The Canadian Apartment Investment Conference is an annual event that attracts the who’s who of the multi-unit residential property industry. This year, because of COVID-19, all breakout sessions were held virtually and featured a number of expert speakers including First National’s own Jeremy Wedgbury, Senior Vice President, Commercial Mortgages. On the eve of the conference, we asked Jeremy to share his views on the state of the market and the outlook for apartment construction activity.
Jeremy, we’re now heading into the final stretch of 2020, a year that has been disrupted by COVID-19. As a lender, how has First National performed?
Incredibly well. Our entire team moved to work-from-home in March and we haven’t looked back. Commercial mortgage originations amounted to $4.7 billion through June 30th – 27% more than a year ago – with contributions coming from all markets with particular strength in Ontario, Quebec and B.C. Our total commercial book now stands at just over $33 billion, making us by far Canada’s largest multi-unit residential lender. First National’s focus on the multi-unit market has made all the difference.
How is that performance even possible in this environment?
Demand for apartment financing has been driven by a couple of factors. Many owners made the decision to borrow at historically low interest rates to increase their liquidity as a risk management strategy and to prepare for the possibility of great assets becoming available for purchase. That drove refinancing business volumes. As well, developers moved forward unabated with their apartment construction projects and consequently we’re experiencing significant demand for construction financing which we are very committed to addressing. We have financed construction projects in just about every city in Canada so far this year.
Are you surprised by the continuation of apartment construction?
Not at all. Our clients are bullish about the future of the apartment sector and I’d say I’m of the same mindset. The reality is, and has been for some time, that there are far too few apartment units in our major cities and the result has been chronically low vacancy rates and almost super-charged rental inflation. As a result, developers see that there is a long-term opportunity to create more supply to satisfy sizeable demand and they are not being thrown off by pandemic conditions. In fact, a number of our clients finished up their construction projects earlier this year and moved immediately to purchase more land for their next venture. Beyond favourable demand-supply characteristics, developers like the fact that with apartments, they continue to own the land and building which is not the case with condo projects, and capex requirements for apartments are usually minimal for the first 10 years after the building opens.
The demand you are talking about is being created, in part, by people coming into Canada.
Correct and with border restrictions, the number of newcomers has declined compared to historical averages and logic would dictate that this has affected demand. However, most experts view this as a temporary phenomenon. Successive federal governments have repeatedly committed to immigration as a source of economic growth and prosperity and Canada remains a sought-after destination for those seeking a better life, and international students seeking access to our educational system. Border restrictions will be lifted eventually and when they are, we will experience a return to more normal demand dynamics.
Is the supply-demand imbalance big enough to absorb these impacts without a major disruption to the apartment market?
In my view, yes. In most major centres in Canada, demand has been running far ahead of supply for so long it would take years to reach a more balanced position even if immigration stayed low. If you are committing to a new apartment building project today, you are looking beyond the present knowing that your units will not come to market for two years or more. That time lag means developers are building for a future market and a different and hopefully better phase of the economic cycle. The bet, and I think it’s a good one, is that there will still be strong demand for new units two years from now.
There is no question that the pandemic and the resulting economic downturn have caused challenges. Is the apartment sector immune?
No sector is immune but so far, I would say multi-unit has shown its usual resiliency with strong cashflow characteristics continuing. That said, there is no question that government wage subsidies have provided an important assist in supporting a high degree of rent collection and that stable flow of cash for owners. These subsidies are coming to an end this fall so it remains to be seen what will happen with November 1st rent collections. The hope is that the re-opening of the economy will lead to a reduction in unemployment which would help those tenants affected continue to pay their rent on time and in full. But as they say hope is not a strategy, so I know many of our clients have been preparing for potential challenges which is one reason we saw significant refinancing activity earlier in the year.
What’s going on with rental rates?
Rents have been holding up in just about every market. A notable exception is the luxury apartment segment in a couple of cities. In those centres, we’ve seen luxury rents decline 10% to 15% per square foot which is a not-so-surprising correction given the rampant inflation in the high-end space in the past few years. The three groups that were driving demand for those units were millennials who were sharing accommodation, seniors who were downsizing and international students. I would think that these groups have probably taken a step back because of the economy, and in the case of international students, border restrictions. As a result, that part of the market may suffer a bit in the short term. But remember that house prices have held up remarkably well which provides seniors with an incentive to take home equity off the table to fund retirement.
What about rental rate inflation?
I would say it has moderated significantly after rising 15% or 20% over the past few years. Frankly, rents were getting to the point of unaffordability in certain markets so slower increases were probably inevitable. Going forward over the next year, I would not plan a building project on the assumption of a rise in rental rates. Having realistic proformas and conservative underwriting in this environment is a necessity, particularly in the luxury apartment space.
You mentioned luxury units. Has COVID-19 changed the features or amenities that are being planned in new apartment construction projects?
Developers are mulling over a number of different approaches. For example, consideration is being given to housing work-from-home suites within apartments that are planned in places like downtown Toronto, Vancouver and Montreal. Attention is also being paid to how in-building gyms might be constructed to enable physical distancing. This is all very new and we’re keeping an eye on it to see how it might play out.
Have apartment cap rates been affected by the economic downturn?
The answer so far is not really. The latest figures I’ve seen for apartment cap rates is they remain low across the country. CBRE’s Q2 report indicated multi-family high-rise A class apartment cap rates were unchanged at 3.79%. There has been some minor upward movement in high-rise B-class and low-rise A and B but these assets still command highly attractive valuations. Many people thought cap rates just had to go up all things considered, and they still might but the counterbalance has been low interest rates. If a developer builds to a 4% cap rate and is able to achieve a sub 2% interest rate that provides really good leverage.
It would appear that no one is expecting interest rates to rise. Are borrowers still interested in your Early Rate Lock program?
I would agree there is little talk now about interest rates rising, which was a major point of conversation last year at this time. However, I would say that developers appreciate knowing that the program still exists and understanding how early they can lock their interest rates on a term loan in future.
What about construction costs?
Costs started going up materially about three years ago and inflation was very acute in areas such as window systems and concrete forming. At times, we saw inflation of 20% and even as high as 40%. From what we can see in the market now, and based on information we glean from cost consultants, costs are not rising at this rate but they also aren’t going down. There was a theory a few months ago that as condo construction reduced, construction costs would as well. That has not been the case. Experienced developers are not waiting for cost reductions that may never come; they are proceeding with projects now on the understanding that they won’t get cheaper to build in the future.
You said earlier that First National was very committed to financing apartment construction projects. What does that commitment look like?
Several years ago when we established our construction program, we sought to develop dedicated expertise that developers could tap into from the very earliest stages of their projects. Our goal was to be an informed advisor able to take our broad access to market precedents and trends and share deep insights that would be valuable to developers as they were considering project specifications, creating budgets, navigating local municipal planning requirements and securing financing. We hired a number of specialists with relevant experience and we really dug deep to understand construction financing incentives available through CMHC. As a result, First National became recognized as an important source of capital but also knowledge such that today, we are one of the top apartment construction lenders in Canada.
How do you approach a client who is looking for a construction loan – what do you offer?
We offer choice. We do a financial analysis of the project, review the proformas and we then use our expertise and experience to present the best product option, whether it’s conventional construction, Market CMHC, affordable CMHC or CMHC’s direct-to-borrower RCFI or Rental Construction Financing Initiative program. The variety of solutions we bring to the table differentiates us compared to many other lenders who tend to have a narrow and sometimes single product focus. We then use our expertise to secure the right financing for the project. In the case of insured loan programs, First National has made it a priority to understand all of CMHC’s requirements and product offers so that we can consistently make applications that achieve our borrowers’ objectives.
You mentioned CMHC. Is insured financing a significant part of your construction business?
Absolutely. We were a first mover in evaluating and securing insured apartment construction loans for our clients and for most if not all projects CMHC programs are worth reviewing as they are very compelling from a cost-benefit perspective. For one, the allowable loan to cost is higher than for conventional borrowing and for another, borrowers are guaranteed that they will secure an insured term loan upon construction project completion without waiting for lease-up. That is a critical advantage over conventional loans when you consider that lease up could take a year or two. Perhaps there isn’t that much uncertainty in the world about interest rates right now, but knowing that there is a secure source of long-term financing at the end of a construction project – in other words a baked-in exit strategy – is a huge benefit to developers in reducing one cause of stress. We recently won a $50 million construction deal with a client that had a variety of conventional product offers on the table but chose to go with a CMHC financing through First National because of the term component.
You mentioned a “direct-to-borrower” option from CMHC. Why would you recommend it if you are not providing the capital?
Because we want to support our clients regardless of the source of the funds. RCFI is an exceptional program with a 50-year amortization and below-market interest rates that are too compelling to ignore. Consequently, we’ve built a strong advisory practice for this program. We use our knowledge to help clients navigate RCFI’s eligibility requirements, which are extensive and assessed on a prioritization scoring system that considers a host of factors. In the event a client finds they do not meet RCFI’s requirements, we can quickly pivot to another type of financing including CMHC Market or affordable Flex. I should note that these alternatives are also attractive. In fact, Flex allows a higher loan to cost, in some cases up to 95%. By comparison, CMHC’s Market program is based on 75% of cost during construction but can be 100% of cost on take out so it too serves as an important solution for First National’s clients.
Is conventional construction financing still available in this environment?
There has been a reduction in conventional funds availability because of the pandemic but the short answer to the question is yes. We do have funds on our balance sheet for conventional and bridge financing and we also partner with other investors who share our appetite. Unlike other lenders, First National is willing and able to present a variety of financing options to borrowers which I know they appreciate. Generally we like to maintain a balance between insured and conventional business but the activity this year has been more skewed to insured and that’s also due to what I said before: the ability to move directly from an insured construction loan to a term loan. It’s a critical advantage for borrowers.
Overall, how difficult is it for apartment developers to secure construction financing today?
I think lenders are getting more comfortable with apartment financing, but underwriting requirements vary greatly. Part of the problem is that many lenders still aren’t comfortable with their exit strategy in an apartment deal the way they are when they underwrite a condo construction project. They also see uncertainty when it comes to achieving planned rental rates. First National understands the sector which is why securing financing with us is much easier particularly for developers with a demonstrated track record. But overall, I would say this is a liquid market for those seeking debt.
What advice do you have for a developer planning an apartment construction project this year?
Start planning early and seek assistance from experts to ensure your expectations for rental rates and construction costs are realistic and attuned to current market conditions, which are pretty dynamic. First National is definitely qualified to help in this regard. I would also say that constructing apartments is a complex business. As a rule, we limit our financing to experienced developers. For those with less experience, my advice would be to partner, and we can certainly help with introductions in those cases.
First National is first in apartment construction financing in Canada because we understand construction, we know apartments, we are an always reliable source of funds and our expertise adds value. We certainly accept that there will be short-run challenges because of COVID-19 but these will not change our commitment to the industry.