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The market to the north: the Canadian commercial property market is going through its own lean times, with an overbuilt office sector and increasingly cautious lenders.

The Market to the North

For years, long before "globalization" became the buzz word of North American commerce and finance, Canadian real estate development companies behaved as if an international border didn't exist.

Their subsidiaries sprang up in major U.S. markets and financing was routine. Today, with a recessionary cycle lurking in the wings, financing is anything but routine.

Canadian developers are attracted to innovative financing devised in the United States, and Canadian financial institutions are more adventuresome in adapting those vehicles - and yet more cautious about whom they have a financing fling with.

Notably, several Canadian developers have reshaped much of the urban landscape in the United States. BCE Development, Bramalea, Cadillac Fairview, Campeau Corporation, Marathon Realty, Markborough Properties, Olympia & York and Trizec, are among those developers from the north who played key roles in the modernization of America's skylines.

Projects developed by these companies have been backed by Canadian and U.S. financial institutions, with investments totally in the billions of dollars.

As the scope of the projects and need for financing has expanded tremendously, European and Far Eastern investors have become involved particularly within the past five years. The $800 million yen-dominated first mortgage on the Merrill Lynch tower at Olympia & York's (O&Y) World Financial Center in Manhattan, arranged by Japan's Nomura Securities Company, Ltd., is just such a record-breaking example.

Financing vehicles developed in the 1980s have now evolved into a higher order of complexity. Interest rate swaps, forward rate agreements and securitization are among the more popular techniques used today.

While in today's overbuilt Canadian commercial real estate market, only borrowers who are among the financially fittest, as well as ingenious, have any realistic prospect of riding out the economic downturn and the rising inventory of empty office space.

Retreating from further U.S. development, Canadian developers are completing projects in the pipeline and selling off others. In addition, cautious lenders are spreading out larger safety nets.

a global view

Eyeing distant shores, Canadian developers are already hedging their bets on this continent with projects in Europe. For example, O&Y planned the four billion pound Canary Wharf in London and a 40-story tower in Moscow; Markborough Properties launched two office projects in London; other developers have descended on the Soviet Union and Budapest.

After serious analysis of the timing and market economy, major players are still commited to proceeding with high-quality real estate projects in Canada - but more cautiously.

In fact, Kenneth P. Leung, O&Y's senior vice president of finance and administration, is not the least bit apprehensive. In an interview at O&Y's head office in Toronto, Leung said financing for North American commercial real estate is abundant, with many alternative financing techniques available - no matter what the marketplace seems to be saying.

In 1985, O&Y started a trend with a $200 million Eurobond issue backed by a first mortgage and assignment of long-term leases on its Maiden Lane office tower in lower Manhattan. But, Leung said that the Eurobond market has cooled off and the Canadian bond market is presently active because of higher interest rates. When asked, "Where is the real estate lending action?" Leung commented on the differences between U.S. and Canadian international market strategies.

"Canadian financial institutions are more active in the United States than in Europe, [whereas] U.S. banks are doing more real estate financing syndications in Europe and the Far East than they are in Canada," Leung said.

Inventive techniques

Closer to home, lenders are trying different techniques to come up with an approach that works. Commercial mortgage securitization as a real estate financing technique is still feasible, but only for top quality projects. In 1986, O&Y made news with the largest-ever commercial mortgage transaction. It consisted of a first mortgage of $970 million on three, Manhattan office buildings, which were then securitized as floating-rate notes privately placed with more than 40 institutions.

Pension funds in Canada also are investing more actively in real estate. In fact, if the Ontario Municipal Employees Retirement System (OMERS) is any barometer, pension fund investors will be taking more of a direct role in commercial development. OMERS, ranked fourth among the top 10 Canadian pension funds in 1989 with $12.4 billion in assets, recently created a real estate development subsidiary to manage its real estate investments.

Other popular financing vehicles are interest rate and currency swaps. Leung says they are so popular, they are taking on the characteristics of a commodity. Bramalea Limited's interest rate swaps, for example, were partly responsible for the company's extraordinary earnings in 1989. Bramalea, controlled by Trizec Corporation Ltd., is the largest publicly held real estate company in North America. Last year, it earned nearly $65 million on sales of $1.1 billion. Given the paralysis that has crept over the real estate industry recently, Bramelea's earnings were a virtuoso financial performance.

The company was bolstered by swaps that held interest rates down as low as 6.75 percent on more than $1 billion of Bramalea's short-term debt. Nearly all of another $3 billion in short-term debt was sheltered by forward rate agreements (FRA).

Hedging interest rates has become more alluring to corporate Canada. In 1989, $200 billion in debt was hedged through swaps and another $100 billion through FRAs. The growing appeal of hedging with swaps has also become more worrisome for the Bank of Canada, as it keeps pushing up interest rates to contain inflation.

Swaps are an ingenious idea whose time arrived in the mid-1980s. O&Y embraced this new concept enthusiastically and inventively. The company pioneered a "step-up" swap, for example, in which the loan principal is drawn down every month during a typical three-year construction period and the swap payments step-up or increase every month. O&Y President Albert Reichman also sits on the Bramalea board of directors and probably had some influence on Bramalea's foray into the swap money market.

Donald Weiss, vice president of finance of Development Concepts, a Toronto real estate consulting firm, believes swaps are destined to become even more attractive among major league real estate developers in Canada. He also commented on the accessibility of commercial financing in Canada, saying that lenders are actively trying to attract developers' business these days by offering lower cost financing.

"There's a fair amount of money available to finance projects, but it's too expensive, especially in a market that's becoming overbuilt," he said. "Deals aren't closing and some institutions, particularly trust companies, are beginning to back off on their rates to try to return to a healthier environment," Weiss added.

But it's going to be a slow comeback. Real estate continues to attract investment and although that sustains its value, it doesn't help fill empty office space.

Caution abounds

While trust companies and foreign investors keep putting money into Canadian real estate, banks are far more wary.

John D. Bottomley, vice president, corporate real estate, Citibank Canada, commented on the cautious approach taken by many banks and thrifts at an Urban Development Institute national conference in Montreal recently.

"The sheer size of the increase in many banks, non-performing real estate portfolios, loan loss provisions and the impact on their earnings, stock prices and debt ratings make for a significantly less aggressive marketplace," he said.

Bank regulators are getting tough with chartered Canadian banks, Bottomley added, because they maintain that basic principles of real estate underwriting standards, "have been ignored or compromised to increase loan volume and fees."

Regulators are also concerned about lack of appraisal policies and proper documentation, and "the inability or the reluctance of lenders to properly identify and categorize risk, such as continuing to accrue interest on loans, despite substantial deterioration in the condition and marketability of the project," said Bottomley.

So, what types of deals are Canadian banks doing? "Smart banks, like smart developers, know that overreaction [by some] can create significant opportunity [for others]. In their rush to get out of problem situations or meet the requirement of regulators, some banks and developers are going to force the liquidation of assets at near `fire sale' prices, and significantly damage long-standing relationships. The purchase of these assets will present terrific financing opportunities for the developers and banks with the staying power," Bottomley said.

But for now, most banks that were heavy players in real estate during the past five years are concentrating on shoring up weaker credits with additional equity or collateral. Marketing for new business is selective. Bottomley added that overall, there is "a return to the fundamentals."

"Attitudes toward financial strategies and projections have changed drastically. If the economic and project assumptions are not realistic, it's a non-starter. Current cash flows, not future projections, are being used to calculate the amount of debt a project or company can successfully carry, said Bottomley.

"Today, banks are insisting on at least 10 percent hard equity [not land at market value] and it could increase to as much as 25 percent, depending on the size of the long-term refinancing gap. There is much less reliance on corporate sponsorship and more emphasis on project economics. Sub-debt players have all but disappeared, Bottomley said.

"Non-recourse financing is just not available, and limited recourse deals are coming back to haunt the lenders stuck with them.

"Large interest reserves are only available if there is significant up-front equity. Interest rate hedging is mandatory on all new deals, at least for the short term. Land loans are becoming increasingly unpopular, particularly in markets where lack of recent sales make determination of value at best an educated guess."

Bottomley said banks tend to syndicate loans of more than $35 million, to limit their risk, regardless of how strong the developer might be. Developers are, therefore, dealing more with syndicates and co-agents instead of a single bank. These complex relationships raise new issues.

Such issues include preparing for the "broader distribution of financial information, future funding risks if a syndicate member decides not to fund half way through a construction loan, increased cost if a syndicate member is reserved, and the requirement for pre-marketing the financing to potential participants before the agent or co-agents are ready to commit."

Lender-developer relationships

Kenneth A. Field, executive vice president of McLean McCarthy Limited and president of McLeanco Realty Services Limited in Toronto, described how his firm structured a participating mortgage on behalf of a developer client whose decision-making lagged too far behind rising interest rates.

The developer planned to build and lease a headquarters building for an insurance group in suburban Toronto last November. The estimated cost was $21.5 million. Long-term financing was projected at 11 percent; the developer decided he would borrow $16 million and put down $5 million to $6 million in equity.

When the developer came to see their firm in January, Field says, rates were up to about 12 per cent, "which meant he had to come up with another $2 million in equity, and was looking for an alternative."

Field's firm advised the developer to build and pre-sell to an investor, with a cap rate of 8 1/2 to 9 percent. "His other assets were in good shape...interest rates were going up and land prices coming down."

By the time the client agreed to take that route, the rate was up to 13 percent, cap rates had moved and "what we thought we could get for the building dropped to below $21 million."

Field's firm, which is part of the Deutsche Bank group, started over again with a new deal. The new financing arrangement looked like this: * A $10,750,000 convertible participating

mortgage, with a coupon of 8.75

percent, based on a 35-year amortization

rate, with a 10-year term. * If the debt service is taken off, the

developer will have a preferred rate

of return of 6 percent and the balance

will be split 50/50. The

year-one rate of return for the investor

would be about 10.2 percent,

about 7 percent for the developer. * The developer's going-in cash flow

in year one is about $700,000, which

he can finance. He ends up with 50

percent, although it's a long wait

until about the 11th year, when the

return starts to look good. * The lender or investor has a one-time

opportunity to convert the

$10,750,000 into an undivided interest

in the property, during the tenth

year. The internal rate of return, assuming

a 4 percent increase in

rental rates, is about 13.2 percent.

"Compared to mortgage rates of 13 percent and Government of Canada 10-year bonds at 11.60 percent, it's a deal that works for the investor. I'm not sure it works that well for the developer, but at least he gets off without taking any losses," explained Field. Developers in the Canadian market must be flexible in their dealings with lenders to thrive in the current tight market. Bottomley noted, "Don't expect a banker to make all the concessions. He will be looking for additional security, guarantees and, perhaps equity, before advancing fresh money to partly offset debt service or additional project costs. He wants your project to succeed, but his strategy now is to get his money back before the developers' financial position further deteriorates and the project he is financing declines further in value."

"There is a large group of middletier developers who don't want to pay the fees for [interest rate hedging] products and who view interest-rate risk, as just another project risk such as leasing or zoning.

"In our portfolio, these are the companies that are seeing those hard-earned project profits and equity being eroded by 16 percent interest rates, when their budgets call for 11 percent as most likely, and 12 1/2 percent, [under a] worst case [scenario. This is] particularly [the case] when project costs in many cities break down as one-third land, one-third `hard' costs and one-third `soft' costs, of which a large part is interest expense," emphasized Bottomley.

Canadian banks are marketing real estate consulting services to Canadian corporations that own significant, but under-utilized, real estate assets. They are placing long-term real estate debt and equity instruments with third party investors, in Canada and abroad, instead of carrying it on the bank's balance sheet. In addition, banks are pursuing real estate brokerage activities through affiliated companies, to access listings of properties for sale or acting as a developer principal or investor principal in major real estate deals.

Lenders involved in brokering commercial developments must rely heavily on the accurate assessment or the projects' creditworthiness to maintain successful business alliances. Banks are not the only institutions concerned with borrower creditworthiness, however. William F. Tremblay, president of Burns Fry Real Estate Services Inc., Toronto, said at a recent industry forum that credit rating agencies are becoming much more familiar with real estate development in Canada and are now rating projects.

This is making it possible for smaller and medium-sized institutional investors to participate in real estate transactions because they depend on the rating to judge a borrower's financing creditworthiness, or the creditworthiness of issue itself.

This also facilitates an entry into the bond market and results in lower interest rates, he said.

Moreover, investment dealers are becoming more willing to commit their own capital to real estate projects that carry an acceptable rating, Trembly said.

With this knowledge, developers and borrowers can go to such financial intermediaries and arrange to sell an entire issue to an investment dealer at an agreed upon interest rate. The dealer is able to resell those loans to institutional investor clients. This way, the interest rate exposure is transferred from the developer or borrower to the investment dealer immediately.

Like the investment dealers, some Canadian life insurance companies such as Imperial Life and North American Life, have begun participating more directly in the brokering process says Orvin Zendel, president of Indevco Properties Inc., of Toronto and chairman of UDI/Ontario's commercial interest group.

Zendel agrees that funds are available for commercial projects. What isn't as forthcoming are loan approvals. "Lenders are concerned about the impact of office space over-supply and a host of new charges on development, including Toronto's commercial concentration tax, which imposes a $1 per square foot levy on properties of 200,000 square feet and more."

The silver lining in a cloudy Canadian real estate environment, he added, is major regional shopping centers, that appear able to weather any economic downturn.

For instance, Citibank Canada's Bottomley said banks are more closely evaluating management capabilities within their particular target segment of the real estate industry. Managing a hotel and managing the actual piece of real estate, he said are two separate businesses, for example. Today, managers of hotels prefer to sell hotels to real estate experts and leave the management to them.

Also, "Marketing strategies are being seriously questioned because in the short-to-medium term, no one really has got a good sense of what's ahead in terms of demand, commented Bottomley.

The Canadian market is roughly 10 percent of the U.S. market. Faced with commercial development saturation and the vagaries of financing in the current environment, Canadian developers and the financial institutions that serve them may well head for opportunities in untapped nooks and crannies in the United States to await a resurgent market. Or they may head off into Europe (including east bloc countries and the Soviet Union) to join the ranks of North American companies tilling that difficult but promising soil.

Albert Warson is a Toronto-based writer/editor specializing in real estate development subjects.
COPYRIGHT 1990 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Warson, Albert
Publication:Mortgage Banking
Date:Jul 1, 1990
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