Distressed Sales Increasing, Triggered by Interest Rates

The consensus in the financial markets is that the Bank of Canada (BoC) is finished raising interest rates. This does not mean that the struggles of a rising-rate climate are over. In fact, two things need to be understood. First, interest rates will likely stay higher for longer. Second, because monetary policy functions with a lag, last year’s rate hikes are still rippling through the Canadian economy.

And, yes, this includes the Canadian commercial real estate market. In recent months, the industry has witnessed firsthand how much higher rates influence the market by assessing the distressed sales data. What is a distressed sale anyway?

Distress Sales: A Primer

A property sale is considered a distressed sale when it is sold quickly and almost always at a financial loss to the seller. In most cases, the seller is under economic duress and needs the funds from the sale to pay debts or cover other obligations.

The Rise of Distress Sales

In today’s commercial real estate market, the number of distressed sales is increasing.

This is primarily due to rising interest rates that have resulted in smaller developers being forced to sell at a loss. At the same time, large institutional and private developers are using this opportunity to acquire properties at lower prices. There are also plenty of instances where a distress sale occurs due to a court order, as the sellers are stewing in dire financial situations.

Apart from the problem of rising interest rates forcing small developers to sell at lower prices, another challenge the industry is enduring is the growing number of new entrants in the commercial real estate market. Indeed, the Canadian commercial real estate sector has low barriers to entry and a higher expected rate of returns.

That is why real estate development is becoming increasingly attractive to local and foreign investors. However, the setback might be that new entrants have limited experience in this corner of the real estate market and, as a result, often underestimate the capital and time they need to purchase a property. They typically do not possess the skills to navigate the developmental process and do not even have sufficient capital to fund them for more than a year of development. This paucity of experience is a significant factor resulting in distressed sales by small developers relatively new in the sector. It is also vital to remember that construction costs have skyrocketed since the coronavirus pandemic.

Investment Costs: From Inflation to Regulations

According to a broad array of estimates, construction costs in Toronto, for instance, have swelled between 10-17%. .

In addition, development charges by municipalities have also increased immensely at an accelerated pace.

Finally, the high level of construction activity in high-demand areas has led to a reduction in quality trades and manpower, which in turn affects construction schedules and can often cause delays and increased costs. This is especially true if provincial or municipal regulators do not provide their seal of approval for the commercial projects, forcing the company to return to the site and improve the building.

Ultimately, not only does this result in financial losses, but it can also have a negative impact on the quality of the final product and the need for extra repairs or deficiencies. Commercial real estate developers must either increase their selling price or accept lower rates or returns. In some cases, high construction costs and excessive delays can render the developmental project unviable, forcing the developers to abandon the deal or get rid of the property at a financial loss.

The Lack of Sophistication

Often, developers will raise capital from unsophisticated investors. They raise millions of dollars by convincing investors their investment is secure and will be income-generating assets. The disclosures by these developers can sometimes be misleading. By the end of the development process, these unsophisticated investors can become shocked when they realize the property value is not what it was initially stated, and they end up losing hundreds of millions of dollars.

When this happens, they have no other choice but to sell at whatever price they can get to recover what they can from their investment.

Finally, there are situations when developers take on too many projects simultaneously. Even a slight delay in one project or additional costs in another can ignite a cash crisis in these types of situations and can then potentially impair other projects. The risk for developers in such a situation is immensely high, and if they become strapped for cash, they often have to turn to lenders with higher interest rates.

Unfortunately, cash flow problems can start an adverse chain event for many of these developers, which can be further complicated if the developer has multiple lenders. They can end up paying exceptionally high interest rates, construction delays, and higher construction costs. In circumstances where they cannot generate the cash, they need to address all these multiple problems; they have no choice but to sell their property at a significant financial loss.

A Volatile Experience

The commercial real estate sector can be quite volatile and is often led by the highs and lows of interest rates.This is why the industry pays extra attention to what the central bank does since its actions can support or hinder growth in the real estate industry and other parts of the economy that are sensitive to higher or lower interest rates.

It is essential for commercial real estate developers first to gather the necessary experience and then take on massive projects. It is also crucial for commercial real estate developers to be well-capitalized and maintain access to reasonably priced capital in the event that they need money urgently.

In the end, being prepared for unforeseen circumstances is a must, and that is often something novice developers fail to grasp. So, when they are in a financial crisis or they are operating in an economic climate that is enduring a recession or stagnation, developers and owners will have no other alternative but to resort to a distressed sale. And this could manufacture a cascading effect for the entire sector.

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