Lenders set to curtail office exposure in 2024

Lenders set to curtail office exposure in 2024

Confidence remains high in real estate market fundamentals
Monday, December 4, 2023
By Barbara Carss

Lenders generally expect to curtail office exposure while increasing overall allocations to Canadian real estate next year. Newly released findings from CBRE Canada’s annual survey reveal that prospective borrowers should see a 16 per cent influx of net new capital into the market in 2024.

Among the 34 survey respondents — which collectively hold more than $200 billion in real estate loans — 33 per cent are looking to expand the quotient of real estate loans within their portfolios and 61 per cent plan to maintain the existing share. That follows a year when 37 per cent of lenders did not fully hit their real estate targets and two-thirds report they tightened their underwriting methodologies.

“The conditions of real estate have been building up for some time and will likely continue,” Carmin Di Fiore, executive vice president, debt and structured finance, at CBRE Canada, observed during an online presentation last week. “As we saw last year, the continued isolation and cost of capital, valuation uncertainty and tightening credit impinged on the industry’s performance.”

That’s reflected in survey respondents’ top economic concerns, as they unanimously tap “elevated interest rates” as a major challenge for the coming year. As well, 73 per cent cite uncertainty around property valuations and 58 per cent identify restrictions on capital as pressing issues.

This fall finds them less focused on the spectre of a recession than in 2022 when all survey respondents predicted a recession was coming and 69 per cent foresaw a moderate to significant impact on their real estate loan portfolios. Now, fewer than 40 per cent rank fear of recession as a major influence on underwriting. Lenders also seem largely confident in real estate market fundamentals, with only 30 per cent flagging them as a concern.

Looking to the future, 42 per cent of surveyed lenders confirm they will actively bid on real estate deals, 48 per cent plan to take a cautious or conservative approach and 9 per cent expect to refrain from bidding in 2024. Toronto, Vancouver, Montreal and Ottawa are considered the most attractive markets.

Across all asset types, the majority of surveyed lenders are willing to offer recourse loans in the range of 61 to 75 per cent loan-to-value (LTV) for top-tier assets and non-recourse loans at 51 to 65 per cent LTV. A 25-basis-point (bps) premium typically applies on Class B assets and assets located in secondary markets.

Purpose-built rental housing and industrial again emerge as favoured asset types, with half to three quarters of lenders aiming to increase budgets for those categories. On the flipside, two-thirds plan to trim budgets for office. It also stands out among the 13 categories in registering a complete absence of lenders willing to increase their office loan books.

“In reviewing the history of our surveys, this is the first time we have recorded that level of sentiment for any segment of real estate,” Di Fiore reported. “Opinions have significantly reversed since 2021 when 70 per cent of lenders were content with their office exposure.”

Dropping confidence in Class A office inventory

Survey respondents again ranked suburban and downtown Class B office as the two most problematic property types in a list of 18 categories, while exhibiting an even greater year-over-year drop in confidence for Class A office inventory. Downtown Class A office rose to 5th on lenders’ index of concern (up from 7th in 2022) and suburban Class A office remained in fourth. Negative sentiment intensified over the course of 2023, whereas regional malls in secondary markets (ranked the third most problematic) improved in lenders’ perceptions.

As borrowers seek renewals or refinancing, 94 per cent of surveyed lenders are factoring elevated or significantly elevated credit risk for office assets. Notably, 45 per cent of respondents attach “significantly elevated” credit risk to office. Only two other asset types even trigger that level of caution, with 17 per cent of surveyed lenders perceiving significantly elevated risk for development land and 6 per cent for hotels. Meanwhile, upwards of 80 per cent of lenders foresee low-to-normal credit risk for renewals and refinancing of industrial and purpose-built rental assets.

Lenders’ tentativeness is linked to ongoing uncertainty about evolving workplace models and long-term demand for office. A slowdown in office transactions has also made it more difficult to corroborate values. However, Di Fiore maintains prospective deal-makers shouldn’t fear a liquidity crunch in Canada.

“That phenomenon may play out in U.S. markets where loose banking oversight now forces bank regulators to catch up and play hardball,” he noted.

Lenders in Canada are turning to a range options for maturing office loans. The majority of survey respondents indicate that they are “occasionally” or “frequently” requiring equity paydowns as a condition of renewal, while 48 per cent record frequent or occasional switchovers from interest-only to amortized loans. Just 15 per cent report they frequently convey long-term renewals (52 per cent do so occasionally), while 17 per cent say they frequently request loan repayment. However, 86 per cent confirm they are open to short-term loans extensions if necessary.

“The Canadian market is relationship-oriented and it generally works to everyone’s advantage,” Di Fiore said. “While tough discussions may be taking place at the time of renewal, at least there are rational and pragmatic solutions being offered.”

Adding context to the survey findings, Peter Senst, president, Canadian capital markets, with CBRE’s national investment team, characterized current market dynamics as among the more difficult, but the not the worst of the past 35 years. He underscored Canada’s stronger performance relative to many other global markets and the prospects tied to projected population, GDP and employment growth.

“The ‘90s were much tougher to get through,” Senst asserted. Nevertheless, this downturn comes with some new trappings.

“For a few in the industry, mid-teen vacancy rates in office have been witnessed before. Trust me, they do improve…eventually,” Di Fiore recounted. “However, what no one has really witnessed before is the value of an office asset where some tenants require five days attendance, while other tenants effectively function on two, three or four days. Layer on retail and amenities that need to support such schedules, and equity has yet to figure it out. At some point, discounts to replacement costs will start to factor in the consideration and drive office transactions.”

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