Commercial real estate a bigger risk than previously thought: OSFI

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Top banking regulator flags co-lending arrangements and lagging ratings changes among heightened risks

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Canada’s top banking regulator is flagging commercial real estate lending as a bigger risk than previously thought as higher interest rates persist and a practice known as co-lending increases.

The Office of the Superintendent of Financial Institutions warned in an Oct. 12 update to its list of the highest risks facing the sector that valuations in a fast-changing landscape could quickly become outdated and that trends including co-lending could increase default risks and recovery values.

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Among OSFI’s concerns is that ratings changes appear to be lagging market conditions, suggesting that risk assessments and collateral valuations used by financial institutions “may not appropriately reflect the risk environment.”

The regulator has alerted the banks that it is taking a closer look at how they are managing commercial real estate loans, and released interim regulatory guidance Sept. 29 that spelled out detailed expectations for processes and procedures including underwriting practices, debt service capacity assessments and portfolio management.

“The outlook remains difficult as seen through an increasing number of strategic defaults in the office space, falling real estate investment trust values relative to their historical net asset value estimates and rising U.S. commercial mortgage-backed securities delinquency and special servicing rates, especially in the office segment,” OSFI said in its Oct. 12 update.

Moreover, the regulator is noticing concerning practices in the commercial real estate market, in particular an increase in the use of co-lending arrangements such as layering and “participation” agreements where risk is “tranched” between multiple lenders and entities. 

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“They can affect lenders’ rights and remedies thereby impacting the probability of default and level of recovery values,” OSFI said, noting that these arrangements are a key reason commercial real estate is viewed by the regulator as a “higher risk item” than it was in April.

“These agreements don’t always have standardized contractual language and therefore can present additional risk to lenders based on legal, operational and structural complexities,” the regulator said.

The commercial real estate sector is a broad asset class for financial institutions, encompassing loans secured by income-producing real estate used for business purposes such as shopping malls and office buildings and loans extended to build or acquire them, as well as loans for residential real estate with five or more units such as apartment buildings where repayment depends on sale or rental income, and real estate held for lease to third parties.

OSFI noted that while office real estate has been particularly hard hit by the shift to remote and hybrid work, the entire category of commercial real estate including shopping malls and apartments must be scrutinized for increased risks amid higher inflation and interest rates.

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In the September guidance to banks and other financial institutions, OSFI warned that economic conditions were contributing to the heightened potential for a rise in borrower defaults.

OSFI is also taking a close look at residential real estate loans with an eye to addressing the problem of growing mortgage balances stemming from a popular product where monthly payments stay the same even as rates rise. These variable-rate fixed-payment mortgages result in what’s known as negative amortization when the fixed monthly payments no longer cover even the interest owed.

The regulator plans to publish the results an initial public consultation on its Guideline B-20, which covers debt serviceability measures, on Oct. 16. 

OSFI said it considered using loan-to-income thresholds to help financial institutions better manage the risks associated with significant buildups of household debt in their loan books. However, while this is a common tool in other jurisdictions, the regulator suggested it may not work in Canada, where lenders have different risk appetites and differentiated products in a highly competitive mortgage market.

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OSFI said the results of its annual review of the mortgage stress test, which the regulator imposed to measure a borrower’s ability to manage increasing interest rates, will be released Dec. 12.

“Our primary aim is to ensure that Canadian homeowners can afford to service their mortgages in good times and hard times,” OSFI said. “As a secondary goal, we aim to ensure that OSFI’s measures impact our regulated constituents proportionately such that all lenders in the federal financial system, regardless of size, can compete and take reasonable risks.”

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