Participants in the Canadian commercial mortgage market are all facing an extraordinary “Black Swan” market disruption triggered by the current COVID-19 crisis and resulting government lockdowns. It is too early to know for sure what the full scope and extent of this disruption will be, or exactly how it will affect Canadian commercial mortgage markets. However, there is no question that it is already having an impact, and we expect more.

This article looks at how this disruption is affecting our commercial mortgage markets today, and what we might expect in the coming months.

What Is Happening Now

To date, the short-term impacts of Covid-19 on Canadian commercial mortgage lending have been seen primarily in adverse changes in property cash flows and borrower requests for payment relief on existing mortgage loans:

• A large volume of borrower requests for mortgage payment relief have already been made to commercial mortgage lenders. Payment relief commencing April 1 has been requested by many borrowers but is being rejected by lenders on many loans because March 1 rents were actually collected. It will be a very different situation however with respect to mortgage payments due on May 1.
• Lenders and their loan servicers are now “sorting through” these borrower requests to identify which are reasonable, and if so, what kind relief should be granted and for how long.
• It is strongly recommended that borrowers be proactive, prepared and cooperative in responding quickly and fully to lenders requesting additional information in response to requests for payment relief. At a minimum, borrowers should be prepared to deliver updated property level operating statements, rent rolls and net worth statements for all loan parties.
• Lenders will ask borrowers (including related sponsors) to make an early and meaningful “commitment” to their assets, by funding realty taxes, operating costs and at least some portion of their mortgage payments from both property and non-property sources during the requested deferral period. Borrowers or related sponsors who have the capital or other resources to fund these amounts but refuse to do so will be viewed negatively by lenders when deciding whether or not to grant payment relief.
• It seems obvious, but borrowers (or their related sponsors) who continue to make equity distributions or who pay “out-sized” compensation to senior management during the requested relief period will likely be refused any form of payment relief.
• Although it is still early, lenders generally appear to be willing to kick the can down the road by granting short term deferrals (i.e. generally up to 3 months) of principal amortization payments, and in some cases, interest payments. Longer term deferrals are generally not being considered at this time. All deferred payments will bear interest and compound interest at the rate specified in the mortgage, and will have to be paid to the lender in full within 6-12 months.
• Initially, short term deferrals will likely be granted with few, if any, lender conditions, other than updated reporting requirements, restrictions on equity distributions and payments on unsecured debt, and a promise to pay any excess net operating income to the lender. More significant loan modifications, including loan reserves, cash management (temporary or permanent), new loan covenantors, and other borrower concessions, may be appropriate if extensions of the initial period of payment relief are required.
• Borrowers who are (truly) unable to pay realty taxes, property-level operating costs and its HST/GST remittances relating to the property during the requested relief period pose a much more serious problem for lenders. Lenders facing any of these issues on a loan may be unwilling to consider payment relief, because it will prevent or delay the lender in taking the steps required to protect its collateral or prevent erosion of the intended priority of its security.
• If payment relief is agreed to by the lender, all loan parties (including all loan guarantors and beneficial owners) should enter into a written agreement clearly documenting the form, term and applicable conditions of the relief. This agreement should confirm the continuing loan obligations of each loan party (other than those being amended). Initially, this agreement can be a simple form of letter agreement.
• Lenders with outstanding loan commitments which are “firm” but not yet closed must seriously consider whether or not to invoke any “force majeure” or other “market out” clauses in their commitments. The application of these clauses in any given fact situation will depend entirely upon how broadly or narrowly they are worded, and whether the lender exercises its termination rights in accordance in good faith. Borrowers who have no realistic financing options other than commitments which are subject to these potential lender termination rights would be well-advised to “get ahead of the problem”.  An open dialogue between the borrower and lender is usually the best approach.
• Certain “alternative” lenders who rely on “open” investment funds as their primary source of loan funding have experienced a high level of redemption requests from investors and have “gated” their funds. For the short term, these lenders will not be writing new loans.
• On a positive note, both last week and this week, other Canadian lenders have advanced new commercial mortgage loans on various asset types, although the details of the individual loans and lender commitment obligations are not available at this time.

What Could Happen

To some extent, any predictions as to what could happen in the future are simply “crystal ball gazing”.  All predictions are highly dependent on the length and depth of the current crisis and the inevitable follow-on recession. But based on the U.S. experience during the “Great Recession” of 2007-2009 (which had a devastating effect on U.S. mortgage lending for many years), there is a reasonable basis to expect some or all of the following:

• The single biggest issue that all mortgage lenders face today is getting a handle on property valuations. The widespread interruption of property-level cash flows, the uncertain prospects of a quick economic recovery and the likelihood of an uneven recovery across various market sectors and asset classes have made property valuation a very difficult problem. Borrowers should expect a temporary pause in new lending in most market sectors and asset classes while lenders assess the length and depth of this disruption and its actual impact on property cash flows. This is not simply a mortgage market issue, but also affects the liquidity, caps rates and trades of real estate across the board.
• It is too soon to make any meaningful predictions as to the scope and extent of future Canadian commercial mortgage loan defaults and real estate insolvencies in the new Canadian mortgage market paradigm we are now facing, other than to say that the extraordinary real estate bull market of 1997-2019 is probably now over and it seems almost certain that there will be a meaningful increase in mortgage defaults, loan losses and real estate insolvencies. Mortgage lenders should underwrite and price the new risk paradigm accordingly.  Conservative loan underwriting will predominate in the short to mid term.
• Depending on the volume of payment relief requests and potential loan defaults they are now facing, as well as other internal and external factors outlined below, it is reasonable to expect many Canadian mortgage lenders to scale back or, in some cases, simply stop all new mortgage lending.
• Many Canadian mortgage lenders have very few (and in some cases no) senior management or staff who have ever seen a Canadian real estate recession of any kind, let alone a market disruption of this scale. Many of these lenders do not have the internal servicing experience, resources or protocols required to deal with the avalanche of relief requests and potential defaults on their current loan book, let alone make new loans. On the positive side, more experienced and better capitalized mortgage lenders will not only survive this crisis, but will thrive.
• In the near term, it will be difficult, or at least more expensive, to finance properties that are development assets, which have weak sponsors or are poorly capitalized, or which are in the harder hit market sectors, such as retail and hospitality.
• Lenders of new mortgage loans will ask for stronger protections and controls over mortgaged properties and loan parties, including stronger borrower sponsors and loan covenants, “market flex” pricing provisions (which allow a lender to unilaterally increase pricing in volatile markets), loan metrics and covenants which focus on ongoing cash flow, EBITDA and minimum borrower capital and liquidity, loan reserves, cash management, more frequent and detailed financial reporting (both property level and for all loan parties), and use of special purpose entities (SPE’s). Lender approval rights over changes of control of loan covenantors (including ultimate sponsors) will likely expand.
• In addition to the more frequent use of SPE’s, we expect that there will be a special focus and emphasis by lenders on minimum equity and minimum liquidity requirements for loan covenantors (including sponsors) on an on-going basis, with periodic (quarterly) testing of these requirements during the loan term.
• The financial strength and liquidity of property tenants (particularly anchor tenants) will be particularly important to future loan underwriting. Prior to the current crisis, tenant-level reporting was sparse to non-existent. Landlords and their lenders must make it a priority in the next 2-3 months to figure out what type of tenant-level financial reporting, if any, is reasonable and practical on an ongoing basis. Since many tenants have asked for rent concessions, there is an opportunity today for landlords to require, at a minimum ongoing tenant financial reporting as long as any existing or any future mortgage lender requires it