Q3 2023 Commercial Mortgage Market Update

Both the Bank of Canada (“BOC”) and the US Federal Reserve (the “Fed”) are aligned this past month, with Canada standing firm on rates in early September as recession seems likelier by the day. On September 20th, Jerome Powell announced a pause in overnight rate hikes while signaling that there may be another rate hike by the end of the year. Inflation numbers came in higher than expected in Canada for August, with a 4.1% inflation rate versus a predicted 3.8%...although adjusting for higher gasoline and mortgage interest costs, the CPI rate does seem to be much closer to the 2.0% BOC target as opposed to what is being shown in the news headlines. In light of all of this, bond yields have risen even higher, with yields not seen since the beginning of the 2007 Financial Crisis.

Housing affordability has dominated the news headlines as the sitting Liberal government has been hammered in recent polling. A step in the right direction has come by way of the GST rebate for new rental construction, which effectively removes the requirement for GST self-assessment in the construction budget. Some provinces, including Ontario and BC have followed suit to eliminate the HST portion as well. Amidst a cabinet reshuffle that saw the Ministers of Housing and Immigration replaced, the government is now eyeing potential reductions in immigration and international student applications, which could have significant implications for the housing market moving forward. An eye-opening statistic is that there were 900,000 international students in Canada for 2022 or roughly 2.5% of the entire population of Canada (Source: CBC). For reference, the United States had 940,000 international students in 2022, despite having 10x the population.

Looking into the world of commercial mortgages, term lending spreads have remained unchanged over the last quarter, however we have observed that more lenders are beginning to either test at higher test rates and/or use an increased debt service coverage ratio. Increased scrutiny over tenancy strength, lease terms, and borrower covenants/liquidity has become more common as well.

CMHC wait times continue to be challenged as underwriters are working through the almost 5,000 application backlog incurred before the premium increase deadline of June 19th. Recent applications from the last few weeks have received notices that a coordinator may not review the file for up to 8 weeks, with an underwriter not being assigned for up to 6 months thereafter. Given that maximum timeline, a borrower sending a fresh application may not see funding for nearly a year. With that being said, we expect timelines to decrease at least a little bit with underwriters returning from summer vacations and from a ramp-up in training/hiring.

On September 13, CMHC enacted a new policy that has caused confusion and disruption in the world of multi-family financing. Effective immediately, CMHC is no longer refinancing existing properties with mortgage debt in place of less than 24 months at the time of application. In addition, all debt must be from an approved CMHC Lender and cannot have been used to perform capital expenditures within the 24-month period. At the time of writing, Oakbank is awaiting clarification (as is the rest of the market) as some CMHC underwriters have specified that the debt must also be amortizing, however that at this point this is hearsay. It goes without saying this significantly hampers the very popular model of acquiring a multi-family apartment building with interest only debt and using proceeds to perform a capital expenditures program over a 12-to-24-month period. As the debt now must be held for over two years, and potentially may even need to be amortizing, this could leave anyone who followed this model “stuck”. CMHC’s official line is that this was implemented to prevent renovictions, nonetheless it creates an array of other problems for apartment owners. We will be monitoring this closely as CMHC clarifies and officially publishes the memo to Approved Lenders and Correspondents.

On a brighter note, on September 26, the government of Canada announced an expansion to the Canada Mortgage Bond (“CMB”) program with an increase in the annual cap from $40B to $60B. In recent months, securitized lenders had begun increasing their spreads and/or reserving their allocations against that $40B cap towards their existing clients. As the majority of CMHC insured loans are securitized through the CMB program, this additional $20B will help alleviate supply concerns that were prevalent earlier in the year and should serve to reduce insured loan spreads in the coming months as the allocation is made available. Otherwise, spreads are relatively unchanged since last quarter but, we expect them to come down within the coming months as additional securitization pools take advantage of the additional allocation.

Land valuations and subsequently land financing remains challenging in Q3 in the majority of Canada except for some of the more resilient (and even hot) markets such as Calgary and Halifax. Unzoned land financing is almost exclusively the domain of private and mezzanine lenders in recent months with institutional capital all but staying on the sidelines except for their more established existing clientele.

Construction Loans, whether it be condo or income producing projects are becoming more challenging from both an allocation and structure perspective. Some institutional lenders are taking a seat on the sidelines as their 2023 allocations are used up or are seeking higher yields elsewhere. For income producing properties, stress tests based on current in place interest rates are challenging the leverage achievable, thus lowering loan to cost ratios. Despite this, we are beginning to see green shoots of activity in the condo construction market as developers begin to forge ahead with projects, albeit with modified deposit structures and we are seeing requests for lower pre-sale thresholds. We are filling this void by pairing institutional and mezzanine lenders to overcome Loan Coverage, and Residual LTV tests that would generally constrain a low presale loan request. On the other end of the spectrum, there is still ample appetite for low rise and wood frame projects from construction lenders, and more leniency on coverage ratios.

Although it is currently a challenging landscape for the commercial mortgage market, we have observed a changing sentiment from Borrowers who have been (slowly) accepting that times have changed. Mezzanine lenders are fulfilling a vital function in providing credit enhancement, comfort, liquidity, and security behind institutional lenders to help their clients through this difficult period. Creativity and flexibility in deal structures along with the acceptance that this comes at an increased interest and fee cost are moving deals forward. We expect more of the same in the upcoming quarter or two before interest rates are forecasted to start easing.