Q1 2024 Commercial Mortgage Market Update

9 Apr
Aaron X. Sun
Q1 2024 is in the rearview mirror and the main topic of conversation continues to be interest rates. Despite what seems to be ever changing predictions as to when there will be a rate cut, bond yields have remained relatively stable, as has lender sentiment on commercial real estate financing.

At the past announcement (March 6), The Bank of Canada (“BOC”) maintained the overnight rate for the fourth consecutive time, putting a dampener on those that were expecting rate cuts by March. There is a divergence in sentiment with roughly half of the economists at the major banks in Canada predicting a June rate cut, while the other half predicting the first rate cut sometime in Q3. Inflation data for February came in marginally lower than expected, spurring hope that rate increases have finally done what the BOC had set out to do…

A recent article by The Globe and Mail provided insight into the BOC’s inflation prediction model (ToTEM). As this is a mortgage market update and not a commentary on macroeconomics, I will simplify the findings by stating that the government’s inflation model was setup as follows: it has consistently been fixed to start dropping in the “next” quarter and reverting to a 2% inflation target by exactly 6 quarters (18 months) following such date (as shown in Figure x). I.e.: the BOC’s model in Q12022 would predict a drop in inflation in Q2 2022 and return to 2% inflation byQ3 2023. This model has been consistent, and as each quarter would pass, so would the exact timeline for projections. Said more bluntly, the BOC consistently predicted inflation incorrectly, as it was essentially using a hard plugged Excel spreadsheet.

The US Federal Reserve has been more hawkish on interest rate cuts than we have seen in Canada, with many economists not expecting any rate cuts until late Summer or possibly into Q4. What has been most shocking is how resilient the economy and the stock market in the United States has been despite the lack of optimism from the Fed. Despite all the above, the steady rate and diminished sentiment for cuts have had bond yields for both 5- and 10-year terms holding steady within a 25 basis point bandwidth throughout the entirety of Q1 2024.  

Term Loans: Sentiment is the commercial mortgage space has remained consistent from Q4 2023. This said, we have observed deal timelines lengthening further as credit conditions tighten. Bond spreads have been virtually unchanged from last quarter with appetite for cash-flowing industrial, residential, and retail still healthy. Unsurprisingly, office remains difficult to finance in 2024, with nearly all lenders looking to shed their existing office exposure.

CMHC: The CMHC backlog has substantially cleared for acquisitions and refinancing applications. Anecdotally, Oakbank recently received a Certificate of Insurance ("COI”) for the refinance of a multi-family property in Toronto within 7days of submitting the application to CMHC. Construction and other more complicated files are being picked up by senior specialists and there is still a substantial queue built up from the premium increase deadline nearly 9 months ago. Some alternative shelter models such as seniors’ residences and student housing are receiving additional credit scrutiny from CMHC underwriters, with projects being scored on CMHC’s alternative risk model in addition to the normal requirements. At least 3 CMHC lenders have told us they are not accepting applications at this time as they are being audited by CMHC. They have cited increased scrutiny by CMHC into Borrowers ignoring the newly implemented rules for paying out “non-approved debt” which has caused these CMHC lenders issues during their audits. Pricing for CMHC insured deals has remained steady, despite the fewer market participants. In the Fall, the Federal Government announced that it was stepping in to buy $30bn of the $60bn CMB issuance which we discussed in last quarter’s article. The government intervention has stabilized pricing for CMHC insured deals (for now), though the future is very uncertain as this is not a viable long-term plan and runs counter to the BoC’s quantitative tightening policy.

Land Loans: Land continues to be challenging asset class to finance with leverage decreasing closer to the 50-55% LTV mark for conventional lenders and only with a reasonable timeline to development. Unzoned land is almost entirely now the domain of mezzanine and private lenders as conventional lenders are focused on retaining/extending their existing land loans from clients who were not able to proceed to construction in the timeline originally projected.

Construction Loans: In February, CMHC noted that new home construction climbed 14 % compared to the previous month with over 253,000 units, beating economists’ expectation of 230,000starts. We are seeing a similar uptick in construction financing requests for condo construction. Although there is ample lender appetite for condo construction loans, conventional lenders have held steady requesting substantial coverage form pre-sales, which has continued to be problematic for developers to deliver as the investor market has dried up and owner-users wait with bated breath for rate cuts that maybe will come in the next six quarters…or never. We continue to see requests from developers with modified deposit structures and lower pre-sales, which we have been able to deliver on by pairing mezzanine financing with conventional sources, as described in past quarterly reports.

Similarly, we are seeing an increase in volume for both apartment and alternative shelter models (retirement, SRO, and student housing), despite challenges noted above. While most developers want to pursue financing via CMHC, we have seen many pivot to conventional financing with mezzanine debt to take advantage of trended rent proformas versus what CMHC believes to be market today.

Inventory Loans: While this has always been an available product, inventory loans were less popular in markets such as Toronto and Vancouver as the condo presale market was red hot. As the market has cooled, we have seen a resurgence in inventory loan requests as developers seek to re-capitalize remaining inventory from dropped sales or deliberately held-back inventory. These loans are being done by the Tier II banks, trust companies, and private equity firms, usually in the range of 60%-65% LTV.

Tongue in cheek quips about economic predictions aside, we have observed improvement in borrower sentiment as many clients have come to terms with today’s reality. While less experienced developers and landlords are sitting idle hoping for interest rates to decrease so their deals make sense, those that have been through a few market cycles understand that “hope is not a business plan” and are finding ways to forge ahead.

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