Jeremy Wedgbury’s Canadian Construction Commentary

  • First National Financial LP

Across Canada, construction activity, particularly in the apartment sector, is on the upswing as risk capital flows have increased in response to strong demand for new buildings. How long this trend will last and what factors are driving it are open questions and ones we pose to Jeremy Wedgbury, our Senior Vice President, Commercial Mortgages who has been involved in construction lending for decades. 

Jeremy, before we begin, congratulations on reaching $25 billion in commercial mortgages under administration.

Thanks. We're very excited to have achieved this milestone during First National's 30th anniversary. It validates what we're doing to help clients meet their objectives while building our position as Canada's largest commercial mortgage lender.

You were on record late last year predicting that First National would set a record for construction lending volumes in 2018, led by the apartment sector. We're now past the mid-way point of the year; how have things turned out so far?

Very well. Despite a somewhat slow start to the year, we've experienced exceptionally strong volumes.  At last count, we were reviewing just over $1.3 billion of construction loan opportunities. That's about 10 times the size of the pipeline last year. We also just received notice from CMHC that they agreed to insure one of our transactions that happens to be the largest apartment construction financing in CMHC's history. We'll wait and see how activity shakes out for the balance of the year, but I'm confident in my original prediction.

Where is lending activity strongest?

Definitely in the rental apartment sector and for two reasons. One, there is significant demand for new apartments. Two, there is more capital available than ever to fund construction of this asset class.

What's fueling consumer demand for apartments?

Population growth, many years of product undersupply, which has resulted in a substantial aging of rental stock, the fact that single-family homes and condos are out of reach for many first-time buyers, and a powerful demographic shift that has led baby boomers to divest their homes in favour of upscale apartments. I was in Victoria recently and saw an apartment complex charging rents of close to $3.00 per square foot. In Victoria, a rate like this would have been unheard of a few years ago.

It sounds like you are surprised by inflation in rental rates.

It is surprising how quickly rents have escalated but that’s due to the demand and undersupply factors I mentioned. The stars have aligned for the sector and as Canada's largest apartment lender, they've aligned for First National and we're seeing that right across Canada.

Where is the capital coming from to fuel apartment construction?

CMHC introduced what they call their Flex Financing program in the spring of 2017, which is aimed at incenting new apartment construction by offering up to 95% loan to cost compared to 75% to 80% for conventional construction financings. First National was the first lender to recognize the opportunity presented by the program. After satisfying ourselves that it was worthy of consideration and learning exactly how to navigate the approval process, we brought it forward to our clients. 

If Flex Financing is geared to stimulating affordable rental unit construction, how does that square with demand for more upscale units?

Building affordable units is the goal but the program's definition of affordable means that only a certain percentage of the units must be affordable, not all units. As well, affordability is judged in the context of competing rents in the local neighbourhood. So, it's not unusual to see apartment units funded by this program charging rents close to $2,000 a month. The incentive was designed to bring for-profit developers into the apartment market and it's working.

Has there been a change in CMHC's and First National’s appetite for construction loans?

CMHC has always supported construction lending and First National has as well. I think what's changed is that developers are recognizing the value of building and owning rental apartments, which has created more demand for financing, and the Flex program has certainly been there to satisfy this demand. By the way, Flex is also a great gateway product for our insured term loan business.

How does the Flex program serve as a gateway to term takeout financing?

One of the compelling features is that once an occupancy permit is granted, term loans are made available. Conversely, in a conventional construction deal, a term loan does not fund until the lease-up is complete, which often takes another eight to 10 months as apartment owners search for the right tenants and strive to achieve the highest rental rates. In a rising interest rate environment, a lot can happen in eight to 10 months to term loan servicing costs and so this feature is a significant advantage for borrowers. And, for First National, it means we can package the construction and term loan together, mitigate borrower risk and provide greater certainty to a project's economics.

In past, has there been an adequate supply of risk capital available for apartment construction, both of a conventional and insured variety?

I would say not, or at least not until CMHC stepped up to fill the void with the Flex program. Outside First National, many lenders were not comfortable doing rental apartment deals because unlike in condominium construction, there is no baked-in exit for the lender. With a condo, the units are pre-sold before the builder applies for a construction loan, construction takes place, and the builder and lender walk away with their profit. With an apartment project, the rent that eventually will be realized is not clear when the application for a construction loan is made, which is a risk. But the clear upside advantage is that there is an ongoing asset for a developer to own and one that is highly suited to term financing because of the potential for reliable, ongoing rental unit cash flows.  Interestingly, many second and third generation developers who long focused exclusively on condo construction have recently come to us and said, 'we want to leave an income-producing legacy asset that our children can enjoy and we don't get that with condos so we're prepared to switch to apartments, can you help us?' The answer is resoundingly yes.

So you're seeing condo developers move into apartment construction?

Yes. When it comes to construction, there are important similarities between the two asset classes that mean the skills and experience needed to succeed in one are portable to the other. But there are also differences in financing apartments and this is where First National can be of real service.

Speaking of condos, there have been stories in the Toronto press about builders walking away from towers that have been re-sold. What's this about?

Generally, it's about some of the headwinds that are beginning to blow for builders. Condo construction works like this. The builder begins to pre-sell units one to two years ahead of applying for building permits. This way, they lock in their revenue and use the tenants’ deposits as equity when they apply for a construction loan. In this case, the builders assumed that they would achieve a certain investment return based on the price per suite set at the time.  Unfortunately, construction costs and development charges escalated to the point that the prices they received for those suites made building them uneconomical in today’s market, so they abandoned the project before ever even applying for a construction loan.

How much have construction costs risen?

Anecdotally, I hear as much as 1% per month or 12% per annum recently although this varies nationally.

Is this a problem facing apartment builders as well?

Construction cost escalation is a headwind for builders in all sectors. What we're seeing with apartments, though, is that rental rates have increased, in some cases by 25 or 50 cents per square foot, so this helps to cover construction cost escalation. This isn't true in all markets. In Calgary for example, some pro forma rents are lower than three years ago because of the oil industry downturn.

But construction costs must also be relatively lower in Calgary because of the recession?

That's not what we're seeing. A local Calgary builder told me in June that if he had to tender a construction project today, his costs would be 20% higher than two years ago.

As a lender, do you advise builders on how to avoid issues like this? 

The borrowers we deal with are very experienced. They understand inflationary input costs. They have track records of building on time and on budget. And, they have the financial means to write a cheque for any building cost escalation. Because they are doing a lot of construction, they also have substantial buying power over building products like doors and windows and trade services that helps them offset some of these increases.

So what is First National's value proposition?

As a lender, our contribution starts with financial modelling and market research. We've developed sophisticated modelling tools that help us run different scenarios for our clients based on different amounts of equity in, different pro forma interest rates and different financing scenarios, be it conventional or insured. We use one approach to model construction loans and another to model term loans and these tools help builders project their investment returns and the risks to those returns under different base cases. We also make considerable market research available to builders. And then of course when it comes to any CMHC program, Flex Financing included, we develop the application submission using our experience as a CMHC-approved lender.

How are you modelling interest rates today?

Interest rates are an important part of any commercial lending arrangement and for a construction project, rate movements provide a special challenge because the building phase usually takes two to three years to complete. Trying to forecast what rates may look like in 2020 or 2021 is a pretty difficult exercise. What I can say is we model different scenarios for borrowers and try to give them the benefit of our insights into the bond market. For example, the yield curve has flattened this year, which is usually a precursor to economic disruption. But it has also reduced the normal disincentive to select long-term financing over shorter term. We believe that we make our borrowers stronger by sharing this kind of market intelligence proactively so that they can avoid issues down the road. It's part of our More Than a Lender approach. We also offer the First National Rate Lock that can help borrowers lock in a term loan rate in advance of lease up.

In Ontario, rent controls were recently reintroduced to buildings built after 1991. Is this a headwind?

Since the legislation is retroactive to 1991 and covers all new builds going forward, I would say it’s a headwind. In effect, it means that for owners of new buildings, all rental increases from now on will be based on the original floor price at the time the sitting tenant moved in and will be governed by the Province’s annual Rent Increase Guideline. This puts additional pressure on the owner to be extra vigilant not only in seeking the best tenants but achieving the highest possible initial rents because those initial rents will influence the building’s economics in future years.

Last year, you said it was a great time to be active in building apartments. Is this still true?

Yes, I would say it's absolutely true for experienced developers. An experienced developer has a network of tradespeople with proven skills and craftsmanship, understands costs and inflationary factors, is able to apply effective counter measures, and most fundamentally, chooses construction opportunities that make sense based on a deep understanding of local market trends and an appreciation of the need for liquidity. We're 100% behind apartment builders who exhibit these characteristics and skills and have a track record of successful developments.

How long do you think the good times will last?

Hard to say but the fundamentals of demand and supply are very favourable right now and despite new units coming on stream over the next couple of years, it won’t be enough to serve the demographic and population growth trends in Canada.

What about construction activity levels in other real estate asset classes?

From our perspective, the trends are positive in the office and industrial sectors and condo construction remains strong in major markets like Toronto and Vancouver. In retail, the rise of Internet shopping appears to have dampened activity as many tenants are now exploring business model alternatives to bricks and mortar stores.

Construction lending is often considered the riskiest form of commercial lending. How does First National manage its risks?

By working with experienced builders. We give priority to those clients who have been building for years, perhaps even decades. These are people who know what they're doing and consequently, they tend to build larger projects with loan values of over $5 million, which is the market First National plays in.

Have you seen a commensurate increase in demand for term loans as a result of new construction lending?

It's too early to say but given the easy progression possible from Flex Financing to term financing, it's a safe bet that more term loans will follow.

Final thoughts?

For experienced builders who are focused on apartments, this is a unique point in the business and economic cycle. For First National, our objective is to help our clients capitalize on the most lucrative opportunities in the most advantageous, risk-managed way. In short, we're open for more business.