What does that feel like?
The combination of declining asset values and increasing debt service requirements can create a funding shortfall. With a funding shortfall comes new challenges. For example, commercial mortgage borrowers will need to find ways to make up the shortfall. This may mean putting more equity into the property, raising additional financing from non-traditional sources, or selling the property. In some cases, this dichotomy could lead some property owners and commercial mortgage borrowers to default on their debt, which is a situation you want to avoid.
Indeed, interest rates are expected to fall in 2024. Still, the expected rate declines may not be enough to eliminate the risk of capital shortfalls for commercial property owners and borrowers. Meanwhile, the broader business environment is becoming increasingly complex.
High uncertainty in the real estate market is causing lenders to become more selective. This is resulting in different or evolving lending requirements for different real estate asset classes. While multifamily, industrial and retail, primarily grocery stores, lending has remained relatively stable, office and development land is increasingly considered riskier.
All of this is happening within a broader regulatory environment that is changing. Many Canadian financial institutions and lenders are being impacted by interim guidance issued by the Office of the Superintendent of Financial Institutions (OSFI) on areas of focus and expectations specific to corporate real estate. OFSI guidance indicates that financial institutions should be prepared to demonstrate this specific diversification policy and concentration limits.
Going forward, even as interest rates eventually adjust, we expect to see a more conservative lending environment with an emphasis on prudent lending practices.
What do these changes mean for commercial real estate in Canada?
Managing debt in this environment is more complicated than it has been in years past. Commercial real estate firms and borrowers cannot take anything for granted. What may have felt like a “standard” loan renewal a year, two years, or even five years ago may now be a much more complicated process.
That said, taking a proactive approach to debt management can help, and EY recommends commercial real estate owners and borrowers take three key steps to get ahead of the situation:
1. Identify risks and opportunities across your portfolio. Conducting a thorough property appraisal and market valuation will provide you with an up-to-date view of your portfolio's current market value, which is essential for planning ahead for renewals and other financing discussions. Engaging a real estate professional or appraiser to provide an accurate valuation will allow you to more easily monitor liabilities across your portfolio.
This insight can also help you identify assets with high and low loan-to-value ratios (LTV) to understand different risk levels. You can then review your loan maturity dates and start planning for renewals and potential refinancing needs.
2. Evaluate the business holistically. Evaluating cash flow projections for each property and factoring in potential changes in interest rates can help you assess the portfolio's ability to generate enough cash to cover debt service obligations. Stress testing your portfolio allows you to evaluate potential scenarios and understand how adverse conditions could affect cash flows and debt service.
Evaluating the best use of individual properties opens up redevelopment and repositioning opportunities that could improve or enhance cash flow. Differentiating between core and non-core assets allows for divestitures to be considered, optimizing the overall portfolio and increasing liquidity.
Executing these actions in a planned manner generates valuable information that allows you to plan ahead and brainstorm potential solutions rather than after a failed loan renewal. This evaluation process is what turns a high-risk environment into your next big opportunity.
3. Seize the opportunity and develop a plan of action. Acting based on up-to-date information about your business, assets and portfolio will position you to act now, rather than reacting to external forces, factors and decisions later. With a deep understanding of where your portfolio is now and how it needs to evolve for the future, you can consider divesting non-core assets or developments to generate capital for debt repayment or strategic investments.
You can also proactively negotiate with your lenders and enter into active discussions to explore creative solutions. Consider loan modifications, extensions or alternative financing structures. Now is a good time to consider portfolio right-sizing by adjusting the size and mix of assets to align with market conditions and your investment goals, and to evaluate alternative uses and lending and financing solutions.
Addressing these factors now can allow you to consider creative divestiture strategies, such as sale-leaseback, to free up capital while retaining ownership.