Challenges with Mid-Market, Class B & C Properties in Alberta

By Bryan Slauko, CFA, Managing Director, Base10 Capital Advisors

We frequently read and hear from market participants that demand from investors and lenders is strong for Class A, investment grade assets in strong locations. We don’t hear much about the mid-market office, retail and industrial properties that make up a significant portion of the commercial real estate market. From our perspective here in Calgary, these properties are facing significant challenges related to operating cash flows, valuation and capital structure.

A number of these properties were either acquired or refinanced during the 2005-2007 period when values were much higher and mortgage financing was readily available. This resulted in significant debt service obligations, even if the mortgage was originally made at a conservative loan-to-value ratio. It also leaves a large mortgage balance to refinance at maturity. Today we find many of these landlords, and therefore their lenders, struggling with two significant risks:

1. Cash Flow Risk

Property cash flows have declined substantially given higher vacancy levels and reduced lease rates. You don’t need to look hard to find office properties in Calgary where lease rates have declined by 50% from their levels of 1-2 years ago.

2. Refinancing Risk

Refinancing a mortgage at maturity can be extremely difficult given dramatically lower valuations. We’ve seen properties with significant vacancies valued 50% lower than when the mortgage was originated. Others have seen values decline by 15-20% in the past year due to broader market factors, despite the presence of long-term leases and minimal vacancy.

Cash flow risks continue to be a concern going forward over the next 1-3 years. Vacancies persist, market conditions do not presently support a rebound in leasing rates and many landlords have yet to roll over tenants at much lower market rates. This is true of the office, retail and industrial sectors.

Lenders exposed to these properties need to be proactive in evaluating portfolio risks given the potential for cash flows to be insufficient to cover monthly debt service. Even if a mortgage can cash flow to maturity, it’s likely that the combination of lower cash flow levels and lower valuations will not allow a mortgage to be fully refinanced.

Mortgage Extensions Can Be Risky

There are serious risks to consider when evaluating a term extension. A detailed property review needs to be completed to understand the dynamics that are driving cash flow and valuation. What does the competitive landscape look like? What are current market trends? Does the owner have sufficient capital to maintain the property, address capital expenditure requirements and fund leasing commissions and tenant improvement expenses required to secure new tenants? Does the
management team have the necessary skill sets in place to deal with very different market conditions and demands?

In a property with minimal or negative equity, a simple extension without detailed analysis effectively places 100% of the risk in the lender’s hands and gives almost 100% of the upside to the owner. In this situation, the owner has a free put option they can exercise to walk away from the property at any time and hand the keys back to the lender. This level of risk exposure demands detailed market analysis and stress testing of factors that impact cash flow and valuation.

The Importance of Loan Workouts & Restructurings

Depending on each property’s unique circumstance, simply extending a mortgage without considering workout and restructuring options may only delay recognition of an inevitable loss by the lender. The major risk with loan extensions is that a failure to promptly restructure the balance sheet will leave a property that is burdened by high debt service obligations and does not have the financial flexibility to reduce lease rates to current market levels. These property owners are therefore not motivated to finance tenant inducements and leasing commissions necessary to secure new tenants, or are likely too capital constrained to do so. We have seen recent examples of this.

These properties will eventually lose tenants to properties that have lower leverage or have been successfully restructured, and are therefore able to offer reduced market lease rates. Property cash flow will deteriorate and resources available to continue to fund debt service will quickly dry up. The probability of significant loan losses now increases significantly. The end result for the lender is likely much worse than if a proactive approach is initially taken to identify portfolio risks and followed-up with a long-term asset management approach designed to maximize the value of these properties.