Distressed asset sales were a nominal and relatively consistent fraction of the Canadian investment property market in the first half of 2023, accounting for less than 2 per cent of total transaction volume. JLL’s newly released fall outlook on commercial real estate calls this “low by historical standards” and suggests lenders are key to the divergence from default trends seen in the United States.
Total deal value from distressed properties is lagging from earlier in the decade, hovering below $200 million for the first six months of this year. That compares to $920 million over 12 months in 2021 and about $800 million in 2020, when distressed asset sales equated to 2.6 per cent of the overall commercial transaction value.
The more modest sales volume from January to June also reflects a general slowdown in deal-making and a shift in buyers’ profile. Small investors and developers have driven a growing share of activity as institutional investors and REITs pull back, resulting in more deals in the $5- to $50-million range. “Asset sales over $50 million are accounting for the lowest amount of transaction volume in over a decade,” JLL analysts report.
They also hypothesize this new dominant segment of investors is well positioned to snag any appealing distressed assets that might come along, noting: “These groups are not subject to the same internal reporting structures as pension funds, REITs and fund managers, and are therefore able to transact faster and take advantage of more opportunities during a time of market dislocation.”
Looking at previous times of economic upheaval, dispersal of distressed properties peaked at 2.7 per cent of total sales volume in 2009 following the global financial crisis, while another upward surge occurred with the collapse of oil prices in 2014-2015. Throughout much of the rest of the past dozen years, 1 to 2 per cent of total transaction value has arisen from distressed properties.
JLL analysts typify Canadian lenders as more conservative than their American counterparts, tending to give more credence to historical and current data than to projections for forward-looking markets. As well, recourse loans are more prevalent in Canada, while prospective borrowers with dubious histories are more likely to be known and shunned given the smaller and more interconnected lending community.
Along with those structural controls, JLL analysts foresee a general reluctance to trigger receivership sales in the current market. “In the case of non-recourse loans, where the lender can only rely on the property for repayment, we anticipate lenders will work with borrowers to avoid taking back assets,” they submit.
That also appears to be the case in the U.S., where DBRS Morningstar has been tracking an upward tick of delinquent loans packaged in commercial mortgage-backed securities (CMBS). For August, the credit rating agency reports a delinquency rate of 4.1 per cent. That varies fairly significantly by property type, at: 0.3 per cent for industrial; 1.5 per cent for multifamily; 4.9 per cent for office; and 6.7 per cent for retail.
There have been more than USD $1 billion (CAD $1.35 billion) in newly delinquent loans in each month since the first quarter of 2023, and, each time, that volume has exceeded the balance of cured loans. For August, office properties underpin about 44 per cent of the new delinquencies with retail adding 39 per cent. The month also saw about USD $1.5 billion (CAD $2 billion) in loans transferred to special servicing to work towards resolving defaults, with about 51 per cent of that tied to office properties.
Distressed asset sales to liquidate nearly USD $419 million (CAD $565 million) in loans resulted in losses of about USD $218 million (CAD $294 million) for the month. DBRS Morningstar highlights similar sinking values of properties in newly delinquent loans — citing the Aon Center in Chicago, which now carries an appraised value of USD $414 million (CAD $559 million), down by about half from when the loan was issued.
“Many special servicers continue to hold on to the debt for longer and work out situations with borrowers,” DBRS Morningstar analysts observe.
Additional recent commentary from the credit rater projects that it will be challenging for many borrowers to refinance office properties. About USD $11.5 billion (CAD $15.5 billion) in office-backed CMBS are due to mature in 2024 in an environment with the highest vacancy rates in multiple decades, average asking rents often about 30 per cent lower than in the pre-pandemic era and expectations that valuations will drop lower as the market continues to respond to rising interest rates.
Older unrenovated buildings look particularly vulnerable. DBRS Morningstar finds that nearly two thirds (246 or 382) of properties facing loan maturity in 2024 were constructed prior to 2000. They also represent about 60 per cent or nearly USD $6.7 billion (CAD $9 billion) of the loan balance.
“Lease rollover will likely take a toll at all but the most recently built properties,” the analysis states. “Roughly 75 per cent of office loans maturing through 2024 will have trouble refinancing based on our analysis because of interest rates that are 3 to 4 per cent higher than when the loans were originated, higher expenses and waning demand.”
