RealCaptial brought together property owners, investors and lenders on February 25, 2020 in Toronto to discuss how Canadian debt and capital markets will perform in 2020. During the panel discussion "Valuations and Underwriting in Today’s Real Estate Marketplace: Challenges & Opportunities," First National's Jeremy Wedgbury, Senior Vice President, Commercial Mortgages, made the following key observations.
1. CMHC insured lending activity has grown markedly as a result of demand from securitization lenders like First National.
As Canada's largest commercial mortgage lender with a portfolio of over $30.7 billion, the Company funded $4.5 billion of new CMHC insured commercial loans in 2019.
2. Perhaps as much as 85% of all Canadian commercial financing is being securitized and the primary securitization vehicle – the Canada Mortgage Bond – has allocation limits for lenders.
As demand for commercial financing – particularly large mortgages – has risen, the supply of capital through the CMB program has not kept pace. To alleviate this challenge for clients, First National has adopted several strategies including using the Mortgage Backed Securities market opportunistically as it did recently with a successful $150 million, 10-year transaction.
3. With a flat yield curve, borrowers have gravitated to 10-year terms.
Two-thirds or almost $3 billion of First National’s commercial financings in 2019 involved 10-year product. With allocation limits, there is not enough 10-year product available in the Canadian market, which is why First National will continue to do MBS transactions while also bringing 15 and 20 year term CMB products to market.
4. Spreads may compress in 2020.
This will not be the case on all loan types due to demand factors but provides good news for some borrowers.
5. Canada is now entering an apartment construction cycle.
New apartments are starting to be built from coast to coast in higher volumes to address urgent demand factors and years of under supply.
6. The Québec apartment market, in particular, is in take-off mode.
First National is experiencing a groundswell of demand in Montréal, Québec City and Gatineau and is optimistic about growth in these markets over the next three to five years. Although Montréal has a large supply of apartment stock, much of it is older stock. As such, First National’s pipeline of construction deals is large and growing.
7. Contingency planning is imperative because the municipal planning process across the country is slow, construction costs continue to rise and construction projects are often delayed because of labour shortages.
First National has an experienced team that works with borrowers to ensure budgets are sufficient to cover the costs that often arise from planning and construction delays and construction inflation.
8. Inflation in apartment rental rates may be starting to top out in some markets due to affordability concerns.
Rental rates on some newly constructed apartments are being delivered at $4 to $5 per square foot in Toronto. At some point, there will be a cap on how much more inflation is possible, meaning the rental rate that is used to underwrite a construction deal today may be the rate that is achieved two years from now.
10. Repositioning apartment assets can create value, but borrowers need smart financing strategies to avoid the use of significant equity to fund repositioning capex.
In the past, a popular strategy for repositioning was to use a bridge loan with an interest-free period. More recently, borrowers are realizing better value when First National arranges CMHC insured first mortgages, backs those with second mortgages to address capex needs during repositioning and then converts the second mortgages on a pari passu basis to insured CMHC loans – which are just as economical as the original first CMHC mortgage.
11. To meet aggressive timelines for borrowers, First National provides interim bridge financing and has done about $1 billion over the last 24 months.
Borrowers who need to move quickly are well served when First National issues a commitment letter, which provides them with the confidence to move forward with a transaction, and then delivers on-balance sheet, conventional interim bridge financing. This strategy means borrowers do not have to wait for CMHC loan approval to seize a time-sensitive buying opportunity.