theoretical baseline build for greenhouse gas emissions and energy efficiency. With the change in policy, the maximum points for energy efficiency on its own is now 50 points, limiting the amortization to 40 years. To obtain 50-year amortization requires at least some measure of affordability for the project, and to achieve 45 could mean a mix of affordability or accessibility measures. What this effectively means is that in municipalities where the “affordable” rent metric is far below market, as is the case with Toronto at $1,347.50, it causes further stress to projects that were already challenged whether underwriting to 100 points with affordability measures or to fully market rents with energy efficiency alone. Overall, we expect equity requirements for purpose-built rental deals to increase 10-15% across the board in the GTA. Tied into this change, CMHC increased the maximum amortization under the MLI Standard (Market) program from 40 to 50 years for new construction. Although at face value this seems to do away with the restrictions under MLI Select, MLI Standard construction is subject to “Rental Achievement” which is a holdback of funds until the project reaches the underwritten stabilized Effective Gross Income (“EGI”). This means that any loan amount achieved under the COI will be subject to a significant reduction in proceeds during construction. Another downside is that the insurance premiums for the standard program, especially at 50-year amortization is materially higher than MLI Select (up to a 2.80% difference). This is however helpful for “construction takeout” which is classified the same as a construction loan. We are beginning to see conventional lenders lend to a more aggressive leverage given the new CMHC insured takeout metrics.

Reclassification of Existing Buildings

Another policy change whereby CMHC did not necessarily consider second and third order consequences was the revision of the “classification” of existing versus new buildings. Previously, if a developer was demolishing an existing multi residential building (ie: a small run-down building) to increase density on a site with new construction (ie: a high-rise tower), CMHC would apply the more stringent “existing building” MLI Select qualifications for energy efficiency and affordability, to curb developers from displacing existing tenants. With industry consultation, they issued a clarification that developers could now apply to CMHC and receive an approval under the less stringent “new construction” qualifications, however the site would have to be cleared and none of the costs for demolition would be an eligible project cost. Sounds like an improvement? Unfortunately not, as CMHC clarified that this policy change now applies to ALL sites with existing residential inclusive of single family homes. An example of this would be if a developer had purchased a parcel/lot with an existing single-family home that would be able to be up zoned into a 5 plex or greater, would not be eligible for application to CMHC until the single-family home is demolished and cleared. This is problematic given that for most developers there would be existing debt on the lot purchase and an existing lender would not generally permit demolition as it negatively impacts the security. The third order consequence of this is that for areas where blanket higher density rezoning has recently come into place, such as Calgary, we would expect that sellers will now be demolishing perfectly good single-family homes which are capable of supporting tenants while waiting for redevelopment and selling them (with an upcharge of course) as vacant cleared land to developers in order for all the land costs to be eligible to CMHC. It is also worth a mention that trying to upzone tired/older larger multi-family apartment buildings just became far more prohibitive as the demolition is now not an eligible cost in a budget.

Equity Takeout and Non-Approved Lenders

A positive change was the decision to rescind the “Use of Refinancing Proceeds” directive issued in May 2020, which restricted/monitored equity repatriation. As of June 5, CMHC will allow for equity repatriation to be used however the Borrower desires. In addition, this has also given the all clear for CMHC proceeds to pay out any type of debt on a property, whether it is financed by a VTB, private mortgage or a non-approved CMHC lender. In a surprising decision, CMHC is not grandfathering this change to COIs issued during the period of May 2020 to June 6, 2024, which means lenders must still track the use of refinancing proceeds for loans funded during that time.

Another positive change is that CMHC will relax their policy of not insuring contaminated sites for construction financing by endeavoring to become in line with industry standards regarding remediation. In the meantime, they will accept applications for contaminated sites, but will not advance until the site is remediated, with an acceptable ESA.

Approved Correspondent Changes

As of September 3, 2024, the CMHC Approved Correspondent Program will drastically change, with CMHC no longer allowing Correspondents to apply directly to CMHC on a lender’s behalf. In addition, CMHC has clarified that lenders will not be able to transfer/assign CMHC COIs to other lenders with the same frequency and will require approved lenders to fund at least 80% of the COIs for which they obtain approval. As many CMHC Lenders relied on broker correspondents to bring in a significant amount of their origination volume, this will negatively impact the market and will make the process more difficult for borrower and lenders. Brokers and borrowers will now need to obtain quotes and select a lender prior to obtaining CMHC approval. During the days leading up to the June 4th announcement, some CMHC lenders were given advance notice of the change and a few account managers reached out to well known clients of correspondents and brokers directly to petition these clients/brokers to apply directly through them, espousing “the death” of the correspondent program. CMHC clarified after the announcement was officially made about the requirement to fund 80% of COIs, with specific notice to CMHC approved lenders that are also correspondents that they would be monitoring and discouraging those lenders from brokering COIs obtained. The reasoning for the 80% rule is that should approved lenders run into liquidity issues, or trouble during securitization, there would be an allowance of 20% of their COIs obtained to be funded by another approved lender in order to keep stability for borrowers within the market. CMHC clarified that it was not an open license for these lenders to broker up to 20% of their COIs.

So what do the changes to the correspondent mean for the industry? We expect that lenders that are both CMHC lenders and correspondents to be negatively impacted, as they will need to face a difficult choice of either being an approved lender that funds their own deals or being a broker. If they issue a COI, they must fund it, which for some lenders that do not have access to the best priced capital, will put them at a significant disadvantage. Brokerages with strong and trusted relationships with multiple CMHC lenders (such as Oakbank) will be increasingly important to borrowers, as they can help guide borrowers to selecting the CMHC lender best suited for their deal prior to application and help guide these lenders in positioning the deal appropriately in their CMHC submissions. In addition, working with a broker will ensure an unbiased application in the borrower’s best interest. When it comes to costs, unfortunately this will almost certainly increase spreads across the board as lenders will need to submit applications themselves, even if aided by brokers. Previously, broker correspondents would be preparing the underwriting and application fully on their end, which can be a significant time investment for each application. CMHC insured construction loan applications under $10mm will be impacted severely, as existing capacity issues from lenders will be exacerbated even further.

A lesser-known change in policy that was recently sent to CMHC Issuers is that it will be more difficult for CMHC Lenders to sell down positions/loans that they have originated to other smaller financial institutions. Previously, individual CMHC Issuers were capped at certain amount of insurable loans per year. They would then sell down positions (usually with some additional spread for profit) to smaller financial institutions such as CMHC approved credit unions, which would be happy to take up some of those positions as they are generally not set up with the infrastructure to originate/coordinate or apply to CMHC on their own. The change in policy now requires these smaller institutions to fund at least 50% of their own origination which will likely again impact underwriting capacity, and consequently spreads for Borrowers.

Condo and Land Financing

Back in the non-insured world, land financing and condominium construction financing remains unchanged from the past 6 months, even despite the interest rate decrease. Condo sales continue to be challenged with investors sitting on the sidelines. The real estate news outlets seem to headline a new foreclosure of well-known developers and projects almost weekly, with projects being shelved left and right. Given the lack of starts, this would suggest that a lack of supply will begin to form once the majority of current projects enter the delivery phase between 2024-2025. Pent-up demand could well drive another condo development rush...

Commercial Financing

Commercial term lenders, particularly in the insurance sector missed origination targets last year and have been more aggressive in their spreads over bond yields this past quarter. Appetite for vintage industrial has softened, with higher quality buildings and long WALTs being preferred. This is a stark contrast to a few years ago where older industrial product with lease terms closer to maturity were bid up. Retail assets have seen more favor from lenders, with many lenders surveyed wanting increased allocation to the asset class. Unchanged from last quarter, office is still difficult to finance with nearly all lenders looking to shed their existing office exposure.

As the summer season starts and commercial real estate activity starts its usual lull, the industry remains hopeful towards recovery in the latter part of the year heading in to 2025. Although the CMHC changes will not be helpful to multi-residential starts, with change comes opportunity.