Our survey revealed that 55% of respondents indicated that their LTV ratios have changed. Additionally, the 45% of lenders that indicated no change in their LTV ratios did suggest they are being more conservative from a property-level underwriting perspective, which necessarily translates to more conservative values and subsequently debt proceeds. Some of these underwriting changes may consist of an increase in bad debt allowance, changes in market leasing assumptions (e.g., market rental rates, rental rate growth and renewal probabilities), an increase in capitalization rates or changes to capital expenditure reserves. According to respondents, conservative underwriting is more likely to lead to lower property valuations and a higher required debt service coverage ratio, which results in less risk for the lender even if their LTV ratios remain largely unchanged.
More than half (55%) of respondents did indicate a decrease in LTV ratios ranging from 5 to 10 basis points. Respondents that provide short-term and/or bridge financing indicated the most significant decrease in LTV ratio.
Respondents largely suggested that defaults are not likely to rise in the short term as both borrowers and tenants continue to benefit from government and mortgage relief programs.
Respondents were unanimous in their belief that borrowers on retail and hospitality assets will constitute the large majority of defaults. Respondents expect defaults to begin towards the end of 2020 as government assistance and cash reserves are eventually depleted. Defaults will also increase with more loan expiries, as borrowers will have difficulty refinancing given the more restrictive lending criteria.
Lenders, particularly ones that are focused on higher-risk assets, have begun to increase loan loss provisions in anticipation of potential defaults and impairments. Many lenders expressed concern that reduced market liquidity will result in borrowers being unable to divest of at-risk real estate holdings in a market with slower transaction velocity.
Outlook on mortgage spreads and all-in commercial mortgage rates
The majority of respondents (67%) expect credit spreads to increase over the next year. Credit spread fluctuations are dependent on a variety of factors, including the status of the benchmark base rate and/or a lender’s cost of funds, and will necessarily vary by asset class and geography, asset quality, creditworthiness of the rent roll in place, and the borrower’s financial strength.
Most respondents preferred to present a viewpoint on potential fluctuations in all-in commercial mortgage rates rather than credit spreads given the potential near-term volatility in base rates and differing cost of funds across institutions.
Overall, most respondents expect all-in rates to remain relatively consistent with pre-COVID-19 for high-quality assets with strong borrowers. Conversely, assets and/or borrowers outside of this first tier should largely expect an increase in all-in financing rates relative to pre-COVID-19 levels as lenders implement wider spreads and floors to mitigate both some of the property-level cashflow risk and structural economic risk and its corresponding impact on commercial real estate. In addition, non-bank lenders have indicated that their all-in financing rates are likely to be higher one year from today.
EY outlook and perspectives
As shown by the survey results, lending institutions are pricing in increased risk on debt capital, applying higher scrutiny on borrower clients and largely asking for higher equity contributions on deals.
As unemployment figures remain near historic levels and consumer spending is forecasted to remain below normal levels for many months, an expeditious recovery appears less likely. As such, we anticipate that higher yield expectations are likely to set in across most major asset classes and geographies, with Tier 1 trophy assets being the least impacted. Our outlook is supported by the following analyses and historical trends.
Government of Canada bond yields vs. cap rates
One of the key relationships that we typically evaluate is the spread between cap rates and the 10-year Government of Canada bond yield. Generally, bond yields and cap rates move in the same direction – as one decreases or increases, so does the other.
However, we see a divergence from this trend during times of economic distress, as evidenced by the last two major events. In both the 2000-01 dotcom crash and the 2008-09 global financial crisis, bond yields decreased and cap rates increased, which translated to the widest spreads between the two data points.