Special Report on Commercial Lending


 

Commercial Mortgage Pricing and Supply

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The events of the last two years have resulted in radical change in the pricing and supply of commercial mortgage financing in Canada.

The Canadian commercial mortgage market (including multifamily mortgages) prior to the recession could be segmented into two classes of lenders: those who intended to hold their mortgages to term (referred to as balance sheet or portfolio lenders) and those who intended to sell their mortgages for a profit shortly after origination (often generically referred to as conduit lenders).

Prior to the late 1990s balance sheet lenders were essentially the only sources of commercial mortgage loans in Canada. Life insurance companies, pension and mutual funds, trust companies, banks and credit unions dominated the sector. In 1998 Merrill Lynch introduced to Canada a structure developed in the United States whereby commercial mortgage loans were bundled, carved into tranches one subordinate to the next and sold to investors. Commercial Mortgage Backed Securities (CMBS) were born in Canada.

By 2003 CMBS lenders were issuing in excess of $3 billion of securities per annum. In a market for term origination thought to be between $15 and $20 billion per year, this represented a substantial new entrant.

As time went on market participants created other more novel forms of structured vehicles and securities to package and re-package all sorts of financial assets such as credit card receivables, auto loans as well as residential and commercial mortgages.

Like any market that sees an abundance of supply relative to demand, prices for commercial mortgage loans started to fall. Commercial mortgage lenders typically price their loans with reference to similar term Government of Canada bonds. For much of the decade ended in 2005, a five or ten year commercial mortgage secured by a decent property in a good-sized Canadian city commanded a spread over government bonds of between 1.5 and 2%. By late 2006 and early 2007 lending spreads had narrowed to as low as 1% over government bonds and in some cases lower.

On August 13, 2007 the music stopped and there were far too few chairs. Fissures in the US structured finance sector, brought on by overindulgence in sub-prime mortgage securitization spread to Canada and around the world. A little-known Canadian publicly traded firm called Coventree Inc. issued a press release stating that it had been unable to refinance or "roll" certain short term commercial paper that had matured that day. Such an event had been until then considered all but impossible. The commercial paper market had been structured to be bullet proof. There was no way highly rated paper should fail to roll. But it did. And in a uniquely Canadian twist on the crisis, the liquidity providers that were supposed to step in if the market failed seized on a subtle but important provision of Canadian-style commercial paper and refused to provide liquidity.

The events thereafter in Canada have been well documented. The commercial paper market in Canada ground to a halt. Equity and debt asset values around the world plummeted. Structured finance, including conduit lending stopped dead. The real estate market was dealt a second blow in that balance sheet lenders found themselves "overweight" fixed income as equity values fell further than fixed income values had fallen. As a result there were times in 2008 when there was for all intents and purposes no capital for real estate for certain transactions at any price.

Canada Bonds Fluctuation
The impact on loan pricing was swift. By the end of 2008, lenders demanded an average spread in excess of 3.5% over government bonds on even the best quality commercial mortgage loans. With an abundance of mortgage loans to choose from and a limited budget, lenders swiftly tightened underwriting criteria while obtaining spreads that according to industry veterans have not been seen since the inflationary days of the 1970s.

As of writing, conditions appear to be reversing somewhat. While structured finance has yet to return to the mortgage industry, we have observed more and more portfolio lenders coming back to the market. Good properties are getting financed whether as a result of new acquisitions or refinance of maturing loans. Lending spreads, after peaking over the summer, appear to be falling. Competition is returning to the market. It will be interesting to see where the availability and pricing of commercial mortgage capital settles as we return to more stable economic conditions.

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