Category: Real Estate

The slate is being cleaned

Slate Office REIT (TSX: SOT.un) today announced an update on its “portfolio realignment plan”, also known as “We’re trying to dump this stuff as fast as we can but can’t find anybody willing to pay a price that will pay down the mortgages” plan:

Slate Office REIT (TSX: SOT.UN) (the “REIT”), an owner and operator of high-quality workplace real estate, announced today that it continues to make progress on its previously announced portfolio realignment plan, and in connection with the foregoing, continues to engage with its senior lenders to determine a mutually acceptable path forward in respect of its obligations to such senior lenders, including in respect of its revolving credit facility. The REIT also announced today that, notwithstanding those ongoing discussions, its senior lenders have provided notices of default, which currently restrict the REIT from making further payments of accrued interest in respect of its outstanding debentures (collectively, the “Debentures”), for so long as such defaults have not been cured or waived. The REIT has determined that based on the information currently available to it, there can be no assurance if or when a cure or waiver in respect of such defaults will be achieved, and as such, the REIT does not expect to make the cash interest payments due on June 30, 2024 in respect of its 7.50% convertible unsecured subordinated debentures and 5.50% convertible unsecured subordinated debentures, nor does it expect to make the cash interest payment due on August 31, 2024 in respect of its outstanding 9% convertible unsecured subordinated debentures. Pursuant to the trust indentures governing such Debentures, failure to pay interest on the Debentures for 15 days following such interest being due will give rise to an Event of Default under the terms of the Debentures.

Needless to say, it isn’t looking good for them. This could be inferred from previous public filings, in addition to them having to beg to shareholders to go above their prescribed asset to debt ratio.

My attempts at being a corporate raider (November 2022) was incredibly brief before I came to the conclusion that there’s no way to win.

My question is not necessarily for Slate (we will see how George Armoyan can try to salvage this situation) but rather whether there will be any ripple effects in the office REIT sector if Slate does decide to go into CCAA. In the sector include AP.un, D.un, SOT.un, TNT.un, and diversified REITs which contain significant office components including BPY/BPO (preferred shares), HR.un, AX.un, and to a lesser extent MRC/MRT.un.

Canadian REITs

Here is a quick snapshot of most of the major Canadian REITs today. Pay attention to the very right-hand column, which is the Year-to-date performance of their units.

I’ll note that they are all universally down for the year.

Considering that such entities are heavily leveraged with debt to maintain the financing of their property acquisitions, this is not surprising. They are recipients of a double-whammy – higher interest rates will decrease their reported asset values (as they get appraised, they will drop), while at the same time, floating-rate debt will cost more, and any fixed-rate debt that renews will incur a higher financing charge. There is also the problem of what happens if the asset collateral declines in value to the point where the company cannot renew the debt.

CapREIT (TSX: CAR.UN) is an interesting example. Looking at the June 30, 2022 snapshot:

* $260 million outstanding in floating rate bank loans
* They have $6.6 billion in mortgages payable, 99% of it at fixed rates. The average effective rate is 2.62%.

I’ll spare the agony of going through this in detail (page 45/46 of their MD&A) and just leave it here. Suffice to say, they’ve done a pretty good job insulating their interest rates for now. But they will have to renew these debts at higher rates, assuming the existing rate structure continues. A 1% rise in interest rates results in a $68 million increase in interest expense.

At the current financing arrangement, in the first half of the year CAR.UN made approximately $200 million in FFO, or about $400 million annualized. With 173 million units outstanding, this is $2.31/unit or a current price/FFO of 5.7%. Not a huge return over the risk-free rate.

Interest rates have risen from 0.25% to 3.25%, starting March 2, 2022. While it will not be an instantaneous increase in financing expenses for CAR.UN, it will continue to eat away at their bottom line, unless if they are able to raise rents to compensate.

In a country with one of the highest rent to income ratios for our urban centres, it will be very interesting to see how much higher rents can ratchet.

CAR.UN is nearly entirely residential. The same math works, albeit with different wrinkles, for the commercial, office and industrial REITs, the latter sector historically being in the highest amount of demand.

But as the strangle of higher interest rates persists, these REITs, all of which are very leveraged, will continue to see financing pressure, especially if they do not have the ability to raise rents to compensate.

One would wonder if we are entering into a bad recession how much demand there would be for things such as office space and how much pricing power there would be to open an office in an urban centre. This likely explains why office REITs like Dream Office (TSX: D.UN) have been massively hammered. I would suspect residential would do better than office REITs, but what happens to people when they are unemployed and can’t afford to live in the city? This probably explains our current government’s immigration policy, which is to bring in approximately 440,000 people a year for the next few years, most of which will come to the urban centres.

My other last comment is that I think the 32% drop in CAR.UN year-to-date is highly reflective of the overall state of the real marketplace in terms of residential real estate – just that in the land title markets, the bid/ask spread is so high for individual properties that this magnitude of price decrease has not registered yet. Sellers still want their November 2021 peak pricing, while buyers cannot raise their bids because they can’t get dirt cheap financing any longer.

The next 10% is going to be very difficult

The rules change in a tightening monetary policy environment. We saw shades of this in the second half of 2018 when the US markets started to vomit over QT and increasing interest rates, and to a lesser degree this happened to Canada.

Recall that the S&P 500 in 2019 very roughly averaged price levels that are about 25% below where it is currently trading at. When factoring in monetary debasement, one can surmise that a “2019 neutral” level would be somewhere around 3,500 but this was with much better economic conditions, coupled with a justification for a sky-high P/E ratio due to extremely low interest rate levels. The average 30-year bond yield in 2019 was lower than it is currently trading at. A more realistic level, all things being equal, would be around the 3000-3200 level (20% lower than present).

Fast forward to 2022 and we are seeing shades of late 2018 – although of course the big difference is that in 2018 central banks could reverse course because inflation back then was at a manageable level. The mandate for higher interest rates is omnipresent with the latest CPI print out of the USA at +8.6% and the latest CPI snapshot in Canada will be released in June 22 and indications definitely suggest it will be up there.

What is particularly damaging in Canada is the spike in mortgage rates. This is going to kill credit in the real estate market:

The 5-year fixed rate is the most common form of mortgage, and from June 2017 (2.4%) to June 2022 (4.3%) is a 190bps increase.

What does this mean in reality? Let’s say in June 2017 you took out $1M in credit financing at 2.4%, with typical terms (25-year amortization). At the end of June 2022 you would be sitting at an $845k balance after making $53.2k yearly payments.

You go and renew this $845k balance at 4.3%, for a 20-year amortization, and you will be paying about $59.5k/year for the next five years – about $528/mo out of your pocket.

Credit has gotten much more expensive. People can mitigate this with a variable rate mortgage, but the Bank of Canada has made it crystal clear that short-term rates will be going higher. For how much longer – who knows. There are conceivably scenarios where if central banks can not get a hold of inflation that short-term rates will be going considerably higher than the so-called “neutral” rate target of roughly 3%. If this occurs, variable-rate mortgages will be under increasing stress.

The point of the above exercise is that unless wages increase dramatically, available credit to be dumped into the real estate market is going to be more expensive and this will be depressing the prices of housing going forward. Since construction is a significant component of urban economic activity, this activity will likely be slowing down as a result – once projects complete, that will be it.

The disaster scenario is that unemployment will spike and you start seeing waves of selling due to foreclosures. It is a scenario that is the big fear for Canada’s mortgage insurers (CMHC and formerly Genworth, now Sagen owned by Brookfield) where you start seeing underwater mortgages. The Bank of Canada is clearly looking at these economic scenarios and I do suspect there is an element of a “Macklem put” in play here – the country simply cannot afford to have a mass collapse in real estate pricing.

Negative economic reverberations would hit the commodity markets as well and higher rates will be triggering this. This is going to make equity picking in the commodity market much more trickier than it has been in the past 24 months.

Even if raw commodity prices take a 25% dip from present prices (e.g. spot WTI from $120 to $90, spot natural gas from $9 to $6.75, etc.), most Canadian (edit one day later: forgot to include a very important word here: ‘energy’) equities are still well positioned to make historically large amounts of free cash flows. However, sustaining capital expenditures will inevitably get more expensive and profitability will diminish, albeit will still be ample. There is likely going to be price volatility as the market grapples between the notions of total returns (their total returns will likely be much higher than companies in other sectors), coupled with pricing in a potential future downslope of raw commodity pricing – essentially pricing the walking down of the futures curve. December 2022 oil is $107.50 as I write this, while December 2025 oil is $74.75. Clearly if spot demand is higher, then existing producers are able to claim the surplus and hedging becomes expensive.

However, the capitalization of future profits (as determined by existing market prices) will continue to gyrate. For companies that are actively involved in share repurchases, these dips are probably more welcome opportunities and shareholders will inevitably be staying at least afloat while the rest of the market continues to tank. However, capital appreciation from this point is not going to be easy – most of the returns will be of the total return type. As I illustrated with an earlier post about Birchcliff, I don’t believe that an investor should be banking on share appreciation, but rather they will be receiving a high dividend stream – in the case of BIR, a healthy double-digit return of cash at the current market rate of $11.75. As raw commodity prices fluctuate, you will see this deviate up and down and this will make for a difficult price environment where, as the title says, the next 10% is going to be very difficult. Getting out of debt and holding ample supplies of cash is going to make people feel very comfortable in this environment.

Canadian housing stats vs. Mortgage Insurance

Genworth MI (TSX: MIC) has taken a hit over the past three weeks due to statistics that housing sales and average prices are declining nationally, according to a CREA report. Another sensationalist headline (“Canada’s average home price drops over 10% year-over-year in March”) is here.

Genworth MI stock rose in the month of March partially due to the company going on a buying spree on a stock buyback – it bought back 1.2 million shares. Other than that, there has been consistent selling pressure.

The report cites the impact of the B-20 regulation from OFSI, which increases the qualification criteria for people to obtain non-insured residential mortgages.

There are two factors here as it relates to Genworth MI that are being confused: 1) the pool of potential insurable mortgages, 2) what exactly the implication of average pricing statistics entails.

Aggregate Statistics

What market participants are failing to understand is that statistical averages fail to capture the economics of the mortgage insurance market, even in a declining average price environment and are probably taking down the stock due to incorrect reasoning (which usually leads to an environment where the stock will be undervalued).

The national housing price statistics are dominated by three regions: Toronto, Montreal and Vancouver. The “right-side tail” of the distribution of housing prices in the Toronto and Vancouver markets (especially in single-family residential) are dominant factors in statistical mean pricing. For instance, if your housing market consisted of a $3 million house, a $1 million townhouse and a $500,000 condominium, a 10% decrease in the house price would dominate over a proportionate decrease in the townhouse or condominium price, due to price weighting.

Vancouver is an extreme market, partially due to the huge influx of foreign capital buyers, which the government is actively trying to curtail. The 95th percentile of the real estate market is dominated with speculation from foreign (mainly people connected to Mainland China) buyers and asking prices have been decreasing in the hundreds of thousands of dollars for single family dwellings in the Metro Vancouver region. I have been paying less attention to the Greater Toronto Area, but apparently there is a similar mechanic going on there.

As a result, when speculation moves the 95th percentile market, it will result in massive price swings that have powerful effects on aggregate mean statistics. There is a “bubble-down” effect on the remainder of the real estate market, but this is more diffuse and domestic demand for lesser priced properties serves as a buffering effect for the absolute decline (not percentage decline) in those prices. It pays to longitudinally study properties that are in the 50th percentile (i.e. using median statistics) as a more intuitively accurate grasp of what is going on. These usually aren’t published.

Mortgage Insurance Eligibility

Keep in mind that properties over $1,000,000 are not eligible for mortgage insurance. Secondary residences in Vancouver, Calgary and Toronto are up to $750,000. (Good luck with this amount in Vancouver!).

Net Impact to Genworth MI

The only impact I would expect from what is happening in Vancouver and Toronto is that less mortgage insurance will be written – this is derived from the decrease in re-sales of real estate. The quality of the underlying insurance portfolio will also exhibit a higher loan-to-value ratio as prices normalize, but as mortgage insurance services the more “retail” element of real estate purchasers, I would expect them to continue paying their mortgages and amortize the existing debt amounts – 15% of the debt is amortized in 5 years with a typical 25 year amortization period and 3% interest rate. Employment is a much bigger driver – I would worry if unemployment rises.

Genworth MI will report the first quarterly report in late April or early May – I would continue to expect to see very good numbers posted with respect to loss and severity. Book value should also creep up another 60-70 cents per share, which would bring it close (but not quite) to $44. At the current price of $39, they are trading at a moderate discount.

Seemingly the only variable that will dampen Canadian Real Estate

I’ve written a lot about this in the past, but Canadian real estate in urban centers is simply about too much capital chasing too little yield. Financially it makes sense to borrow at 2.83% like REITs such as Rio-Can (unsecured debt!!) and turn it around and invest it in a real estate yield product at 5.8% and pocket the difference in income.

This only becomes dangerous when credit markets start shutting down and you’re facing a cascade of debt maturities, or the collateral backing your loans (in this case, real estate) has a material mark-to-market drop (and then your debt leverage ratios will go out of whack and nobody will want to lend you money).

So I will bring your attention to interest rates. I’m fairly convinced at this point that until interest rates start rising (or we start seeing provincial governments enact serious foreign capital restrictions that can’t be easily bypassed like it is in British Columbia) we are not going to see any collapse in real estate pricing in Canada.

However, the US Federal Reserve is going to start to rise all boats fairly soon, and this will likely have knock-off effects in the rest of the world, including Canada.

I’m looking at Canadian interest rates at the Bank of Canada, and notice those longer term yields start to creep up again – 5-year government bond rates are at 1.23% and the trend on yields are seemingly upwards.

It remains to be seen whether this is white noise or whether this is the start of a trend, but it is something worth watching. If interest rates normalize to something resembling historical standards (e.g. 2% higher than present levels), Vancouver residential real estate that is currently renting for a 3% cap rate would be selling for a 5% cap rate – the result would be a 40% drop in price. This is not a prediction, it would be financial reality if a 2% rate increase occurred. Leverage has gotten to the point where such a change in interest rates would cause significant financial dislocation and this is likely why central banks are very afraid to make sudden changes to short term rates.