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SESSION C3 FINANCE SESSION: HOW DO LENDERS STRESS TEST
THEIR DEALS? AN INSIDE VIEW
Moderator: Steven Hart, Managing Director, Prairie Region , CMLS Financial Ltd. Panel: Geoff Coombe, AVP & Regional Director, Commercial Mortgages, Prairie Provinces, Manulife Financial Jeff GoveD, Calgary Regional Head, Commercial Real Estate, HSBC Bank Canada Jason Jogia, Director & Group Lead, Prairie Region, ScoFabank Dean Proctor, VP & Deputy Regional Manager, Prairies, Canadian Western Bank
CANADA’S MORTGAGE COMPANY.™ Over 35 years, 7000 customers and 6 billion in assets. A dedication to Customer Forward.
-
20
40
60
80
100
120
140
160
180
200
2011 2012
Billions
Estimate
CMLS Survey
Size of the Market
$173 B
CANADA’S MORTGAGE COMPANY.™ Over 35 years, 7000 customers and 6 billion in assets. A dedication to Customer Forward.
-
5
10
15
20
25
30
35
2011 2012
Billions
Estimate
CMLS Survey
2012 Origination – A BIG YEAR
$33 B
CANADA’S MORTGAGE COMPANY.™ Over 35 years, 7000 customers and 6 billion in assets. A dedication to Customer Forward.
0%
2%
4%
6%
8%
10%
12%
14%
5 Year GoC Interest Rates
Source: Bloomberg
CANADA’S MORTGAGE COMPANY.™ Over 35 years, 7000 customers and 6 billion in assets. A dedication to Customer Forward.
0%
1%
2%
3%
4%
5%
6%
7%
Commercial Mortgage Loans 5 Year Spreads and Coupons
Coupon Spread Source: Canadian Mortgage Loan Services Limited, Bloomberg Source: CMLS Financial, Bloomberg
CANADA’S MORTGAGE COMPANY.™ Over 35 years, 7000 customers and 6 billion in assets. A dedication to Customer Forward.
Canadian CMBS History
• First Canadian CMBS in 1998 • Expected 2013 volume is approximately one-third of peak 2006 issuance volume
-
500,000,000
1,000,000,000
1,500,000,000
2,000,000,000
2,500,000,000
3,000,000,000
3,500,000,000
0
2
4
6
8
10
12
Out
stan
ding
Bal
ance
# of
Tra
nsac
tions
Canadian CMBS Outstanding
# of Transactions Outstanding Balance
COMMERCIAL BANKING 7
RISKS • Inflationary Costs
• Interest Rates
MITIGANTS • Fixed Price Contracts • Developer Experience • Contingency • Presales/Preleasing • Stress test unfixed costs • Completion and Cost Overrun
Guarantees
• Contingency/Interest Reserve • Unfixed revenue
Interim Construction Stress Testing
COMMERCIAL BANKING 8
RISKS • Sales/Market
• Timing/Scope
MITIGANTS • Presales/Preleasing • Deposit Level • Time to completion • Rental Economics • Contract provisions • Stress test unfixed revenue
• Developer Experience • Local Market Knowledge • Nature of project • Contingency level
Interim Construction Stress Testing
COMMERCIAL BANKING 9
Interim Construction Stress Testing
• While Lenders stress test a project a Lender can not look at a project in isolation, thus Lenders must look at the support of the covenant involved in the project to further mitigate key identified risks
• Cost Overrun Guarantees • Completion Guarantees • Financial Guarantees • Cross Collateralization
COMMERCIAL BANKING 10
Case 1
SITUATION: • Client seeking interim construction loan to build 4 storey condominium with 55 units and
retail component in inner-city Calgary • Project cost: $20,500,000 • Client wants to mobilize construction a.s.a.p. in advance of presales in order to:
• Mitigate against rising costs • Take advantage of the inflationary sellers market • Demonstrate to market that project is mobilized
KEY RISKS: • Sales/Market – Unproven market acceptance of product with lack of presales • Inflationary Costs – if project launch is delayed face higher construction costs
SOLUTION: Staged presales test 1. Initial land loan @ 60% of land cost - allows commencement of development 2. Zero sales – ~25% equity requirement 3. 25% sales – ~20% equity requirement 4. 50% sales – ~13% equity requirement
COMMERCIAL BANKING 11
Case 1
Benefits to Lender Benefits to Developer 1. Sales/Market risk is mitigated through added equity upfront of 25%. - Ensures LTV remains conservative (< 52%) which substantiates rental economic underwriting model
1. Phased solution provides our client with access to bank financing at various stages to ensure project is developed in their desired timeframe.
2. Inflationary costs risk is mitigated through fixed price contracts and short time horizon to completion.
2. Further allows for equity repatriation as sales momentum builds within the project. - Further enhances client’s overall ROE
COMMERCIAL BANKING 12
Case 2
SITUATION: • Client seeking interim construction loan to build 65 unit 4 storey condominium in Edmonton
AB. Subject building is the 2nd phase of an existing bank financed project (identical building) • Project cost: $12,000,000 • Client wants to mobilize construction on next building to take advantage of strong market
• Continuation of sales momentum in existing building • Wants to sell out of first building before achieving sales milestones in second. • Client does not want to inject excess equity at this time – held flat at 15%
KEY RISKS: • Sales/Market – untested demand in second building due to lack of presales • Scope/timing – product in initial building could cannibalize sales in second building
SOLUTION: Cross collateralization • Zero presales requirement in 2nd building based on strength of presales (80%) in 1st building • Upon completion of 1st building, portion of proceeds will be injected in second building to
increase equity to 25% or, • @50% presales sales in 2nd building – equity remains flat at 15%
COMMERCIAL BANKING 13
Case 2
Benefits to Lender Benefits to Developer
1. Sales/Market risk is mitigated through the cross collateralization and undertaking to inject further equity if sales momentum stalls.
1. Solution allows client to manage cash resources effectively.
2. Scope/timing is mitigated through added equity from net sales proceeds in Building 1 if sales are cannibalized in Building 2.
2. Allows client to sell out of initial building and repatriate equity from initial building when presales are achieved.
Canadian Western Bank
¨ Case Study # 1 ¤ $ 7.5MM interim construction financing over a 35M square feet multi – tenant retail
development
¨ Challenges ¤ Non – metropolitan location ¤ Only 40 % pre – leased at the time of authorization (market risk) ¤ Partially owner – occupied
¨ Solutions ¤ Staged loan authorization:
n $ 500M à no leasing, land advance for predevelopment n $ 4.5MM à 55 % LTC and 40 % pre – leased n $ 6.5MM à 75 % LTC and 75 % pre – leased n $ 7.5MM à 86 % LTC (70 % LTV), construction complete, substantially pre – leased,
refinanced over 25 years
Canadian Western Bank
¨ Mitigation ¤ Seasoned developer with historic track record of completing projects on time and on budget ¤ Long – term leases (solid mix of national, regional and local tenants) minimizing rollover risk ¤ Satisfactory covenant support / liquidity in case of a cost overrun / cash call, project delay or
slow lease – up ¤ Major construction components under a fixed price contract, reducing the potential for a cost
overrun or cash call
¨ Stress Testing ¤ As this is a build and hold project, we examine the ability of the sponsors to handle increases
to the budget during construction and what impact this might have on LTC and LTV underwriting assumptions as well as the potential ability of the project to handle more debt if an increased loan authorization is requested
¤ Upon completion and consideration of takeout financing, we consider how the property on a standalone basis can handle shocks, namely increases in vacancy, decreases in rental rates, increases in interest rates and rollover risk of tenants upon lease maturity
Canadian Western Bank
¨ Case Study # 2 ¤ $ 20MM interim construction financing over a residential lot development
¨ Challenges ¤ Stub loan after initial phase ¤ Deposits utilized in the loan program ¤ Non – recourse
¨ Solutions ¤ Higher level of pre – sales combined with increased deposits from reputable builders to help
mitigate stub loan component ¤ As an alternative to sponsorship, a Letter of Credit / cash reserve facility was established to
cover off the potential for cost overruns / cash calls, project delays or pre – sale rescissions / slow sales on remaining lot inventory
Canadian Western Bank
¨ Mitigation ¤ Experienced land developer ¤ Pre – sales from Tier 1 home builder group with stipulated lot takedown requirement
minimizing the probability of sale rescissions ¤ Major construction components under a fixed price contract, reducing the potential for a cost
overrun or cash call
¨ Stress Testing ¤ As this is a develop to sell project, we examine the standalone metrics of the project to
ascertain the following: n Pre – sale coverage of loan facility (potential market risk / exposure on unsold inventory) n If there is a cost overrun / cash call or project delay, how is profitability impacted n Protracted or rescinded sales (will an extended marketing campaign elevate the project
budget via additional carrying costs that again hamper profitability) n If sale prices decline (how does this potentially impact the value of unsold lot inventory as
well as the value of the residual land component / is the project still viable going forward)
Over the past few years Life Companies have adopted Moody’s and/or DBRS raFng matrixes
A number of underwriFng factors come into play, with various weighFngs, that affect required LTV and Stabilized DSC levels and affect loan raFngs assigned by lenders and accordingly affect interest rates offered by lenders.
STRESS TESTING COMMERCIAL MORTGAGES
Calgary Plaza -‐ 123 Somewhere Street SW
DescripQon: 45,000 square foot, class B, mulF-‐tenant, retail strip anchored by a 15,000 SF naFonal drug store.
The property was built 10 years ago and has received proper maintenance since it was built.
The property has a desirable locaFon an upper income neighbourhood in southwest Calgary.
EVALUATING THE PROPERTY Property Type & Quality
Effective Age
Location
RATING: GOOD - VERY GOOD
EVALUATING THE TENANCY
Leasing InformaQon: Anchor tenant (drug store) has extended their lease for another 10 years. Remaining tenants have typical remaining lease tenures.
The drug store is a financially strong enFty and the remaining tenants are a mix of local and regional firms of typical financial strength.
A lease just rolled yielding a current vacancy of 1,200 SF or 2.6%, however, the property’s historic occupancy level was superior to comparable properFes.
Remaining Lease Tenure
Financial Strength of Tenants
Current and Historic Occupancy
Lease Rates
RATING: GOOD - VERY GOOD
Lease rates in the property average $32 per square foot, while the anchor tenant pays $28 per square foot. Lease rates are somewhat below going Market. All leases are triple net with operaFng costs averaging $8 per square foot.
The Borrower -‐ Joe Smith’s Real Estate Holding Company
The borrower provided un-‐audited externally prepared C/A financial statements for the year ending 2012.
The borrowing enFty owns the subject and a good number of commercial real estate assets with substanFal equity in each property.
The borrowing enFty is a limited company with Joe Smith as the sole shareholder.
Joe Smith is a somewhat experienced commercial real estate owner/operator and has a good reputaFon in the business.
Borrower is seeking best pricing vs. most aggressive loan term opFons. Borrower is prepared to provide loan recourse if necessary.
EVALUATING THE BORROWER Quality of Financial Information
Financial Condition of Sponsor
Borrower Structure
Reputation and Experience
Additional Security & Guarantee
RATING: GOOD
EVALUATING THE LOAN – Key Stress Test Factors Key Factors
Examining Loan Options & Pricing
• Loan to Value RaQo (LTV) -‐ 0% – 75%
• Stabilized Debt Service Coverage RaQo (DSC ) -‐ 1.20X and up
• Refinance capacity at end of term (DSC and LTV)
These three factors account for approx. 75% of the stress test raFng. Note the raFngs may be massaged using common sense. Loan raFngs are internally re-‐evaluated annually.
60% LTV
Recourse
20 year am
1.5X DSC / 25 year am Spread: 150 BPS
A+ 65% LTV
Non-‐recourse
25 year am
1.35X DSC / 25 year am Spread: 160 BPS
A-‐ 72.5% LTV
Non-‐recourse
25 year am
1.2X DSC / 25 year am Spread: 170 BPS
BBB
Based on the aforemenFoned stress tesFng we can offer the borrower the following loan opFons:
RESTRICTED
HSBC BANK CANADA Project: Multi Family Rental Project Structure: Term Debt Drawn $15,000,000
Term Debt Undrawn $2,500,000 Purpose: Payout Construction Debt (drawn amount) and provide Capital for
another project (undrawn amount) at a future specified date Term: 5 year term, 20 year amortization Loan to Value: 70% Sensitivity Analysis: DS cover requirement at current rates plus 1% Challenge: Borrower wants to take advantage of the lower interest rate
environment on both the drawn and undrawn portions of the loan. Solution: Provide a 5 year interest rate SWAP against 30 day Bankers’
Acceptance to hedge against any increase in interest rates. Forward starting SWAP allows for the advance of the Undrawn
portion at a future date
Companies with floating rate
borrowings are exposed to interest
rate volatility
Rate volatility translates into
interest expense volatility
Swaps can be used to manage interest rate
risk, to reduce variability of interest
costs, and net income
• Currently, companies are enjoying an environment of historically low interest rates
• Many clients have floating rate loans based on short-‐‑term interest rates, such as 1-‐‑month Bankers’ Acceptance (BAs)
• The interest rate on these loans is reset monthly at prevailing market levels
• This can lead to fluctuations in interest expense • Swaps can be used to manage interest rate risk by fixing the BA
component of the loan, to reduce variability of interest costs, and net income
Lender
HSBC (or third-‐‑party)
Swap Counterparty
HSBC
Client
Floating-‐‑Rate Loan Underlying Risk
Interest Rate Swap Hedging Instrument
Floating 1mBA + Stamping
Fee
Fixed [5%]
Floating 1mBA
RESTRICTED
HSBC BANK CANADA
AFTERNOON REFRESHMENTS SPONSOR