Canada’s commercial property financing market is enjoying one of its healthiest years on record in 2021 as low interest rates stimulate significant borrower activity. How long will the good times last and what should borrowers expect in 2022 are questions we put to First National’s Jeremy Wedgbury, Senior Vice President, Commercial Mortgages and Thomas Kim Vice President and Managing Director, Capital Markets at the beginning of November. Their answers follow.
Jeremy let’s start with an analysis of 2021. What are you seeing?
The market has been exceptionally strong and I’ll use First National’s most recent performance as a proxy. Our total mortgage portfolio expanded to a record $122.3 billion at September 30th, up from $117.1 billion in 2020. Of that amount, $37.6 billion was held in commercial mortgages, also a new record and 10% higher than a year ago. What’s most satisfying to me is that this growth was achieved even though we saw the return of some commercial mortgage competitors who reduced their lending activity in the early quarters of the pandemic. First National chose instead to be a consistent partner for borrowers, as is our tradition, and we’re being rewarded for it.
What’s driving strong performance?
Again using First National as a proxy, I would say the low interest rate environment, very strong investor appetite for certain types of properties including in smaller Canadian markets that were previously overlooked but are now popular because of work-from-home opportunities driven by the pandemic and having the right products to offer and a team strong enough to deliver. We’ve added over 400 talented new people to the company in all departments. These hires enhanced all aspects of our Commercial offering: from analytics and origination to underwriting, funding and servicing. I think this is sign of confidence in both our future and the market’s but this added horsepower is also extremely important today given incredible market demand for our mortgages. A case in point: our commercial team funded $2.3 billion of mortgages in the third quarter alone, 33% or $567 million more than last year. After starting 2021 slowly, we’ve more than more than made up for it in the past two quarters. In fact, through September, First National’s commercial originations amounted to $6.7 billion, over $300 million higher than in the first nine months of 2020.
Unpacking those headline comments, and starting with interest rates, what’s going on with bond yields Thomas?
Since mid-September, 5- and 10-year yields are up about 65 and 47 basis points, respectively. This is a reflection of expectations for tapering of bond-buying activity by the U.S. Fed, concerns about high inflation, and the Bank of Canada’s recent announcement that quantitative easing is over. There has been no shortage of big themes for the market to consider.
What about the yield curve?
The difference in yield between the benchmark 10-year and 5-year Government of Canada Bonds was over 60 basis points in May. It’s now around 20 basis points. By comparison, it was zero back in mid-February 2020 before the pandemic shut down the economy. The shape of the curve will move around to reflect the market’s views on growth and inflation and of course the evolution of COVID-19.
What does this mean for mortgage rates in the near term?
Government of Canada Bond yields are the highest they’ve been all year. It certainly feels like the market wants to see higher yields, but it’s worth remembering that as recently as July, yields pulled backed materially. I’ve never believed that timing the market is a good strategy for borrowers. Financing is just one part of operating their business and I would never recommend turning a business decision into a trading decision.
According to Federal Reserve Economic Data, the 10 years between 2010-2020 joined 1930-40 and 1950-60 as the decades with the lowest levels of inflation. Thomas, is it possible the 2020s will mark a return to high inflation?
We’ve been accustomed to CPI of around 2% for a long time. Recently, inflation increased to over 4% in Canada and 5% in the U.S. While higher than what we’re used to, this is not what I would label as high inflation. The big question is how persistent this elevated inflation will be and does it start altering people’s expectations about future price increases. With so many compelling narratives out there, it does invite speculation. I tend to think these are unique times and drawing too direct a comparison to historical anecdotes or taking textbook relationships too literally is probably not useful. Time will tell.
Jeremy, given the possibility of rising interest rates, has borrower interest in interest-rate hedging increased?
We offer an Early Rate Lock program and frankly because rates have been so low since the pandemic began without any sign of increasing, our clients have not been particularly focused on hedging strategies over the past 18 months. That is now changing. When the Bank of Canada announced that rate increases will occur earlier than originally anticipated next year, we saw an uptick in conversations about Early Rate Lock and I expect to see a lot more going forward. Taking a pragmatic view, it’s certainly wise to look into this option as it may very well add value to a future financing.
With these economic developments taking place, what are you advising clients to do as we head into 2022?
Do what they should always do: plan their property financings well in advance with the help of a qualified advisor and make sure their assumptions are realistic, whether they relate to property valuation, projected rental rates, lease-up expectations and so forth. First National’s commercial team lives to provide detailed market insights, crunch project numbers and find creative financing solutions that provide the best risk-managed returns for borrowers. We’re not in the market to sell a specific type of mortgage like a balance-sheet-only bank lender. We have a much broader product range including bridge, mezzanine, conventional term, conventional construction and as a CMHC-approved lender, access to all manner of insured mortgages including incentive-driven programs like Affordable Flex.
What type of mortgage products are popular right now?
We’ve done a lot more conventional business than ever which is testament to the market’s preference for our Core Conventional program. Since we launched this less than a year ago in response to requests from borrowers, it has proven to be very popular as it comes with highly competitive lifeco-level interest rates, attractive amortization periods and is supported by First National’s responsive service. Based on volumes through the first nine months of 2021 and commitments so far in the fourth quarter, we’re on track to fund upwards of $800 million in 2021, so even more than our first-year ambitions, which were pretty high. About 50% of our recent Core Conventional fundings are for multi-family property projects, with the remainder being industrial and self-storage, although this program can be used to finance virtually any type of property asset. With this program, we can fund loans quickly and in the case of apartment projects, borrowers have no restrictions on the rental rates they can charge, unlike affordability-linked insured financings.
Has the rise of conventional been at the expense of insured mortgage volumes?
No, it has not. Core Conventional has simply augmented our insured volumes and given our clients another option for quicker approvals or larger equity takeouts. We work very closely with CMHC and have done so for decades. It’s a great partnership. We’re big proponents of the work of the national housing agency and are intimately familiar with the RCFI, Flex and Market programs as well as the various incentives CMHC offers such as their energy efficiency grants. Insured mortgages are not right or even available in every instance, but when they are, we recommend them. As a CMHC-approved lender, we make it our business to stay connected at every level of that organization to understand their goals and policies and share our thinking with them as advocates for our borrowers. We think this advocacy role is important for clients and we hope it adds perspective when CMHC is making decisions.
What about construction financing activity? Have you seen strength in commitments or demand generally and do you think that level of activity will continue for the foreseeable future?
Yes, there’s been considerable strength in demand for construction project financing. To date this year, we’ve added 32 new construction loans representing total commitments of over $1 billion. This brings our total commitment to $3 billion across 90 different projects. As far as the future is concerned, there is certainly a supply-demand imbalance in several commercial property asset classes, notably apartments and industrial space. Accordingly, the long-term market fundamentals look strong, but we do worry about immediate headwinds provided by inflation in building material costs and construction labour particularly as it relates to large building projects in city centres. Getting to target rental rates in luxury apartments in urban centres is proving to be a current challenge, driven by factors such as out migration to suburban markets and border impediments to foreign students and immigrants.
Jeremy, all things considered, what is your outlook? Will the good times last?
In the immediate future, our outlook for the final quarter of 2021 is that commercial origination at least here at First National will remain strong based on our current pipeline. Beyond that, I think growth of the two main asset classes we serve – apartments and industrial – is likely to remain supercharged as property demand exceeds supply. We’re quite bullish on both sectors and not just for 2022. Our medium-term outlook is very positive. But as Thomas said about inflation, only time will tell. I would say a balanced view needs to consider the state of the economic recovery, the sustainability of employment levels – which recently returned to pre-pandemic levels – and the reopening of Canada’s borders. That reopening is underway and will restore Canada’s welcoming stance to immigration. The federal government’s plan is to encourage the settlement of 420,000 permanent residents in 2022, which in turn will create additional demand for apartments and other forms of housing. We will also keep a close eye on the work-from-home trend as COVID-19 dissipates since it has a bearing on housing demand – type of properties, property amenities and location. And like everyone else, we’ll be looking to central banks for clues on the direction of interest rates which are likely to rise but according to central bankers, not until sometime next year. In total, I think the scales are tipped toward a healthy 2022 and that’s certainly what we’re hoping and planning for at First National along with a strong finish to 2021.
Planning a commercial property financing in 2022? Please speak to a First National advisor today.