What could that look like?
A potential funding gap, as lower asset valuations rebalance against higher debt-servicing requirements. With that funding gap will come new challenges. For example, commercial borrowers will need to find ways to bridge the deficit, which could require putting more equity into properties, finding additional financing from non-traditional sources or even selling properties off. In some cases, this dichotomy could push some property owners and commercial borrowers into default — a situation you want to avoid.
True, interest rates are expected to drop in 2024. Even so, the projected decreases may not be enough to eliminate the funding gap risk for commercial property owners and borrowers. Meanwhile, the broader operating environment is becoming increasingly complex.
So much uncertainty in the real estate market is pushing lenders to become more selective. As a result, we’re starting to see different or evolving lending requirements emerge for varying real estate asset classes. While multifamily, industrial and grocery-anchored retail lending remains relatively stable, office and development land are considered increasingly risky.
All of this is happening in a broader regulatory environment that’s also changing. Many of Canada’s financial institutions and lenders are impacted by interim guidance issued by the Office of the Superintendent of Financial Institutions (OSFI) on corporate real estate-specific focus areas and expectations. OFSI guidance indicates that financial institutions should be ready to demonstrate this specific diversification policy and concentration limits.
We’re likely to see a more conservative lending environment going forward, with an increased emphasis on prudent lending practices, even as interest rates ultimately adjust.
What do these changes mean for commercial real estate in Canada?
Managing debt in this environment is more complicated than in years past. Commercial real estate organizations and borrowers cannot afford to take anything for granted. What might have felt like a “standard” loan renewal one, two or even five years ago may now be a much more complex process.
That said, taking a proactive approach to managing your debt can help. At EY, we suggest commercial real estate owners and borrowers aim to stay ahead of this situation by taking three key steps to prepare:
1. Identify risks and opportunities across your portfolio. Conducting thorough property valuations and market assessments offers you an updated sense of your portfolio’s current market value. This is essential to planning ahead for renewal and other financing conversations. By engaging real estate professionals or appraisers to provide accurate valuations, you can more easily monitor debt across the entire portfolio.
This insight also helps you identify assets with high and low loan-to-value (LTV) ratios to comprehend varying risk levels. Then, through a review of loan maturity dates, you can start planning ahead for renewals and potential refinancing needs.
2. Evaluate your business holistically. Assessing cash flow projections for each property, and considering potential changes in interest rates, helps you evaluate your portfolio’s ability to generate sufficient cash to cover debt service obligations. Stress testing the portfolio enables you to assess potential scenarios and get a sense of how cash flow and debt servicing might be affected by adverse conditions.
Evaluating the highest and best use of individual properties opens you up to possible redevelopment or repositioning opportunities that could improve or enhance cash flow. Distinguishing between core and non-core assets allows you to consider divesting, so you can optimize the portfolio overall and increase liquidity.
Carrying out these actions methodically generates valuable information and empowers you to make plans and brainstorm potential solutions ahead of time — not after a loan fails to renew. This evaluation process is how you turn a higher-risk environment into your next big opportunity.
3. Seize the moment and make an action plan. Informed by updated insight on your business, assets and portfolio, you’ll be well positioned to take action now, as opposed to reacting to external forces, factors and decisions later on. With in-depth understanding of where your portfolio stands and how it must evolve for the future, you can consider selling non-core assets and developments to generate capital for debt repayment or strategic investments.
You might proactively engage lenders, initiating proactive discussions to explore creative solutions — think loan modifications, extensions or alternative financing structures. Now is a good time to consider rightsizing your portfolio by adjusting the size or composition of assets to align with market conditions and investment goals, and evaluate alternative uses or lending and financing solutions.
By addressing these factors now, you can explore creative divestment strategies, like sale leasebacks, to unlock capital while retaining ownership.