Debt & Structured Finance | Canada Research

Curve inversion draws CRE capital

Increasing evidence of a global economic slowdown in recent weeks has elevated the risk profile for Canada’s economy. Globally, Brexit negotiations are still gridlocked, the Eurozone economy falters and U.S.-China trade negotiations drag on. Domestically, household debt-to-income levels are the highest they have ever been, retail sales are slowing, oil sands producers are reevaluating projects due to pipeline delays and the likelihood for ratification of the CUSMA trade deal wanes as tariffs remain. These developments have sparked concern that a technical recession may emerge in Canada given weak expectation for Q1 2019 growth and a potential downward revision to Q4 2018’s already meager results.

Amid these growing headwinds, the Federal Reserve eliminated their expectations for an interest rate hike this year. The Fed acknowledged the need to avoid getting stuck in a deflationary environment like that which has plagued Japan for the last two decades. In turn, this dovish shift in tone triggered an inversion on another segment of the U.S. yield curve as investors sought the safety of bonds. Widely considered a reliable harbinger of a downturn within a few years, the spread between 10-year Treasury bond yields fell below its 3-month counterpart for the first time since just prior the Great Financial Crisis. The inversion also emerged in Canada and pulled down global bond yields. In fact, investors are even pricing in expectations for central banks to cut interest rates by the end of 2019 to keep the economy going. For the commercial real estate market, falling bond yields may translate to lower mortgage rates with wider cap rate spreads. The precipitous fall in bond yields has some lenders contemplating next steps.

Against this backdrop, commercial real estate has become an increasingly attractive investment vehicle. According to CBRE’s Global Investor Intentions Survey 2019, diversification is the primary driver for investors in the Americas showed the strongest interest for value-add property assets. However, the commercial real estate sector has attracted an abundance of capital over recent years and real estate funds are now challenged to deploy all that capital as the levels of dry power continue to rise. But even more capital is expected to come with the recent formation of several mega-sized real estate funds such as BCI and RBC’s CA $7 billion investment partnership, Brookfield’s recent closing of its US$15 billion BSREP III fund and Blackstone’s record-setting US$20 billion property fund on the horizon.

 

 

 

 

 

 

 

 

 

 

 

This disclaimer shall apply to CBRE Limited, Real Estate Brokerage, and to all other divisions of the Corporation; to include all employees and independent contractors (“CBRE”). All references to CBRE Limited herein shall be
deemed to include CBRE, Inc. The information set out herein, including, without limitation, any projections, images, opinions, assumptions and estimates obtained from third parties (the “Information”) has not been verified by
CBRE, and CBRE does not represent, warrant or guarantee the accuracy, correctness and completeness of the Information. CBRE does not accept or assume any responsibility or liability, direct or consequential, for the Information
or the recipient’s reliance upon the Information. The recipient of the Information should take such steps as the recipient may deem necessary to verify the Information prior to placing any reliance upon the Information. The
Information may change and any property described in the Information may be withdrawn from the market at any time without notice or obligation to the recipient from CBRE. CBRE and the CBRE logo are the service marks of
CBRE Limited and/or its affiliated or related companies in other countries. All other marks displayed on this document are the property of their respective owners.AllRights Reserved.

Image result for cbre

Commercial Mortgage Commentary – Customer Forward Thinking.

Making News

Economy

2018 started with confidence from the Bank of Canada’s (“BOC”) economic outlook for the year. However, the GDP growth forecast gradually declined as oil prices dropped and as tensions grew in international trade markets. As a result, we saw a reversal in the increasing trend of Government of Canada (“GOC”) bond yields at the end of 2018. 2019 begins with some uncertainty around the growth in the Canadian economy, the direction of GOC yields, and whether further increases in the overnight rate will occur in 2019..


.

GOC Yields

GOC bond yields ended generally flat in 2018 – the 3-year GOC
increased by 11 bps, 5-year increased by 1 bps, and the 10-year
GOC yield decreased by 9 bps.

.

Overnight Rate

There were three rate hikes in 2018 for the Bank of Canada (“BOC”) overnight target rate, which brought the rate to 1.75%, the
highest since Q4/08, but the Bank of Canada held the overnight
rate constant for their last two meetings.


Commercial Mortgage

Capital supply and competition for commercial mortgages remained strong throughout 2018 as spreads continued to absorb the increases in the GOC yields, holding commercial mortgage coupons relatively steady. During Q4/18, GOC bond yields fell in response to the deteriorating outlook from the BOC, reversing the upward trend in 2018. Corporate bond markets reacted as investors demanded higher spreads – roughly 50 bps higher for BBB-rated corporate bonds in Q4/18 alone.

Commercial mortgage spreads became a hot topic towards the end of Q4, as brokers and investors alike were looking for signs of change in the market. Commercial mortgage spreads eventually reacted with an increase in December by 10-15 bps, ending the 

year at 150-170 bps for top quality assets. The average 5-year conventional commercial mortgage coupon ended 2018 roughly flat at 3.60%. January 2019 has quickly seen another 15 bps increase in spreads, now in the range of 165-185 bps for top quality assets.

BBB-rated corporate bond investments tend to compete for the same capital as commercial mortgages, since BBB-rated corporate bonds provide a similar return on risk. As firms look to make portfolio investment decisions, the spread premium for commercial mortgages over BBB-rated corporate bonds can be an indication of where capital supply may shift or how commercial mortgage spreads may respond to changes in BBB-rated corporate spreads.

Recent increases in BBB-rated corporate bond spreads improved the relative attractiveness of this investment against commercial mortgages. The spread premium for commercial mortgages dropped from 85 to 25 bps year over year – significantly lower relative to the 67 bps long term average. Consequently, commercial mortgage funds may 

require higher spreads to compete for capital against their BBB-rated corporate bond counterparts.

Based on the low spread premium for commercial mortgages compared to the long-term average, a further widening in commercial mortgage spreads is possible.


Senior Unsecured Debt

In Q4/18, senior unsecured debt issuance reached $1 billion,up from $375 million in Q3/18. Total issuance for the year was driven largely by the nearly $2 billion raised by Choice Properties REIT in Q1/18. 

Overall spreads on BBB-rated senior unsecured debt rose sharply from 145 bps at the end of Q3/18 to 194 bps by the end of Q4/18. With the increase, spreads surpassed those of conventional commercial mortgages. With the current premium for unsecured debt, REITs and REOCs may consider more conventional mortgage financing.


CMHC

CMHC-insured mortgages offer an attractive return for lenders looking to earn additional yield, while maintaining an indirect

guarantee from the Government of Canada. As most insured mortgages are originated with the purpose of securitization into the National Housing Act (“NHA”) Mortgage-Backed Security program run by CMHC, lenders tend to quote spreads based on Canada Mortgage Bond (“CMB”) spreads. Given this, it is no surprise with the increases in CMB spreads seen in Q4/18, that CMHC-insured spreads also increased.

Through Q4/18, the 5-year and 10-year CMB spreads increased from 29 bps to 42 bps and from 38 bps to 55 bps, respectively. Spreads on CMHC-insured mortgages followed suit with a 10 – 15 bps increase to 90 – 115 bps over GOC on 5-year terms and 100 – 125 bps on 10-year terms.


Quarterly Lenders Sentiment Survey and
Annual Commercial Mortgage Survey

The CMLS Mortgage Analytics Group conducts market surveys to enhance market knowledge and transparency on areas such as size, segment analysis, and trends in the Canadian commercial mortgage market. Since inception in 2010, the surveys have grown to cover over 90% of the commercial mortgage market.

 

February 2019