What do you think the cap rate is? Executives from First National Financial, CMLS Financial, and Meridian convened a "Top 10" list for navigating challenges in today's debt market at SHURE GTA on November 15, 2023.

SHURE Toronto panel: Is real estate investment sales activity in ‘hibernation?’ A Top 10 List (Part 1: #10, #9, #8)

December 3, 2023

SHURE Initiative


Post-pandemic micro and macro factors are having a significant impact on commercial real estate investment sales transactions. Unexpected inflation has persisted. Inflation rates have risen rapidly, and it continues to be challenging to deliver new housing product or buy and sell assets. Simultaneously, global factors such as the wars in Ukraine and the Middle East drive continued uncertainty and could cause rates to increase again.

Predicting the future is a challenging task. However, three leading debt sources convened at SHURE GTA on November 16 to offer a proactive and direct "Top 10 List" for navigating today's debt-raising for new development or investment. Participating in the session were Andrew Drexler, Assistant Vice President and Team Director of Commercial Financing, First National Financial LP; Sandy Harrington, VP - Managing Director - Team Leader London Office, CMLS Financial; and Jason Hingston, Director - Real Estate Development, Meridian.

Drexler, Harrington, and Hingston convened with The SHURE Initiative to devise ten statements about the market today and offer reaction in front of the live audience at SHURE GTA on Nov 16. Some of the statements are positive, while others are negative. The session was designed to offer a candid assessment of the market today.

Below is the summary of the Top 10 List and each contributor's thoughts and analysis.

#10: The capital stack does not reflect current times.

Drexler: It's a very different world from a financing perspective. You know, it is a lot more illiquid there than it used to be. If you're buying or developing assets right now, it is very challenging to get your financing. If you successfully get your funding, it's a much lower level of debt than you're used to. Mezzanine debt, can be lucrative, but it's is very difficult. People in the mezzanine debt world are struggling with some loans that could be going better and have various challenges. Equity should cost a lot more. So, it's a very different capital stack than it used to be—a lot less senior debt. Very challenging, the liquid debt on the mezzanine side and the land loan side and equity would also be dramatically different.

Hingston: The capital stack reflects an assessment of risk, and in the real estate market, certainly on the development side, the risk curve, we're up the risk curve. From a senior lender perspective, that will cause a bit of constraint. And so when we talk about capital stack change, it has changed relative to what it's been in the low-rate environment. There's a perceived increase of risk, and risk is an equity coverage for the most part. And so that's what lenders are looking for. And there are secondary forms of equity, as we spoke about. It can come in, and that's an entirely acceptable addition to the capital stack, but certainly, you won't see the ceilings of senior debt reached as they were during the pandemic.

Harrington: My team has had a solid year in student housing financing this year, which is unusual because it comes in waves. I've been doing PBSA for 30 years plus through many different cycles. This year, over 500 Million of student housing put half of what we've done on our team's book this year. And I've done a lot of CMHC- everybody has, so construction and permanent, but that also covered some bridge debt, structure debt, conventional debt, portfolio debt, who have one acquisition. We saw and delivered debt for our clients. It's different than what it was, for sure. You're up against resistance, but you have always that in the student asset class and what we're hearing today, which is helpful. I love what we're doing with bringing the macro information. It will be beneficial because every step we take for financing PBSA requires education. It is related, but we must educate the lending world constantly. There just needs to be a consistent flow of deals of scale and quality to keep a constant flow of sources. So that changes the stack for sure. But there's always a place. It comes at a price, and it comes at a level.

#9: Loans are now determined by underwriting DCR and not valuation.

Drexler: Well, it used to be that you'd have these fights with your borrowers about valuations, and an investor would come in and say it's a three cap, and we'd say it's four, and you know, it doesn't go on and on. But, now it's different. So, we're no longer talking about cap rates because we discussed debt coverage ratios. So, if we need to be at 120, 125, or 130, today's interest rates speak volumes about how much debt you'll get. And so your loan amounts will be capped by the debt cover that the property produces. It is no longer a question about where cap rates should be. As the guys mentioned earlier, there are no transactions in the market. We need to find out where the cap rates are. When you look at private portfolios, if you look at pension funds, nobody's revaluing their portfolio, but on the public market side, it speaks volumes, right? The stock prices for the public companies are  trading at considerable discounts to their net asset value. And so if you look at the math and see what the implied cap rates are, there's certainly a substantial divergence from where the perceived cap rates are from today's owners and developers, but the loans are being underwritten based on the debt cover that the property can support more so than the cap rates that we would underwrite them at.

Harrington: Absolutely, debt cover dictates the proceeds, but the process of getting your loan, both on the borrower side, as Andrew talked about, everybody wants to talk about what you think the value is and the lender side, same thing. What do you think the cap rate is? And there's always some background uncertainty, but again, to bring it back to the student housing, there's hardly been transactions. We've got a couple of portfolios that will never trade. They're my clients. They're never going to sell a thing. Once in a while, one pops up. So when we do something on the other side of the country, you're dragging from some comparison to multi-res or somewhere else and projecting the capital. So we're in the same position today that covers more accessible. It's monetary. It's easy to calculate.

Hingston: I think the fundamentals of it mainly stayed the same from a lender perspective. We were always interested in what you could afford regarding monthly payments, annual payments, and debt service coverage versus how much we would go up the leverage curve. And concerning student housing, there's one point: there is a positive in our environment. And we heard earlier today that we are seemingly at the peak of interest rates. And so we're talking about the need for student housing development and anything getting into the ground today. You're talking about a two-year completion. Well, we don't necessarily have to underwrite. At the interest rates today, we will take a bit of a conservative view. However, we can look then at providing debt through the development period, looking at the DSC, which will always be necessary. However, utilizing forward-looking assumptions may help with the equity side of the equation while keeping the DSC coverage in line.

#8: Very few transactions are occurring.

Drexler: Should we go to number seven? There are no transactions. It's the same on the apartment side. There's not much to say there; we've seen portfolios that are not traded come to market in the apartment sector. Expectations for cap rates haven't moved much, and people still expect to get yesterday's price, but it just doesn't work with today's interest rates. This year will be very slow from an acquisition perspective. We'll be busy with refinancing and whatever's in the pipeline. I don't expect any meaningful transactions to occur in terms of either the apartment sector or the student housing sector.

Harrington: The acquisition arena is going to be tough. It is hard to finance acquisitions, more so than development. Because of development, you go on the premise of bringing an advantage to the market on your cost side. And then what are the proceeds I can get? If you're patient enough, you can still drive. You're getting some very high-level loans for me, and that brings you to the game, but finding stuff is tough.

Hingston: Stabilized assets are simply not moving in the current environment. We see some development proposals come across our desk, but there's also a challenge. But the cap rates [and] there have been volumes previously, but it's not happening right now. The word the Canadian Real Estate Association uses is hibernation. We're seeing that on the commercial side.

#7-#1 of The Top 10 list coming soon.

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