Commercial real estate market faces 'very trying times,' analysts' report warns

Canada's commercial real estate sector faces "very trying times" that will send owners into creditor protection as the market corrects from overblown valuations during the last cycle, PricewaterhouseCoopers warned in a report Monday.

"We're very pessimistic, and we think there are going to be big issues in the Canadian real estate market," Holly Allen, managing director for PwC's real estate practice in Canada, said in an interview.

"We think there are going to be foreclosures and default situations on some of the buildings."

Allen said Alberta is particularly vulnerable, due to an oversupply of product and weak demand driven by tumbling prices for natural gas, which constitutes a significant portion of the province's energy industry. Further pressuring the industry as a whole has been the collapse of the commercial mortgage-backed securities.

"The credit crisis and ensuing recession have dragged commercial real estate markets into very trying times, marked by value losses, rising foreclosures, and reduced property revenues," Frank Magliocco, leader of PwC's real estate practice in Canada, said in the report.

"Owners need to ... immediately identify what options are available to overcome inevitable refinancing hurdles," said Magliocco. "In some cases, a formal restructuring process, equity injection or other non-traditional strategy may be beneficial."

The report identified hotel and leisure properties, and suburban office and industrial space as pockets of weakness. It also said properties in secondary markets and small- to medium-size strip malls are at greater risk than properties in large urban centres or iconic mall space.

Without putting a number on it, PwC said "a large cohort" of commercial real estate renters are facing "significant financial or operational challenges."

Yet at the same time, the cost of capital has gone up, while access to that capital has diminished, Allen said. In the past, lenders would be willing to finance up to 85 per cent of the property's value. Now they will finance 60 to 65 per cent of a property's value, forcing borrowers seeking refinancing to make up the difference. And they're charging a higher interest rate to do so.

Still, the situation in Canada is nowhere near as desperate as in the U.S., where shoddy lending practices have created a "huge problem," said Earl Sweet, managing director for economic research for BMO Capital Markets.

It is now almost impossible for property owners south of the border to secure new financing once existing financing matures, Sweet said.

In many cases, that means being forced to sell properties at below-market values and has led to a 40-per-cent collapse in prices since the market's peak in mid-2007.

Canada, however, doesn't have the history of lax lending practices that put the froth into the U.S. market and later helped bring it down. As well, the sector's past two decades have been marked by extremely cautious investing since the debt-ridden bust the Reichmann family's Olympia & York in the early 1990s.
"I wouldn't agree that it's a dire situation," Sweet said. "Will there be a default? Will there be a foreclosure? Sure, there are going to be some. There always are."But is there going to be a massive flood of them like in the U.S.? No."

(prepared by John Morrissy/Financial Post)