Q4 2023 Commercial Mortgage Market Update

Speaking first to the monetary policy, the Bank of Canada (“BOC”) maintained the overnight rate for the third consecutive time. Economic headwinds are stronger in Canada versus the United States who are still seeing GDP growth, both on a gross and per capita basis. Meanwhile Canada is likely in a technical recession at face value and certainly in a recession when adjusting per capita. December statistics show that Canadian GDP per capita sunk back to 2018 levels, erasing 5 years of growth. In mid-December, Jerome Powell signaled that there would be 3 rate cuts in 2024 from the US Federal Reserve which sent bond yields plummeting back to levels that we have not seen since the earlier half of this year.

A long-awaited Fall Economic Update from the Federal Government was released on November 30, with virtually no real plan and few new announcements to address the increasing dissatisfaction of the government and CMHC on housing affordability. Most changes announced, such as the HST elimination on rental projects, increased CMB allocation, and the increase to the Apartment Construction Loan Program (“ACLP” formerly known as RCFI) had been disseminated in various news releases in the previous months and while all of these measures help, the update lacked a true plan of action. CMHC’s restated goal for an additional 3.5 million housing units by 2030 (at a cost of $1 trillion) has been panned as completely unrealistic and out of touch.

Commercial term lending has remained consistent this past quarter, with the tightening of restrictions in the earlier half of the year still in effect. As bond yields have fluctuated, so too have lender spreads. A recent OSFI directive as of late November has changed the landscape for “bridge” financing. Pursuant to the BASEL III implementation back in March (see our BASEL III memo from last year for more details), OSFI has now clarified that bridge financing should be risk weighted the same as a construction loan, thereby increasing the necessary capital allocation for bridge loans. Pricing for new deals shot up virtually overnight by 50 to 75 basis points, and availability of funds has been impacted as OSFI regulated lenders audit their loan book to allocate additional capital to existing bridge loans. We know of at least 2 lenders who completely removed themselves from the lending market in December to accommodate this OSFI audit - stating that they expected to re-enter mid-late January.

CMHC insured loans continue to be popular and the queue of backlogged deals is slowly being whittled down. At the time of writing this article, approximately 500 applications remained in the queue from the ~5,000 submitted ahead of the June 19 deadline rush. To help reduce this backlog, CMHC has introduced more draconian measures to force unqualified/underqualified deals out of the queue and speed up timelines. Changes include a reduction/removal of the grace period to rectify any deficiencies in “incomplete” application. As of January 1, applicants now must have all necessary required documentation to apply to CMHC with no room to maneuver if they are missing anything. As predicted with the increase of the CMB program from $40bn to $60bn, spreads for both 5-year and 10-year CMHC deals dropped as availability improved. Large volumes at most CMHC lenders have caused a funding backlog, with wait times to close a deal once committed of up to 3 months.

Land valuations and land financing is unsurprisingly still challenging in Q4 as project starts have dwindled. With a lack of liquidity caused by the OSFI directive mentioned above, lenders have had to allocate capital away from land financing (and renewals) towards covering off the necessary allocated capital towards bridge loans. Land financing is still available for top-tier clients and projects that are pre-sold, multifamily rental projects, and for commercial income properties where some pre-leasing is in place. Most land loans are being taken on by the private lenders who are also scrutinizing underwriting more closely. Additionally, we have observed that for the limited new acquisitions taking place, most Borrowers are opting/pushing for a VTB instead of sourcing their own financing, which is a prudent choice in this market.

We will repeat the same messaging for our update on construction loans in Q3 with a slight update. Whether it be condo or income producing projects, construction loans are becoming more challenging from both an allocation and structure perspective. For income producing properties, stress tests based on current in place interest rates are challenging the leverage achievable, thus lowering Loan-to-Cost ratios and in turn requiring more equity. 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 an inflow of 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 woodframe projects from construction lenders, and more leniency of coverage ratios. In addition, as bond yields have begun to subside slightly, there are numerous condo construction projects that are now converting to rental and being financed by CMHC programs. In addition, the recent bond yield drop along with the elimination of the HST/GST self-assessment is making conventional rental construction slightly more attractive.

There is no questioning that 2023 was a dynamic and challenging year for the commercial real estate market in Canada. Creativity in financing structure, as well as borrower’s acceptance of interest rate and credit realities were crucial to success. Our opinion is that both of these concepts will continue to be true into 2024. Although most economists forecast a reduction in interest rates in the latter half of next year, it does not necessarily mean that it will be enough to brave the headwinds of changing regulations and lack of liquidity from lenders in the market who are burdened with “problem” loans with a 2021 and 2022 vintage. We will conclude 2023 and start our 2024 echoing the same advice that we first gave back midlast year… if a lender offers you a deal that works, take it. Nothing kills a deal quicker than time. Just as we have seen the winds change for the better in Q4, they could just as quickly blow the other direction.

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