As the summer unfolds, all eyes are still on interest rate hikes by the US Federal Reserve and the Bank of Canada (“BOC”), and their impact and effectiveness on slowing down the economy. In this report we will outline major economic events that have occurred, and the market trends we are observing in the commercial mortgage markets throughout these changing times.
On May 3rd, 2023, the US Federal Reserve announced its 10th consecutive rate hike, increasing the overnight rate from 5.00% to 5.25% - a 25-Bps rise. Despite this increase, the US inflation rate was quoted at 4.05% (as of May 2023), well above the target rate of 2.00%. Consequently, Jerome Powell’s testimony hinted at the possibility of further rate hikes later this year.
Keeping up with the US, Canada implemented its own 25-Bps rate hike on June 7th, 2023 and followed up with another 25-Bps again on July 12. This has brought the BOC’s benchmark interest rate to 5.00% and the Prime Rate to 7.20%.
While observing the direct impact of these rate hikes on mortgage payments seems opaque, let us consider a hypothetical scenario. The average price of a home in Toronto is approximately $1.15 million (Source: the Financial Post). Assuming a 20% down payment, the mortgage for this home would be $920,000. Factoring in the difference in interest rates between now and a year ago, and assuming a conventional 25-year mortgage, homeowners face an extra $1,650 per month in monthly carry, a tough pill to swallow for most.
Earlier this year, four regional banks failed in the US, and Credit Suisse was forced to merge with UBS. In response, Canada’s banking regulator, the Office of Superintendent Financial Institutions (“OSFI”), raised the reserve requirement from 3.00% to 3.50%, meaning the Big 6 Canadian Banks must keep more capital on hand, and thus have less capital to lend. This strategic measure aims to mitigate risks but has already led to lenders implementing higher test rates, increased liquidity requirements, and stricter borrower criteria for various loan types (but most specifically construction loans). Consequently, we are observing increased due diligence and scrutiny from credit committees for new loan applications and renewals, which has resulted in longer lead times for underwriting and closing. In today’s environment, it is not uncommon for a new loan to take (at minimum) 3-4 months to close—the longest we have ever observed. Our advice to all clients as we assist them in navigating these hurdles:
a) come to the table ready with all Due Diligence materials in hand
b) determine a clear and defined loan ask
c) be patient
d) recognize that this is a lender’s market and that room for negotiation has diminished, and
e) market conditions are changing rapidly, if a lender offers what is being asked for, act quickly
While loans are still getting done, there is more friction now then ever. In brief, incomplete and changing requests will get the least attention from lenders, and nothing kills a deal quicker then time. If you have a proposal in hand that works—act on it.
In the world of insured loans, CMHC implemented IFRS 17 standards this year, resulting in increased premiums due to rising interest rates and higher default risks. Some loan products have experienced premium increases of more than 200% (i.e. CMHC MLI Select). To avoid this premium increase, Borrowers overloaded CMHC Lenders and Approved Correspondents with applications to be submitted before the June 19th deadline, which Oakbank similarly experienced. As it stands, CMHC has over 4,500 applications in the queue awaiting evaluation, resulting in an estimated wait time of 10 to 12 weeks. In addition, a major Canadian multi-family owner/asset manager is out to market refinancing ~$1.2 billion in CMHC insured loans, which will further impact the CMHC queue and consume a significant portion of the lending market’s insured loan allocation. One thing of importance to note is that we have observed CMHC strictly adhering to the refinancing of existing debt by NHA approved lenders only, posing a potential issue for existing bridge loans. Aside what what’s been noted above, here is what we have observed across various loan types and asset classes in the Second Quarter of 2023:
Spreads for Conventional Term Loans have remained steady since Q1. This has been observed across all asset classes, even for asset classes of choice, such as multifamily and industrial which continues to thrive on a relative basis. Strong deals are being quoted with a minimum spread of the 200 bps over the GOC, with the opportunity for slightly tighter spreads and aggressive bidding for assets with strong tenant in the e-commerce, logistics, and manufacturing industries. This said, DSCR requirements have not changed, with 1.25X being standard. With 5-year bond yields approaching 4.00%, loan-to-value (“LTV”) ratios have dropped significantly to meet the 1.25x ratio required.
Multifamily, whether CMHC Insured or Conventional Non-Insured, remains attractive to lenders and shows no signs of slowing down. Although housing starts reported by CMHC dropped 23% in May 2023, the projected influx of over 400,000 new permanent residents through immigration this year sustains demand for single-family homes, residential condos, and multi-family units. As such, CMHC Insured Loans continue to be a hot commodity, however allocation capacity and lender quotas continue to be challenged as previously discussed. We have observed lenders implementing minimum deal sizes of $5mm+, and a large spread divergence between loans $1mm - $5mm, $5mm - $10mm, and $10mm+.
Jumbo Loans (i.e., loans $200mm+), continue to be challenging as lenders are bowing out of the role of leading a syndication. The feedback we have received is that the administrative burden is not worth the “Arranger Fee” and that the preference for many lenders is to simply participate.
Land Loans continue to prove challenging amongst the institutional lenders as there is limited allocation available. Lenders with 2021, and 2022 vintage land loans are not seeing these loans convert to construction at the pace projected, leaving their land allocations fully deployed. While the big five banks continue to step up for their top clients, we have observed that there is little appetite to onboard new clients, especially with a request for a land loan. Even amongst the loans that are getting done by institutions, we have seen the leverage being offered drop at minimum 5%-10% from previous norms (~75% LTV) as land values continue to be scrutinized. Where the institutions are backing out, we have seen Mezzanine lenders and MICs fill the void with a large portion of loans for acquisitions of un-zoned sites being placed amongst the privates.
As costs have stabilized, we have seen a resurgence in Lender requests for Construction Loans, so long as the pre-sales are underway. Given that it is not uncommon for projects to take 4-6 months to sell in this environment, Lenders are taking the “proof is in the pudding” approach and waiting for evidence of market reception on sales before putting in the work to underwrite and obtain credit approval. This said, if the market is absorbing a product (whether it be residential, industrial, or commercial condos), there is ample lender appetite.
Jerome and Tiff may be creating some challenging times for commercial real estate but the sentiment from borrowers and lenders is that deals are continuing to get done, although in different shapes and forms than what we have seen in the past. Changing (and potentially tough) conditions are here to stay, and perhaps for longer than we had all hoped. We have heard the phase “Survive ‘till ‘25” thrown around a lot in the boardroom lately, and the key to surviving (and ideally thriving) is to be patient, have a clear and concise plan, and when you get a deal that works, act on it.
To view a PDF version of the Q2 2023 Commercial Mortgage Market Update, click here.
Oakbank is a real estate capital advisory firm based in Toronto. We originate and structure financing solutions for developers and real estate investors in the form of construction, bridge, mezzanine, and term loans.
Oakbank Capital Group is licensed and regulated as a Mortgage Broker by the Financial Services Regulator of Ontario (FSRA Broker #13455).