February 10th, 2023
Value is an interesting, if not, abstract concept.
For example, there are a multitude of approaches and formulas one can use to value an asset.
From the traditional income approach, to a look at recent and similar comparables, and a replacement cost calculation, commercial real estate professionals have various tools to pinpoint the magic number of what something is worth.
Yet, along with value, we must also consider cost. Some people may view these terms as synonymous, however, cost can be much more subjective and run more deeply. While ‘surface-level’ costs are fairly obvious, we must also factor in items such as opportunity costs, risk appetite, and deal structuring.
Because, with increased costs across the board, how is it that we see different outcomes from a group of market players all with similar strategies and risk tolerance?
The truth is, the high-performing professionals who are able to get deals done have a team of experts behind them to ‘finesse’ and orchestrate transactions so that undesirable factors – such as higher borrowing costs – are mitigated and managed in a way to unlock value.
And these small tweaks, when viewed over a long-term horizon, can result in dramatic cost savings, an outperforming of the broader market, and better positioning to capitalize on future opportunities.
That is why, for this week’s newsletter, I spoke with Mark Kay, President and Principal Broker and Richard Tavares, SVP, Origination of CFO Capital, a provider of creative debt and financing solutions for commercial real estate.
Below is a partial transcript of our conversation together…
Mark Kay: Why don’t we tell you what we’re seeing right now we can talk about exactly what’s taking place.
The Lay of the Land
So in terms of the lay the land of the lending environment, the industrial asset class is now the golden child of all the asset classes; superseded by residential. Compared to a couple years ago, where residential and industrial were both in the forefront, industrial is now the golden child, which means that institutions in this lending environment have a focus on getting creative when lending towards industrial.
Debt Service Coverage
For example, we recently financed and closed on a couple of industrial buildings in Mississauga. One is about 130,000 SF the other one’s about 150,000 SF. They’re both single-tenanted; one of the tenants is an international company paying $21 PSF net, when the market was sitting between $19 and $20 PSF.
And when we went to market, there was a bidding spread between 20% on dollar amounts and rates. And what that means is, for the first time, we have seen institutions – for good quality industrial buildings with an economic life of 50 years plus and a good tenant – are going to 30-year amortizations. This is important to note, because, historically, 30-year amortizations are typically only for brand-new buildings.
The service coverage, where the norm we’ve seen is 1.25, we had an exception basis down to 1.15 debt service coverage, as there were upticks in the rents during the five-year term to hit 1.25 in the third year.
The Lending Environment and Creative Solutions
The lending environment for this asset was from 5% to 6.25%. And the rationale is each of these institutions have a different cost of capital in this lending environment. And therefore, institutions start getting creative with amortization and debt service coverage.
Cap rates have been obviously the hottest topic as what is the cap rate to sell versus the rate being locked in. From a lending perspective, the cap rate is not a focus. The debt service coverage ratio is the focus. The quality of tenant is the focus. And lastly, it’s the sponsorship behind it.
Because in today’s market, there is a subjective opinion as to what the cap rate is. And we’re not going to get stability until we have a stability in 5 or 10 year money, so that we can understand the interest differential.
Lending on Below-Market Rents
Now in terms of the current transactions that are taking place where there’s lag… there’s a lag in terms of net rents, lower rents, not hitting market rents. So for example, they’re buying the building today and it has a $8 PSF rent, where we know the market is at $18 PSF.
We have a large number of institutions that are supporting these transactions. They will lend on the value of the market rent. Obviously you have a cashflow deficit if you’re lending on market rents today. Therefore we are putting together a term that matches the balance of leases that are rolling over to market rents. We’re still giving the leverage to make it work. The deficit position we can add as an interest reserve for the differential, and/or we can take a guarantee, if necessary from a third company or a third guarantor that has cash flow, either way.
So we’re still encouraging those acquisitions. And pricing is ranging from prime plus one and three quarters to two and a half over prime, depending on the quality of the tenancy, and the location of the asset.
Jumping over to land… Land, as we know, is a very tight commodity right now from a debt perspective. The majority of institutions are limited on the amount of debt that they can provide. However, when it comes to industrial, if we’re seeing that there will be site plan approvals within a 24 month period… a shovel in the ground… then institutions are supporting it up to 65%. And the bridge lenders are going as high as 75% with the right sponsorship and experience behind the project.
Richard, is there anything you want to add?
Richard Tavares: The only feedback that I have to further some of your comments is that there is still some hesitancy around industrial if it’s considered to be way outside of the Greater Toronto Area. Although industrial is – as Mark alluded to earlier – perceived as being the golden child, location still is a big factor. So, some of the stuff that’s in a secondary or tertiary market… they’re not as easily able to get financing.
Mark Kay: Agreed. And we really like to look at it in terms of being an urban market. Because from a CFO perspective, we still look at markets like Montreal or Vancouver. These major cities are still very aggressive for institutions. But to Rich’s point, the secondary or tertiary market within the different provinces is not as aggressive.
Goran Brelih: So in your opinion, what would be considered to be secondary or tertiary market in in Ontario or GTA?
Richard Tavares: Well, like right now, I have a deal that I’m looking at in North Bay. And there have been lenders that have been cautious on lending to an industrial property there. Mind you that the sponsorship and the covenant is not super strong, but they’re not as bullish on that location.
Mark Kay: But we do need to point out that this case is more of a bridge facility, as opposed to institutional type asset. So if the industrial building was well-tenanted, and then you’re in a secondary market, there’s still going to be an aggressive amount of institutions bidding on it. But when you’re in a bridge scenario, where there’s no tenant in place or there’s a lapse in vacancy, then you’ll have less private lending. Like cities like Guelph and London, they’re still aggressive.
On the owner-user side, the appetite has not changed for the institutions. So your typical 100% lending at a little premium or a 65% to 75% lending at low-fives still exists, that liquidity, that market is still liquid.
With respect to the due diligence in a higher interest rate environment, the analysis is on the company’s current and future cash flows to determine any effects on the business from a macro standpoint, as well as their ability to service the debt within the requested financial covenants. Provided the financial covenants are met, and there is comfort on the projections, the aggressive lending has not changed and is independent from the cap rates.
Goran Brelih: And do you see that people are likely to go for floating rather than five year money or ten year money? What do you see there?
Mark Kay: The focal point right now is trying to lock in a three year deal. Because the variable rate is the highest because you have an inverted yield curve. For a five year term, you’re getting low five, so the borrower may hedge at a low-five. If they are banking on a further reduction in interest rates and if you go for a three-year then you may be mid-fives or mid-to-high fives. I think three to five year terms are the norm.
Goran Brelih: What is your crystal ball going forward with respect to interest rates?
Mark Kay: In the last couple of weeks we’ve seen the 5-year bond and 10-year bond is quite volatile, but on average, they have come down. As long as we have a clear view of reduction, and a steady reduction in inflation, the expectations are that the five and 10 year bonds will reduce first. We’re not economists but what we’re hearing in North America is the variable rate will stay for a couple of years in order to avoid that inverted V-shape of inflation.
Goran Brelih: What are some of the biggest challenges that you’re seeing right now for people looking to finance those acquisitions? Borrowing costs are higher, but are there any challenges that are less obvious?
Mark Kay: On the owner-user side, the institutions that traditionally had the lowest interest rates saw a limited amount of guarantees. And that remained as status quo. The institutions that provide higher leverage and have the ability to provide non-recourse loans base their due diligence on the strength of that company.
So there is more due diligence today in this inflationary environment as we examine the potential effects on the subject tenant. If the borrower concludes that the corporate entity is robust, then non-recourse would still be available.
If there’s less comfort, then there may be a guarantee attached to it. And in our world is even if there’s a guarantee attached to it, we can sometimes provide sunset clauses to release the guarantee over the coming years as they meet or maintain certain financial covenants.
When it comes to investment, the covenants are a function of the strength of the tenant. If you have a long term, grade-A tenant for a 20-year lease and you’re looking for a 10-year term, non-recourse is available, and the loan-to-value would drop 50 to 60%; with recourse up to 75%.
Again, to recap, it’s important to note that industrial is still the golden child. And depending upon what variables are given to us, there will be multiple debt structures available, compared to other asset classes, ie office.
Goran Brelih: And when you talk about additional guarantees, what’s really at stake here? What are they providing?
Mark Kay: It’s typically personal. If it’s an owner-user scenario, then it’s a corporate guarantee from the operating entity that’s occupying the space.
Overall, it’s so rare that anybody has to go after one’s guarantee anyways, because you’re applying so many different types of provisions when you’re testing the cash flow. Even in default events, I’ve never seen an enforcement situation where the lender couldn’t get their money out from the asset itself.
One other area we’ve seen a movement in is not on the buy and sell, but it’s on the refinancing. We’ve seen a surge in refinancing where there’s not as much interest-rate sensitivity to the industrial owners who have owned their buildings for 5, 10, 20 or 30 years and just recently saw their property values triple. And, to their delight, they have an opportunity to take full equity out today. They never had that opportunity to pull out that magnitude of equity to do other things, such as acquisitions, succession planning, retirement, etc.
Coming out of the pandemic, lenders are supporting this, especially given the lack of stabilization in other asset classes. So while the industrial market is hot, and while vacancies are low, lenders are allowing the full equity out which took place over the last two to three years. And people are exercising on this today.
Goran Brelih: What separates your firm from other lenders?
Mark Kay: So, for us, what we look at is understanding what the client is looking for as opposed to prescribing them a pre-defined, cookie-cutter solution. Also, clients want to see what options are on the market.
So a client will say, “give us an example of the max leverage you can get out there. And what is the relative rate versus the lowest rate out there as it pertains to the loan to value.”
And it’s only until you run this exercise… And what we do is we structure the debt, we get the lender-approved appraisers, environmental companies, building condition assessments, underwrite the financials, and we go to market on a tendering process between institutions, insurance funds, trust companies, credit unions, etc.
In this way, it flushes out what the client is looking for, which is maybe a max leverage, or the best yield with the lowest leverage with the most economic deal. Once they have that in front of them, they can choose what’s best for them.
On bridge loans where you may have a vacant building or below-market rents for the next few years, your traditional institutions are bound by an income approach. So they can only lend on the income that is being produced today, not on what’s being produced three years from now. For argument’s sake, that may be 30% loan-to-value of that purchase price, because that’s what it could afford at $8 PSF when the markets $18 PSF.
Rather, we can arrange 80% of the purchase price at a little higher interest rate, but we can do it for the term in order to bridge that gap to bring it to market rents and then it rolls back to the institutions. So we’re giving it some creativity and providing those options.
We would like to thank our friends at CFO Capital for providing this insight to our readers.
For more information on how CFO Capital can help you secure debt or creative financing solutions for your commercial real estate decisions, please visit www.cfocapital.ca or contact:
President, Principal Broker, CFO Capital
Since 2004, CFO Capital has provided a consistent flow of competitive capital to all Commercial Real Estate Industries raising billions of dollars for our clients. Their team’s 150 years of combined commercial banking experience has established tenured relationships with over 100 industry partners.
They bring a wealth of credit experience in creating customized strategic financing structures that meet their developers, investors and owner operators’ requirements. This is a key reason why CFO Capital is one of Canada’s fastest growing commercial mortgage brokerage firms.
Our discussion with Mark Kay and Richard Tavares helped provide some context and colour to some of the broad-stroke trends we see from a brokerage perspective.
While the team at CFO Capital did confirm that the volume of transactions has slowed down according to our previous industrial sales analyses, the asset class remains the ‘golden child’ of commercial real estate. And as such, there has yet to be any impact on securing financing for those Parties intent on executing a deal, depending on the asset and location.
It bears repeating that the GTA industrial market is incredibly robust and, with the right team of advisors in place, a Party looking to acquire, dispose, or lease space can still find value through creative solutions and off-market opportunities.
With that said, if you would like a confidential consultation or a complimentary opinion of value of your industrial asset, please give us a call.
Until next week…
Goran Brelih and his team have been servicing Investors and Occupiers of Industrial properties in Toronto Central and Toronto North markets for the past 30 years.
Goran Brelih is an Executive Vice President for Cushman & Wakefield ULC in the Greater Toronto Area.
Over the past 30 years, he has been involved in the lease or sale of approximately 25.7 million square feet of industrial space, valued in excess of $1.6 billion dollars while averaging between 40 and 50 transactions per year and achieving the highest level of sales, from the President’s Round Table to Top Ten in GTA and the National Top Ten.
Goran is a Past President of the SIOR ‐ Society of Industrial and Office Realtors, Central Canadian Chapter.
Industrial Real Estate Sales and Leasing, Investment Sales, Design-Build and Land Development
About Cushman & Wakefield ULC.
Cushman & Wakefield (NYSE: CWK) is a leading global real estate services firm that delivers exceptional value for real estate occupiers and owners. Cushman & Wakefield is among the largest real estate services firms with approximately 53,000 employees in 400 offices and 60 countries.
In 2020, the firm had revenue of $7.8 billion across core services of property, facilities and project management, leasing, capital markets, valuation and other services. To learn more, visit www.cushmanwakefield.com.
For more information on GTA Industrial Real Estate Market or to discuss how they can assist you with your real estate needs please contact Goran at 416-756-5456, email at email@example.com, or visit www.goranbrelih.com.
Goran Brelih, SIOR
Executive Vice President, Broker
Cushman & Wakefield ULC, Brokerage.