OSFI Flags Risks in Canadian Commercial Real Estate Amid Rising Interest Rates

The Office of the Superintendent of Financial Institutions (OSFI) in Canada has highlighted commercial real estate lending as a heightened risk due to persistently high-interest rates and the increasing use of co-lending arrangements. In an update to its list of the highest risks facing the sector, OSFI warned that rapidly changing valuations in the real estate market, coupled with co-lending practices, could lead to outdated risk assessments. The regulator expressed concerns about the lagging changes in credit ratings, suggesting that the risk environment may need to be accurately reflected. OSFI has provided interim regulatory guidance to banks on managing commercial real estate loans, emphasizing detailed expectations for processes and procedures.

Of particular concern to OSFI is the rise in co-lending arrangements, such as layering and participation agreements, where risk is distributed among multiple lenders and entities. The regulator noted that these arrangements, needing more standardized contractual language, can present additional dangers to lenders due to legal, operational, and structural complexities. OSFI considers commercial real estate a "higher risk item" than in April, pointing to the impact of strategic defaults in the office space, falling real estate investment trust values, and rising delinquency rates in U.S. commercial mortgage-backed securities, especially in the office segment.

While the office real estate sector has been particularly affected by remote and hybrid work trends, OSFI emphasizes that the entire category of commercial real estate, including shopping malls and apartments, must be scrutinized for increased risks amid higher inflation and interest rates. The regulator is closely monitoring residential real estate loans as well, focusing on the issue of growing mortgage balances associated with variable-rate fixed-payment mortgages that result in negative amortization when fixed monthly payments fail to cover the interest owed.

OSFI is set to publish the results of an initial public consultation on its Guideline B-20, covering debt serviceability measures. It considers loan-to-income thresholds to help manage risks associated with significant household debt buildups in loan books. However, the regulator notes that such thresholds may not suit Canada's unique mortgage market, characterized by different lender risk appetites and a highly competitive landscape.