Special Report on Commercial Lending


Are We There Yet?

Bank of America

It's been approximately one year since the concepts of securitization, debt and insurer ratings, and adequacy of tangible bank capital gravitated from computer screens to TV screens, from footnotes to headlines, and from boardrooms to dining rooms.

Yet relative to where we are today and the events of the last 12 months, I can't help but think of a TV commercial involving the Pillsbury Dough Boy being poked in the abdomen. Once poked, the Dough Boy giggles as his belly re-inflates to normal shape.

Currently, equity markets have been on a tear since March and the September sobering that generally occurs in equities has not. The debate now extends to whether this has overshot on the upside. Regardless of valuations, the bounce back has had a positive and welcomed effect on the psychology of households, consumers and the housing market.

With bond yields compressing, those who believe in the concept of relativity seem to be winning the day and winning deals in the mortgage market. Those who believe in the concept of supply and demand for capital seem to be winning fewer deals.

One could argue that the fear caused by a non-functioning global credit market and interbank illiquidity is far greater than the fear associated with an 'old fashion recessionary credit market'. Hence credit spreads in the past 12 months reflected an historical aberration and the compression now occurring is a natural market function with liquidity returning to the market place.

Regardless, one of the principle reasons why the global capital markets ostensibly shut down was that risk was not priced accordingly. Pricing influenced by relative investments seemingly won out over the concept of finite capital for certain asset classes.

A recession has yet to be materially felt on commercial real estate north of the 49th parallel which leads to the question, is this the lull before the storm, or did we miss it?

Headlines from the US indicate that US commercial real estate is, or will be, the next problem sector. Did the structure and lending practices of the Canadian banking system effectively moderate the effects of a recession?

In contrast, the Federal Deposit Insurance Corporation was responsible for approximately 8400 US based banks at the beginning of September 2008. The economy also supported numerous unregulated commercial finance organizations. Arguably there would not be the need for that many financial providers had they all offered the relative same risk tolerance. Hence in such a fractured and competitive environment, there is the potential that the risk spectrum gets stretched out and manifested into leverage ratios and deal structures that have a tendency to snap under stress.

Vacancies and sublets in Canadian office and industrial markets have yet to manifest themselves into spectacular fire sale. The question remains what impact will a recession have given the institutionalization of Canadian commercial real estate. Relative to the US, the Canadian retail sector has a more concentrated retail landlord and tenant base and has not been subject to the same retail build up.

As expected going into this correction, there hasn't been an issue with well managed and properly leveraged borrowers in accessing a full gamut of capital whether it be equity, mortgage bonds, convertible debentures, bank lines or conventional mortgage debt. In some cases, even unsecured financing has made its way into the market.

However it may be the tale of two worlds in this cycle.

In the case of the lodging sector, recessionary effects on REVPAR have been felt by every Hotelier. Not only are guests difficult to find, but so are capital providers.

The high rise condo sector also seems to be encroaching on either single name, single project and/or, portfolio limits with lenders. Absent of increased portfolio capital, capacity will likely only be restored once the significant pipeline of presold development projects begin to monetize and provide repayments of construction loan facilities.

To borrow the phrase from industry notable Blake Hutchinson, "unintended consequences" have resulted.

Despite the relative sound underwriting of the Canadian CMBS industry, the sector was stigmatized and totally seized up. All lenders have exited the market and associated capital provided by the sector has yet to be replaced. In addition, there are less absolute real estate lenders in the Canadian market now then in mid 2008 and many of those that remain in the business are restricting new business activity to their existing client base.

In a constrained debt market, which we are in today, the creative rationalization of days past won't work. What seems to be working and present in every successful deal are transparent and sustainable relationships, deal structure and pricing reflective of risk.

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