Industrial availability dropped to a record low in Q1 2019, while office markets across Canada had some of the best results in recent memory
Canada’s office real estate recorded the most vigorous leasing activity in years, primarily spurred by a rapidly expanding tech sector. Overall, the national office property vacancy rate decreased by 40 basis points (bps) quarter-over-quarter to 11.5% in Q1 2019, the lowest level since Q2 2015. The amount of office product under construction nationwide in the first quarter reached 16.0 million sq. ft. for the first time since Q4 2015, as Vancouver saw an additional 1.4 million sq. ft. of new office development break ground this quarter.
The rise of online retail sales, and the associated warehouse space needed to keep up with consumer demand, has pushed the Canadian industrial market into overdrive. The national industrial availability rate dropped to a new record low of 3.0% in Q1 2019. To meet user demand for taller clear heights, larger door counts, and specialized warehouse configurations, 22.6 million sq. ft. of industrial space is under construction, the bulk of which is in Toronto and Vancouver. This is the highest level of national industrial development seen since 2015.
“Canadian office markets continue to gather momentum, in large part as a result of rapidly growing tech and co-working sectors. The remarkable office market momentum continues to build, but tenants have fewer and fewer options if they don’t plan ahead,” commented CBRE Canada Vice-Chairman PaulMorassutti. “Meanwhile industrial developers are responding to chronic space shortages with new construction, while tenants are opting to secure space prior to construction completion. In Toronto, all new supply delivered in Q1 2019 was pre-leased, and 77.6% of the 9.58 million sq. ft. under construction already has tenancies in place.”
Here are some of the other commercial real estate records logged in the first quarter:
- Downtown Toronto office vacancy tightened another 10 bps, dropping the rate to a new record low of 2.6% in the first quarter.
- Montreal’s downtown office vacancy now sits at 8.6%, the lowest it has been since Q4 2013, with tech company growth playing a key role in this decline. The downtown core has had 819,500 sq. ft. of new product delivered over the past eight quarters, with 998,139 sq. ft. of additional space under construction as of Q1 2019.
- Calgary experienced 289,515 sq. ft. of positive net absorption of downtown office space in Q1 2019, the largest quarter of positive absorption since the oil downturn in 2014. Much of the activity came from tenants taking back space previously listed for sublease, spaces being converted to co-working uses, and landlords turning unoccupied supply into amenity space.
- Toronto’s industrial market, which has had 16 consecutive quarters of positive net absorption, saw its availability rate hit an all-time low of 1.5% in Q1, with 2.2 million sq. ft. of positive net absorption.
- Calgary’s industrial market, which has logged nine consecutive quarters of positive net absorption, had a further 649,080 sq. ft. of space taken up in the first quarter of 2019.
- The Halifax industrial market had 50,465 sq. ft. of positive net absorption in Q1, the ninth straight quarter of positive net absorption for that city.
“In recent years, the Canadian real estate market had been somewhat polarized between areas of pronounced strength and areas facing challenges; however, this quarter showed more momentum for cities across the country, including hard-hit Alberta,” said Morassutti. “It’s worth noting that while overall office vacancy has remained stable quarter over quarter in Edmonton and Calgary, the amount of sublet space on the market – which serves as a bellwether for the office segment – decreased by 25.1% and 8.6% respectively. This is a promising indication that Alberta’s CRE conditions look to be improving at long last.”
For further details and insights, download CBRE’s Canada Q1 2019 Quarterly Statistics report here.
A Falling Vacancy Rate
Once per year, Canada Mortgage and Housing Corporation provides a comprehensive review of rental markets across Canada. The survey occurs during the first half of October. Results for this year were released on November 28.
For October 2018, the vacancy rate was 2.4%, which was a substantial drop from the 3.0% rate recorded a year earlier. The vacancy rate for 2018 is far below the average of 3.3% for the entire period shown in this chart. The reduction in vacancies resulted in more rapid rent increases, at 3.5% this year. Over the entire period shown, the average increase was 2.6%. This data shows that the situation has become increasingly challenging for Canada’s tenants.
Vacancy rates fell in 7 of the 10 provinces. Manitoba, BC, and Ontario saw small increases in their vacancy rates. These three provinces also saw the most rapid rent increases. The lowest vacancy rate is now in PEI, followed by BC and Ontario. The highest vacancy rates are in the three provinces where economies have been hurt by the plunge in oil prices (Saskatchewan, Newfoundland and Labrador, and Alberta). These provinces saw the weakest rent increases.
Since the data is collected only once per year, it is difficult to construct any models for analysis or forecasting of rental markets. The author’s experimentation over many years, for many different communities across Canada, has resulted in statistical models that have low “reliability”. But, those low-reliability results have been surprisingly consistent, and have led to a conclusion: the two most important drivers of changes for the vacancy rate are job creation during the past year (which allows more people to buy or rent housing) and total completions of housing during the past year.It is tempting to expect that completions of new-rental apartments would be important, but the author’s analysis has found that this is rarely the case.
On reflection, this makes sense:
- The rental market is part of a complex housing system in which there are very large flows between ownership and renting, and between different forms of housing.
- Expansion of the total stock of housing offers people more choice: even when people move into new home ownership dwellings, that move sets of a chain of other moves. Much of the time, that chain of moves includes someone moving out of a rental, which creates an opportunity for a new tenant.
- Moreover, the tenure on a new dwelling is not fixed for all time. In particular, it is well known that many new condominium apartments are occupied as rentals. In addition, some low-rise dwellings (single-detached, semi-detached, and town homes) are ostensibly built for ownership but are made available as rentals.
It is also tempting to expect that changes in resale market activity will affect the rental market. But, once again while the statistical analysis produces unreliable results, over many repetitions it has been found that resale activity has little effect on vacancy rates. This also makes sense on reflection. Most of the time a resale transaction does not add to total demand for housing (the buyer usually moves out of a different dwelling) and it usually does not alter the total supply of housing (unless the new buyer adds or removes a basement apartment).
Our impressions about the employment situation are largely based on data from Statistics Canada’s Labour Force Survey (“LFS”). This data indicates that during the year up to this September, employment in Canada expanded by 1.2%. This is slower than the rate of population growth (1.3%), and this therefore should be considered a mediocre result. Based on this data, we would expect that housing demand would be weak, and the drop in the vacancy rate this year would be a surprise.
However, the data from the LFS is derived from a sample survey and like all such surveys, it can produce errors. Statistics Canada has a second survey (Survey of Employment, Payrolls and Hours, or “SEPH”), which is based on data from employers, and is therefore likely to produce more-accurate data. This data receives much less attention because it is published almost two months after the LFS (the most recent data is for August). The two datasets usually tell similar stories. At present, however, SEPH shows growth of 1.8% (as of August) versus the 1.2% shown by the LFS (as of September).
Over the entire period shown in this chart, job growth averaged 1.5% per year. Strong job growth in both 2017 and 2018 helps to explain the drops in the vacancy rates that were seen in both years. Housing completions were at above average levels during 2017 and 2018 (the chart shows the figures for 12 month periods ending in September). These elevated volumes of new housing supply provided some relief for rental markets. Without this additional housing supply, the drops in the vacancy rates in 2017 and 2018 would have been even larger than they were.
The mortgage stress tests have resulted in reduced buying of new and existing homes. It takes some time for changes in purchases of new homes to translate in reduced housing starts (and even longer for housing completions to be affected). Increasingly, it appears that housing starts have peaked, and may have started to fall. The next chart illustrates that total housing starts were very strong during 2016 and 2017, but the trend has started to fall during 2018. A more detailed examination would show that housing starts have turned sharply for low-rise dwellings (single-detached, semi-detached, and town homes) but remain very strong for apartments. During 2019, starts for apartments will gradually reflect the reductions in sales that have occurred this year. This is explored in more detailed within the Housing Market Digest reports (for Canada and the regions) that can be found here: https://goo.gl/kJ6mcC
Following from these trends for housing starts, housing completions are expected to fall only slightly during the coming year, meaning that new housing supply will continue to provide some relief for the rental sector. However, housing completions are expected to fall considerably during 2020. As for employment, higher interest rates can be expected to gradually weigh on job creation during 2019 and 2020.
For 2019, a combination of continued high levels of housing completions and a slowdown of job creation should mean that there will be little change in the apartment vacancy rate (perhaps a drop to 2.3% from the 2.4% seen in 2018). The low vacancy rate can be expected to result in continued rapid rent increases, at a rate of at least 3%.
During 2020, the reduction of housing completions that will result from the mortgage stress tests will add to pressures in the rental sector. For 2020, the vacancy rate is expected to drop further (approaching 2.0%) and rent increases will quicken.
Government Policies at Cross Purposes
The federal government has announced plans to make major expenditures in support of affordable housing ($40 billion over 10 years). The federally-mandated mortgage stress tests, by reducing movements out of renting, will add to pressures within rental housing markets, and are operating at cross-purposes to the National Housing Strategy.
Disclaimer of Liability
This report has been compiled using data and sources that are believed to be reliable. Mortgage Professionals Canada Inc.
accepts no responsibility for any data or conclusions contained herein. Completed by Will Dunning, November 28, 2018.
Copyright: Mortgage Professionals Canada 2018
Top 5 Reasons to Use Mortgage Alliance Commercial Canada (MACC)
- MACC is Licensed across Canada with offices in Quebec, Ontario, Alberta, and BC
- MACC has maintained privileged relationships with all major lenders across the country to allow our clients to access better terms and conditions for their financing needs
- MACC simplifies and manage the entire process of any lending transaction from pre-screening requirements and options; completing loan underwriting and lender negotiations, through to the disbursement requirements, to ensure successful completion and funding.
- MACC is an approved CMHC correspondent and experienced in preparing and presenting applications directly to CMHC for underwriting and approval. This provides access to preferred rates and terms, and higher loan to value ratios. This includes multi-unit rentals, mixed-use, purchases and refinances. We pre-screen deals to determine potential loan amount available based on property information provided such as rent roll, and statement of income and expenses.
- MACC has over 20 years’ experience in the commercial broker industry and a significant track record in deal success covering all commercial industries. We are well-positioned to guide clients through the most complex transactions and obtain the best options in the market. See our website for just a few of the projects completed. http://macommercial.ca/projects/
Marion Cook | November 2018
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Middle-class families in Ottawa will benefit from 243 new rental units being built in the city with an investment from the federal government.
Two projects will be financed through the CMHC’s Rental Construction Financing initiative including $70.8 million for the construction of a twenty-seven storey building with 227 rental housing units. More than 200 will have rents lower than 30% of median household income in the area.
“The project represents a major step forward in sustainable design with ambitious design targets to reduce energy consumption by 50% and reduce carbon emissions by over 75% with an integrated geothermal system for the project,” said Neil Malhotra, Vice President, Claridge Homes who will build the 70 Gloucester development.
The other will be $3.9 million for a passive housing Centretown Citizens Ottawa Corporation project on Arlington Avenue. It will feature 16 rental housing units with rents well below 30% of median household income in the area.
“Through the National Housing Strategy, more middle class Canadians – and those working hard to join it – will find safe, accessible and affordable homes where their families can thrive and have the stability and opportunities they need to succeed. Our Government is committed to increasing the supply of rental units for Canadians through projects like the ones we are announcing today,” added Jean-Yves Duclos, the Minister responsible for Canada Mortgage and Housing Corporation.
by Steve Randall Ι 24 Sep 2018
When I first started working with Commercial Mortgages about 10 years ago, I had a hard time wrapping my head around what went into putting one of these deals together. Each deal is truly unique and I soon found can have many moving parts. In order to get a better understanding of what I was doing, I needed to put in place a process, or standardized approach that I could follow on all my deals. After a while, I found what works for me and wanted to share this approach. I found that there are several key factors that contribute to a typical deal and how addressing these factors can help you to “See the Deal”.
Since most, if not all commercial mortgages are paper-based and there really isn’t a web-based system like filogix that you can use to enter information into in order to produce a clear picture, the story or summary that is prepared for a commercial deal is very important. This summary gives me a good overview and allows me to “See the Deal” so that when I’m speaking to a prospective lender, colleague or drafting a quick email, I can highlight the critical points fairly quickly and concisely.
One way to “See the Deal” is to use the 3-legged stool or a 3-point triangle like the one at the beginning of this article. Basically, the main points or factors that I work with and focus on in my approach are:
1) The Covenant
2) The Income
3) The Real Estate
The idea is to analyze each point and gather the necessary details for each in order to determine whether that point is weak or strong. What documentation do you need to assess each point? Also, what or where are the risks associated with each point and if necessary how can these risks be mitigated? How can you best sum up each point?
When looking at the ‘Covenant’, consider this;
- What is the Borrower’s net worth? With commercial mortgage financing, the Borrower’s income is not that important since we don’t rely on their income to pay the mortgage – the property’s rent does. The Borrower’s net worth is more important.
- Is the Borrower’s net worth all comprised of real estate or is it well diversified? How much in liquid assets do they have?
- If they needed to inject funds into the property for emergency repairs (ie. Roof or HVAC system needs a replacement immediately) or they need to cover the mortgage payment from their own resources due to unexpected or chronic vacancy, would they have the funds available?
- How’s their personal credit? Are their taxes current? Do they have any other sources of income?
When looking at the ‘Income’, we typically consider what determines and what can affect the property’s rent and this can include;
- Cash flow. What does this look like? How much rent does the property generate? What is the likelihood that it will continue?
- Net Operating Income (NOI), which is Income minus Expenses. The NOI is important since we use the NOI to calculate the two critical ratios used in commercial lending – the Loan To Value (LTV) and the Debt Coverage Ratio (DCR)
- What are the leases like? Short term, long term? Do the tenants pay for any expenses such as taxes, utilities, insurance or maintenance? Ie. Are the leases Gross, Semi-Gross or Triple Net?
- Do all the leases come due at the same time, in the same year or are they staggered over several years (this is known as Rollover Risk)?
- Are the rents below, at or above market rents? How do they compare to similar properties? Are there yearly increases (step-ups)?
- What type of tenants are they? Weak or strong? For example, Tim Horton’s is a great tenant; stand-alone restaurants, not so great. What’s the history of the tenancy?
- What is the vacancy like and how has it been historically?
- Does the client have a properly prepared Rent Roll?
Finally, when looking at the ‘Real Estate’ (which IS the lender’s main security) some of the points to consider are:
- What type of property is it? Conventional, unconventional or special use? Can it be easily converted for other uses?
- Where is it located? Is it urban or rural? Is it located in an area with other similar properties? Or does it stand out?
- What is the property worth? How does the value compare to similar properties? Do we have an appraisal?
- What is the property’s condition? Are there any major repairs or upgrades that are needed in the short or medium term?
- How old is the property? Is the property too old to repair? Do we have a Building Condition Report (BCA)? Will we need one?
- Are there any sources of environmental impact on or near the property? What is located across, next to or upgrade to the property? Do we have an Environmental Site Assessment (ESA)? Will we need one?
I’ve ended each section with Etc because by no means did I include all of the possible things to consider or questions to ask.
By being able to “See the Deal” a commercial broker will be able to discuss the file clearly. Discuss the strengths and weaknesses. Discuss the risk factors and what can be done to mitigate those factors. This will also help in gathering the necessary documentation and identify what will be required in order to proceed, quickly and efficiently.
The benefits to developing an approach similar to this are many. This allows for a more streamlined and standardized process which will also make a broker’s life easier when putting the deal together and making the process as painless as possible for the client.
It also instills confidence in the lenders you will be marketing the deal to since it shows some thought and insight into your underwriting. Also, one factor I know is critical with most lenders, is to have some conviction and to believe in the deal; when submitting a file for review I find that really standing behind the deal, “…I recommend the deal based on…..” and list your thoughts goes along way versus saying, “….I have a deal….what do you think……?”. “Seeing the Deal”, makes it easier to stand behind the deal and express why. This will only strengthen your relationship with your lenders.
In the end, this will result in a quicker turn around and the ability to get a better deal for your client.
Ermanno Tasciotti | January 2018
“It Depends”. These are the two words I frequently use when discussing a commercial mortgage. Whether it’s how much of a downpayment is needed, what the rate is, amortization, etc. It depends.
Let’s consider the first one; downpayment. How much does a client need to put down for a commercial property purchase? When determining this amount, the process isn’t as simple as it is for a residential deal but in some ways is very similar.
Please note that the following discussion pertains to when underwriting a deal based on the property’s cash flow and when dealing with a lender that will look to the rental income as the primary source of repayment.
With residential, the clients can get a preapproved mortgage by calculating how much they qualify for using their income and existing debts. They can then make a Purchase based on their Pre-Approved Mortgage plus their Downpayment.
Preapproved Mortgage + Downpayment = Purchase Price
With commercial, you really can’t get a preapproval since the mortgage is generally based on the income of the property and not the borrower – having said that, I can take the income and expenses on a commercial property and approximate how much of a mortgage it can carry, while not a preapproval, it can give you some guidance – contact me for details!
So you start with a Purchase Price and then work backward similar to a residential preapproval and end up with the Qualifying Mortgage amount and subsequent Downpayment. The process looks like this,
Purchase Price – Qualifying Mortgage = Downpayment
The best way to illustrate this is with a couple of examples. To make things simple I will be looking at conventional and not high ratio financing.
Please note the following terms:
- Net Operating Income or NOI
- Debt Coverage Ratio or DCR, DSC or DSCR
- Loan To Value or LTV
- NOI. This is the net income once all expenses pertaining to the property are deducted from the rent collected. Typical expenses can include, property taxes, property insurance, utilities, snow removal, routine maintenance, etc. There will also be allowances made for Vacancy & Bad Debt, Structural Expense and Management. Every deal is different and it depends on the specifics of a particular deal which expenses will be included. Note that these expenses do not include mortgage principal and interest.
- DCR. This is the ratio of the NOI to the mortgage principal & interest payments. Depending on the deal, an acceptable DCR would be as low as 1.10 (or 110%) to 1.30 (or 130%). This should always be greater than 1.00 or 100%. The ‘extra’ or excess over 100% is a cushion that gives the lender comfort to account for any interruptions in rent due to high or chronic vacancy, unexpected costs, etc that could reduce the income for a period of time.
- LTV. The ratio of the loan or mortgage amount to the lesser of Purchase Price or Appraised Value. ‘Rule of Thumb’ LTVs can range from 60% to 70% for most commercial deals and 75% for multi-family (m/f) properties. (Note this 75% for the example below). Each lender is different.
Clients are looking at purchasing a single-family dwelling. They are preapproved for a $562,500 mortgage (GDS/TDS are in line) and have $187,500 for the downpayment. Using the formula above,
$562,500 + $187,500 = $750,000
Pre-Approved Mortgage + Downpayment = Purchase Price
They can purchase a home valued at $750,000. This works out to an LTV of 75% ($562,500/$750,000). Assuming that the credit is good and the property is acceptable – the deal could be fairly straightforward.
Now let’s look at a commercial property selling for the same amount of $750,000 and again, the client has $187,500 to put down.
We’ll assume the subject is an 8-plex m/f. The subject is fully occupied with a rental income of $7,200/mo or $86,400/yr. Applicable expenses come to roughly $46,400/yr.
The NOI in this case is $86,400 – $46,400 = $40,000.
I’ll assume that the property is appraised at $750,000. As you will see below, the property value won’t be a factor in determining the mortgage amount. The driver will be the DCR.
Now here’s where they differ. In order to get an acceptable mortgage amount, we will use a trial rate (let’s go with 3.5%) and generate a P&I payment based on a 5 yr term & 25 yr amortization. Working backwards we make sure to stay within an LTV of 75% and a DCR of 130% (In this case – some lenders may go with 120%).
Trial and error yields a mortgage of $515,000, a DCR of 130% and an LTV of 68.7%. Using the formula above,
$750,000 – $515,000 = $235,000
Purchase Price – Qualifying Mortgage = Downpayment
So if they are buying the subject for $750,000 and the property qualifies for and can only support a mortgage of $515,000, the client will have to come up with a downpayment of $235,000 or $47,500 more than they have. As you can see, you just can’t take the purchase price and calculate an amount based on either 60, 65 or even 75% LTV. Furthermore, if the same property sold for $800,000, the mortgage amount is the same since the NOI doesn’t change and the client would now have to put $285,000 down (64.4% LTV).
In this case the client now has three options if they wish to proceed:
1) Come up with the difference from their own resources.
2) Secure a second mortgage. This will likely be at a higher rate & fees and note that the lender providing the first may have to approve allowing the second due to serviceability.
3) Look at an alternative lender (private, etc) that will do the full amount requested ($562,500) or even higher but at a higher rate & fees.
In summary, when calculating downpayment for commercial, treat it like a residential preapproval and work backwards.
- The ‘client’ would be the property and the ‘client’s income’ would be the NOI.
- The DCR would be the qualifying ratio much like the GDS/TDS.
- Once you have a ‘Qualifying Mortgage’ (ie. Pre-Approved Mortgage), then you look at the purchase price/appraised value for the difference.
Now I must stress that the numbers alone DO NOT determine whether or not you have a deal; they’re just a guide or an estimate to get the analysis going. As per the Mortgage Triangle I will discuss in a future post, the Income is one point that must be fully analyzed; there’s also the Real Estate and the Covenant.
I hope this helps give a clearer picture as to how the downpayment needed for a commercial mortgage is determined. As you can see, it depends.
If you have any questions or comments, please feel free to call me at 647.302.8065.
Now is the time to think commercial!
By: Ermanno Tasciotti | January 2018
New regulations, rising interest rates will mute spring sales
Immigration, high-tech jobs to keep floor under market
It’s a tale of two housing markets in the Toronto area as Canada’s biggest city gears up for the crucial spring selling season: sales of big detached homes are slow, while condo deals are booming.
On one side are people like Karen Berends, who put her C$1.5 million ($1.2 million) house back on the market in nearby Oakville this month after two failed attempts to sell in the past year. She reduced her asking price by about C$51,000, but still there are no takers, and she’s kicking herself for not cashing out last spring when the market was in a frenzy.
“We could’ve walked away with a really good amount of money in our bank account if we had taken the money last year, but our head wasn’t in it at that point,” Berends said in a phone interview. “It’s been a complete 360 this time around — it’s absolutely dead.”
Then there’s Beth O’Donoghue, a sales representative at Brad J. Lamb Realty Inc., who says the market is as hot as it’s ever been. Her clients recently lost out in three separate condo bidding wars in a week, including one with 11 offers. That’s convinced O’Donoghue, who’s invested in four new condos herself in the city in the past four years, to hold onto her assets for now.
One she bought in pre-construction for C$420,000 and figures she could sell for close to C$700,000. “If you would have told me three years ago when I bought this place that I would’ve made this much money on it already, I would have said you’re crazy,” she said.
After a decade as one of the world’s hottest housing markets, Toronto is moving in two directions. Transactions have certainly cooled since May as the government introduced new rules to tame runaway prices. But the impact has been largely on big, expensive detached homes, with sales plunging 41 percent in February from a year earlier, and prices dropping 12 percent since hitting a record last year. Condo prices, in contrast, soared about 20 percent since last February.
Toronto Market Heat Moves to Condos
The deviation is largely as a result of mortgage regulations that went into effect on Jan. 1 as well as rising interest rates. The rule requires that even people with a 20 percent down payment, who don’t require mortgage insurance, prove they can make payments at least 2 percentage points above the rates under which they go into contract.
That’s pushing buyers out of the detached segment and right into the condo market.
“I’ve been looking at the condo market for years and I’ve been waiting for it to correct and it’s just not happening,” Patrick Rocca, a real estate agent at Bosley Real Estate Ltd., said by phone. “Honestly, this scares me. When you have condos selling at C$1,000 to C$1,200 per square foot for resale, that’s mind-boggling.”
Real estate agents and economists expect some stabilization in the detached market as the spring selling season swings into full gear, but the price spikes of last year are probably history. The condo market is likely to keep chugging, bolstered by millennials in high-paying technology and financial jobs, strong immigration and pinched supply, according to Bank of Montreal economists.
“Spring will probably take a little more time to get going than years past, but there’s so much demand in the marketplace as Toronto continues to attract people around the country and the globe,” said Christopher Alexander, regional director at real estate firm Re/Max Integra.
Meanwhile, things are getting tough for tenants too. The combination of stress tests, urbanization and high home prices is creating the perfect formula for skyrocketing rents, said Simeon Papailias, co-founder of the Real Estate Center, a Toronto-based real estate management company. Many homebuyers who no longer qualify for a mortgage are turning to renting instead, which in turn attracts investors who want to become landlords.
“This market is creating new monsters — it’s taking a life of its own and it’s creating a new marketplace,” Papailias said by phone.
Berends, the Oakville homeowner, has placed ads in several Chinese media outlets in hopes of attracting foreign shoppers. “Apparently there are still buyers in mainland China, but they’re not really jumping,” she said.
She’s hoping to retire to a home she’s building north of the city in a few years, but she’s waiting for the right price for her existing house.
“I’m thinking we might have to take it off and wait till next year,” she said. “It’s just so difficult to know.”
By: Nathalie Wong
— With assistance by Erik Hertzberg
29 March 2018
Commercial Real Estate Loan (CRE) is income-producing real estate that is used solely for business purposes, such as retail centers, office complexes, hotels, and apartments. Financing – including the acquisition, development, and construction of these properties – is typically accomplished through commercial real estate loans: mortgage loans secured by liens on commercial, rather than residential, property.
Just as with residential loans, banks and independent lenders are actively involved in making loans on the commercial real estate. Also, insurance companies, pension funds, private investors and other capital sources, make loans for the commercial real estate.
Let’s take a look at commercial real estate loans: how they differ from residential loans, their characteristics and what lenders look for.
Individuals vs. Entities
While residential mortgages are typically made to individual borrowers, commercial real estate loans are often made to business entities (e.g., corporations, developers, partnerships, funds, and trusts). These entities are often formed for the specific purpose of owning commercial real estate.
An entity may not have a financial track record or any credit history, in which case the lender may require the principals or owners of the entity to guarantee the loan. This provides the lender with an individual (or group of individuals) with a credit history and/or financial track record – and from whom they can recover in the event of loan default. If this type of guaranty is not required by the lender, and the property is the only means of recovery in the event of loan default, the loan is called a non-recourse loan, meaning that the lender has no recourse against anyone or anything other than the property.
Loan Repayment Schedules
A residential mortgage is a type of amortized loan in which the debt is repaid in regular installments over a period of time. The most popular residential mortgage product is the 30-year fixed-rate mortgage.
Residential buyers have other options, as well, including 25-year and 15-year mortgages. Longer amortization periods typically involve smaller monthly payments and higher total interest costs over the life of the loan, while shorter amortization periods generally entail larger monthly payments and lower total interest costs. Residential loans are amortized over the life of the loan so that the loan is fully repaid at the end of the loan term. A borrower with a $200,000 30-year fixed-rate mortgage at 5%, for example, would make 360 monthly payments of $1,073.64, after which the loan would be fully repaid.
Unlike residential loans, the terms of commercial loans typically range from five years (or less) to 20 years, and the amortization period is often longer than the term of the loan. A lender, for example, might make a commercial loan for a term of seven years with an amortization period of 30 years. In this situation, the investor would make payments for seven years of an amount based on the loan being paid off over 30 years, followed by one final “balloon” payment of the entire remaining balance on the loan. For example, an investor with a $1 million commercial loan at 7% would make monthly payments of $6,653.02 for seven years, followed by a final balloon payment of $918,127.64 that would pay off the loan in full.
The length of the loan term and the amortization period will affect the rate the lender charges. Depending on the investor’s credit strength, these terms may be negotiable. In general, the longer the loan repayment schedule, the higher the interest rate.
Another way that commercial and residential loans differ is in the loan-to-value ratio (LTV): a figure that measures the value of a loan against the value of the property. A lender calculates LTV by dividing the amount of the loan by the lesser of the property’s appraised value or purchase price. For example, the LTV for a $90,000 loan on a $100,000 property would be 90% ($90,000 ÷ $100,000 = 0.9, or 90%).
For both commercial and residential loans, borrowers with lower LTVs will qualify for more favorable financing rates than those with higher LTVs. The reason: They have more equity (or stake) in the property, which equals less risk in the eyes of the lender.
Commercial loan LTVs, in contrast, generally fall into the 65% to 80% range. While some loans may be made at higher LTVs, they are less common. The specific LTV often depends on the loan category. For example, a maximum LTV of 65% may be allowed for raw land, while an LTV of up to 80% might be acceptable for a multifamily construction. There are also private mortgages available for commercial lending.
Debt-Service Coverage Ratio
Commercial lenders also look at the debt-service coverage ratio (DSCR), which compares a property’s annual net operating income (NOI) to its annual mortgage debt service (including principal and interest), measuring the property’s ability to service its debt. It is calculated by dividing the NOI by the annual debt service. For example, a property with $140,000 in NOI and $100,000 in annual mortgage debt service would have a DSCR of 1.40 ($140,000 ÷ $100,000 = 1.4). The ratio helps lenders determine the maximum loan size based on the cash flow generated by the property.
A DSCR of less than 1 indicates a negative cash flow. For example, a DSCR of .92 means that there is only enough NOI to cover 92% of annual debt service. In general, commercial lenders look for DSCRs of at least 1.25 to ensure adequate cash flow. A lower DSCR may be acceptable for loans with shorter amortization periods and/or properties with stable cash flows. Higher ratios may be required for properties with volatile cash flows – for example, hotels, which lack the long-term (and therefore, more predictable) tenant leases commonly to other types of the commercial real estate.
Interest Rates and Fees
Interest rates on commercial loans are generally higher than on residential loans. Also, commercial real estate loans usually involve fees that add to the overall cost of the loan, including appraisal, environmental report, legal, loan application, loan origination and/or survey fees. Some costs must be paid up front before the loan is approved (or rejected), while others apply annually. For example, a loan may have a one-time loan origination fee of 1%, due at the time of closing, and an annual fee of one-quarter of one percent (0.25%) until the loan is fully paid. A $1 million loan, for example, might require a 1% loan origination fee equal to $10,000 to be paid up front, with a 0.25% fee of $2,500 paid annually (in addition to interest).
A commercial real estate loan may have restrictions on prepayment, designed to preserve the lender’s anticipated yield on a loan. If the investors settle a debt before the loan’s maturity date, they will likely have to pay prepayment penalties. There are four primary types of “exit” penalties for paying off a loan early:
- Prepayment Penalty. This is the most basic prepayment penalty, calculated by multiplying the current outstanding balance by a specified prepayment penalty.
- Interest Guarantee. The lender is entitled to a specified amount of interest, even if the loan is paid off early. For example, a loan may have a 10% interest rate guaranteed for 60 months, with a 5% exit fee after that.
- Lockout. The borrower cannot pay off the loan before a specified period, such as a 5-year lockout.
- Defeasance. A substitution of collateral. Instead of paying cash to the lender, the borrower exchanges new collateral (usually Treasury securities) for the original loan collateral. High penalties can be attached to this method of paying off a loan.
Prepayment terms are identified in the loan documents and can be negotiated along with other loan terms in commercial real estate loans. Options should be understood ahead of time and evaluated before paying off a loan early.
The Bottom Line
With commercial real estate, it is usually an investor (often a business entity) that purchases the property, leases out space and collects rent from the businesses that operate within the property: The investment is intended to be an income-producing property.
When evaluating commercial real estate loans, lenders consider the loan’s collateral; the creditworthiness of the entity (or principals/owners), including three to five years of financial statements and income tax returns; and financial ratios, such as the loan-to-value ratio and the debt-service coverage ratio.
By: Daniela Peeva | June 26, 2017
For the last 15 years, M. Durand has built and led a firm that has become the largest, most active pan-Canadian firm dedicated to the Commercial Mortgage Brokerage Industry. M Durand’s efforts have been recognized by his industry peers’ who have nominated him in each of the last 4 years as the best commercial mortgage broker in Canada. No other professional in the industry has seen such recognition.