The effects of declining oil prices have been felt in a variety of unpleasant ways, particularly in Western Canada. One of the more pronounced repercussions is the office vacancy rates in Calgary and Saskatoon, the largest cities in their respective provinces.
Analysts are predicting office vacancy rates could hit 20 per cent before the end of 2016, a number unimaginable not so long ago.
This level of vacancy is having numerous negative consequences. Real estate investment trusts with Western Canada exposure are losing unit value.
Lenders are losing interest in placing money in these assets and markets while investors and developers have focused their attention in other markets. The list goes on.
Two Calgary office buildings
Property owners who have a mortgage maturity during this downturn have an increased amount of risk compared to those who secured long-term financing as recently as early 2015. To compare, let’s examine two office buildings that were purchased and financed in 2012. The buildings are located in Calgary, the city grabbing the most headlines.
Both buildings had market average rents at the time and the purchase price was based on a 5.75% capitalization rate (cap rate). They both enjoyed a very low vacancy rate of 3.53%, which happens to be exactly at market for Q2 2012.
Both buildings obtained 75% financing but one had a five-year term while the other had a 10-year term. My financial models are all based on figures obtained from Colliers International market reports issued in 2012 and 2015.
Renewal or refinance?
The owner who selected the shorter term is approaching the maturity of their loan and must consider renewal or refinance. Five years of paying down the mortgage has reduced the principal amount from $39,460,000 to $34,200,000. An income0based lender will determine a new lending value calculated on the property’s ability to service debt under current market conditions.
Cap rates as of Q4 2015 have widened 12.5 basis points from 2012, which has marginal impact on the lending value. The vacancy of 20% is a major problem, as are the recent plummeting lease rates in that market.
Accounting for all of these variables, a new loan amount would be $27,022,000. You can see the huge problem a property owner would face, specifically the $7,178,000 shortfall in loan amount. Coming up with that money in a down cycle can be difficult and could put the building ownership in serious jeopardy.
Why a Q2 2012 base year?
I specifically chose Q2 2012 as the base year for my model, as that was the lowest vacancy rate in the last five years. The example I’ve created here demonstrates a perfect storm for mistiming the market.
Many property owners with mortgage maturities in the next 12 months could be protected from this horrible reality. They may have bought the building 15 years ago, or they didn’t have a 75% LTV mortgage or they had long-term leases in place with multi-national tenants.
Responsible real estate asset managers typically try to distribute their lease maturities evenly over the years, as a protective measure against this situation. Given that the Calgary office market has many large portfolio owners, the pain of one building suffering this fate would be shouldered by numerous buildings in different markets.
Diversification one advantage of REITs
Diversification is one of the selling features of investing in REITs, rather than owning a single building yourself.
In our example. I also mentioned a property owner who opted for a 10-year term. That owner will obviously be happy a higher interest rate was paid for the longer term, as the predicament described above can now be avoided.
However, they would still be feeling some pain. Simply adjusting my model up to 20% vacancy sufficiently decreases net operating income that the monthly revenue won’t quite cover the mortgage payment. And factoring in the likelihood of lowered net rent will further pain.
Both the five- and 10-year mortgagors would be sleeping fitfully in the current climate. Most people would rather be the building owner struggling to find a little extra money every month to contribute a partial mortgage payment, than be the one trying to find a very large sum of money in a semi-liquid mortgage market.