by Dru McAuley
The mortgage market is constantly evolving. Below is a summary of a mortgage product in the marketplace that some borrowers might not be familiar with.
Conduit Mortgage Financing
This is a term used to refer to the act of securitizing a commercial mortgage, including conventional mortgages on apartment buildings. Pools of mortgages are created by issuers, who then resell the mortgages as securities to their retail and institutional clients. If a single asset is large enough, the mortgage may be securitized and sold as a standalone. The securities are referred to as Commercial Mortgage Backed Securities or “CMBS”. These should not be confused with CMHC insured securitized mortgages (do you have any MBS in your RRSP?), for which there is a mature market in Canada.
Conduits emerged as the answer to problem loans on the books of failed Savings and Loan companies (known as “Thrifts”) in the US in the early nineties. Financial institutions that were stuck with non-performing loans sold them to firms that became the “conduits” to Wall Street, where the mortgages were sold as securities to investors by Wall Street firms. The mortgage securities were well received by the market and the business flourished. As the conduit market matured, the activity spread to Canada.
Reliable data is scarce, but the volume of new commercial mortgage business in Canada is estimated at between $12 billion to $15 billion each year. From the first issue in Canada in 1998, it is estimated that CMBS now makes up about 20% of new commercial mortgage volume annually. Furthermore, the amount of CMBS issuance in any given year could increase dramatically if a single life insurance company or bank decided to sell some of its existing mortgage loans as CMBS. Of the roughly $13 billion in CMBS issued in Canada to date, multi-family properties make up approximately 10% of the volume. Conduit financing has been well received by both borrowers and investors and this form of mortgage lending is expected to grow. Apart from filling an investment need at dealers, CMBS allows lenders to earn fees by selling and servicing the loans while freeing up capital.
What are the advantages for borrowers?
- Firstly, loans are usually approved without the requirement of personal guarantees, with non-recourse to the borrower except in cases of environmental claims, fraud, theft, malfeasance, misrepresentation, etc (referred to as standard carve-outs or “bad boy clauses”).
- The benchmark term is 10 years, which has been an advantage to borrowers in the current low rate environment.
- The maximum loan to value ratio is 80%, versus the Canadian statutory maximum of 75% for banks and life insurance companies.
- More flexibility is available to borrowers on the amortization period, where 30 years is not uncommon.
- Less restriction on property location. Lending policies at many Canadian lending institutions preclude them from funding conventional mortgage loans in smaller towns. CMBS loans are less restrictive.
- Unlike traditional lending sources, there are no concentration limits with individual borrowers or geographic locations.
- Although the mortgage is closed for the term, the loan can be defeased in the event of early termination of the mortgage. Defeasance, in basic terms, is a substitution of the property being held as mortgage security by Government of Canada bonds that yield an equivalent revenue stream.
What are the disadvantages for borrowers?
- The third party reports (i.e. appraisals, engineering) may cost slightly more due to specific reporting requirements in order to meet securities regulations. Accordingly, conduit mortgages might not be suitable for loans under $1,500,000.
- Defeasance, in the event of early termination, can be expensive.
- Since the loans are eventually sold as securities via a prospectus that contains specific conditions, the lender may have limited latitude in amending certain aspects of the loan after closing (i.e. changing the amortization period.)
Conduit financing emerged in response to a market problem and has now become an accepted financing solution. Borrowers should consider its suitability as they review their financing options.