As I have explained to many at OREIO (the real estate investing group I founded, www.oreio.org), the world of commercial lending is very much different from that of muli-family residential (4 units or less).

In recent months things have changed drastically. A year ago if you were a good covenant and you had a building that cashflowed, there were several lenders falling over themselves to get you financing. With CMHC on board they were willing to go as high as 85% of purchase price.

Today this is no longer the case, thanks mostly to the crash of the real estate market in the US. Conventional mortgages in the commercial space typically are defined as 65%. Anything above that is considered high ratio and CMHC gets involved. Compare that with 80% LTV conventional on the residential side.

Lenders are now evaluating the buildings based on, not surprisingly, the income and expenses. If after looking at the income and expenses they determine that the net income only supports a certain mortgage amount, then they will offer that amount, regardless of the purchase price. Location is also a critical element. It must be in a major urban centre.

Translation, you the purchaser must come up with the difference. If you get a VTB, great! Take it!

If you go high ratio, CMHC will also do their own cashflow analysis and provide their own estimated value based on their market data. This will likely be higher than what the lender determines, but still likely lower than your purchase price.
Yes, CMHC will still go to 85% LTV… of their estimated value based on many variables, but primarily the net income.

On the residential side, it’s business as usual. Banks still need to make money and the best way they can do that is on a mortgage (cashflow in is still king). Rates have inched up slighly, but that’s due to market pressure (over night lending rate) and little to do with the Bank of Canada prime lending rate.

The prime lending rate did drop 0.25% today for those that missed it amongst the flurry of recent annoucements. Bank prime lending rate now stands at 4%. Expect 5 year rates to drop in the coming weeks, but not significantly.
That’s my education minute for commercial lending.

I had the pleasure of listening to Benjamin Tal, senior economist with CIBC World Markets. I’ll give his write up at the end.

I’m going to provide the highlights and let you draw your own conclusions.

—

(In reference to the stock markets) We don’t know where the bottom is.

This is the worst economic melt down since 1929. (Notice he didn’t say it was worse than 1929, just the worse since then).

The single thing that is the trigger for the market crisis is the collapse of the US housing market.

First quarter of 2009, house prices in the US should stop falling. This will signal the beginning of the end of the current crisis. Prices were dropping at a rate of 5% per month. Things have slowed to a mere 0.5% per month.

In 2003 the household earnings closely matched the house value, as they have for the past 20 years. Since 2003 house values have spiked and as a direct result, the US Fed raised rates to slow the rise in house values. Unfortunately the mortgage brokers were very creative at this time and managed to “work around” the increase in the Fed rate. Result? A very large balloon market was created.

Today, the income ratio to house value has come back to “normal” or equilibrium.

Cumulatively the banks have lost $500B. The overall loss of equity in the market has been tagged at $700B.

Warren Buffet and many like him are actively looking for equity stocks. Basically today, they are bargins. They may still drop more, but the collective thinking is all these stocks will rise long term.

CIBC predicted back in 2003 that there would be a market collapse of $250B in the US housing market. Unfortunately they did not predict the additional $230B loss coming from foreign investment.

During the last few weeks, the cost of borrowing rose to an incredible spread of 6%. This was the beginning of the crisis as this kind of spread is simply unsustainable. The norm for the last few decades has been in the 1-2% spread range. Prior to that less than 1%.

There’s been some confusion as to why the US government signed a bailout package. “Isn’t this just giving the money to the markets who just lost it?” The statement here that I liked was as follows.

“They bailed out Wallstreet, in order to save mainstreet”. If the market doesn’t have cash, then they can’t lend money out. No lending means no one can purchase.

2010 should see the end of the crisis. Depending on the rate of inflation, you should see a rise in the prime lending rate.

Today variables are at prime +1. They’ll stay this way until the spread decreases and even then the best rate might be prime – 0.2.

Auto sales have been hit the hardest. Sales are down to 91 levels.

$700B in credit lost in the last 6 months.

Commodities are down across the board, but can’t stay down for long. The emerging markets will drive the cost back up again. Canada is looking at a growth of 30% in GDP due to China alone.

Demand in energy and food will continue to rise thanks to the emerging markets of China, India and others.

Grain supply will directly affect mortgage rates. Rise in grain prices influences inflation. Rise in inflation sparks a rise in prime lending rate, which in turn causes mortgage rates to go up.

Expect a rise in food costs of about 7-8%.

Core CPI doesn’t include food or energy. Someone asked why it doesn’t. Historically these two items showed wild fluctuations and it was difficult to predict and plan future changes based on something that might not be the same in weeks to come. It has been suggested that the Bank of Canada start including these items as they have stabilized and better reflect the prices being paid.

Inflation and spreads will naturally increase rates over the next 5 years.

Expect a 5-10% decrease in RE in Canada. He did mention that Ottawa seems to be inverse cyclical to the rest of the country, so prices may simply stabilize.

Metaphorically, we are in the 7th inning. There is light at the end of the tunnel. We are closer to the end than the beginning.

The stock market is always a key leading indicator by at least 6 months. Once the stock market finally settles, then we can start the recovery process.

–

Benjamin Tal

Senior Economist with CIBC World Markets. In this capacity, Bengamin is responsible for analyzing economic developments and their implications for North American fixed income, equity, foreign exchange and commodities markets. He also acts as an advisory capacity to Bank Officers on issues related to weath management, household/corporate credit risk and has lectured in the economics and business programs of various Canadian universities. Benjamin is also a regular commentator on financial and economic trends in the Canadian and Amercian media with regular appearances on CNBC, BNN, Bloomberg TV & radio, and was recently described by the International Monetary Fund (IMF) as on of Canada’s leading experts on the real estate market.

Well folks it’s been another exciting week on the markets.

Someone told me of an interesting observation. If you graph the increase in the market back from the late 30′s you’ll see a steady incline until about the early part of this decade. Post market “crash” or correction, you should see a return to this “steady line”.

What you need not expect is a steady growth from here. Instead what’s going to happen for the next little while, while everyone waits nervously to see what this all means to the average company, is the stocks are going to rise suddenly and fall just as quickly the next day. In otherwords, speculators, short sellers and day traders will have a great opportunity to make some money during this “yo-yo” effect.  Prices will settle eventually, but how close to the “steady” line is anyone’s guess.

The smart money is going to wait for 2 quarterly reports before deciding that company X is still on the mark.

In the mortgage world, people are still asking me “Can I get a mortgage”? You bet. Don’t forget this is primarily how banks make their money. If they were to stop suddenly, well they would STOP SUDDENLY. Kinda like jumping off a cliff. It’s not the fall that kills you. It’s the sudden stop at the bottom that creates havoc with your day.

Banks need to lend out money in order to make money. Yes they make it elsewhere (like fees, service charges, car loans etc.), but nothing beats the cash flow from monthly mortgage payments. In the banking world, like any business, cash flow is king.

They are a little more hesitant (read strict) on lending out. So they opt for lower risk, run of the mill, plain old residential mortgages. Have a salaried job, good credit? No problem. Anyting else but good credit. Expect higher rates to start if they are even willing to risk it. Bankrupt folks, are severely limited today. A year ago I had 20 lenders. Today? Two? Maybe.
Everyone is also telling me that the Bank of Canada has lowered it’s prime rate, why haven’t any of the banks followed suit? The goverment also put $25M in to the banking system, why aren’t things changing?

The banks were nervous before, because they saw their reserves being slowly eaten up. They now have cash, but they, like most consumers, are opting to “sit” on it until they can see what’s going to happen next. They want to be prepared to weather the next storm as it were.

So banks are holding onto their cash, consumers across the board are uncertain what to do, so do nothing. End result, no cash flow, economy slows. Feds see this and lower the prime rate, but the banks don’t move. Neither do consumers. Prices beging to rise and voila. The perfect recipe for recession.

How do we get out of this downward spiral? The best solution is to stimulate the economy. How does this happen? Traditionally the goverment offers incentives to consumers and businesses. Unfortunately, I think we’re stuck until both the US economy restarts and their housing market starts to show signs of life.

I did see one report from an economist at CIBC that said the US housing market is declineing less. In stead of declining 30%, it’s only declining by 10%. So the end is near! In another 6 months we might see a leveling off of prices.  That’s one glimer of hope.

The Canadian election is over. Not much change, which for the Canadian markets is probably a good thing. The real question is, will the powers that be recognize that they might have to do some deficit spending in order to recover from this mess more quickly.

In the US, I get the impression that Obama will be leading the change. That might make the markets happy, but you never know. Unfortunately, neither candidate has given any indication what they would do about the economy. Too much of a political hot potato. (Or potatoe as one former VP liked to spell it).