While the commercial mortgage-backed securities (CMBS) market in the U.S. awaits its anticipated return to normalcy, market players who are eager to keep transactions flowing may wish to explore lending and securitization options north of the border: With a recent tax policy change, the Canadian CMBS market has become a viable and potentially profitable alternative for U.S.-based firms.
Specifically, effective Jan. 1 of this year, the Income Tax Act was amended to eliminate Canada's withholding tax on arm's-length interest payments made to U.S. and other foreign residents (regardless of country of residence) – for the first time in 30 years.
Although the tax remains in effect in certain interest situations – including interest paid to a person with whom the payer does not deal at arm's length, as well as interest on participating debt – the new rules present enormous possibilities for cross-border CMBS activity, according to panelists who spoke at the recent Commercial Mortgage Securities Association Investors Conference in Miami Beach, Fla.
Non-Canadian lenders were previously at a major disadvantage in both pricing and structuring loans, said Douglas J. Klaassen, a partner at Stikeman Elliott LLP.
Tax rules proved to be at odds with many of the transaction features deal participants sought to include, and complex requirements from the Canadian Revenue Agency – including specifications on assignments, participations, permissible events of default and other technical issues – presented additional snags.
Consequently, very few classes of Canadian CMBS were sold or held by U.S.-based investors – despite generally strong Canadian credit fundamentals and a creditor-friendly legal environment that otherwise would have likely been extremely attractive to U.S. investors in particular, the panelists noted.
Klaassen predicted that under these appealing new tax rules, many U.S. lenders will be interested in participating in the Canadian CMBS market ‘at some level. It may not be a full-scale lending platform, but it will probably be a very selective and strategic move.’ Collectively, this activity is expected to benefit both the U.S. firms and the Canadian market itself.
{OPENADS=zone=16}According to Klaassen, offerings that lenders can now provide arm's-length borrowers in Canada on a ‘cost-effective and competitive basis’ encompass a wide range of products, including revolving facilities, warehouse facilities, construction loans and term loans. Most importantly, foreign lenders are allowed the same flexibility as Canadian domestic lenders.
At the same time, U.S.-based participants considering entry into the Canadian CMBS market should keep in mind certain key differences in the two countries' respective CMBS histories, climates and general philosophies.
For example, the recent separate lifting of investment restrictions on non-Canadian investments for investors within the country has tilted a previously balanced supply-and-demand relationship.
‘All of a sudden, you had foreign issuers coming into Canada doing what were called 'maple deals,'’ explained John Ho, a Canada-based managing director at Merrill Lynch Mortgage Lending. ‘We found that as the volume of our product was growing, the demand was no longer there. We were creating more bonds than could easily be absorbed.’
He added that the latest tax elimination will give Canadian market players greatly improved access to selling bonds.
As for the CMBS content itself, although supersenior structures were recently introduced in Canada, ‘In the U.S., you have some slightly more innovative and complex structures,’ Ho noted. ‘We're still using more vanilla structures.’
The most striking difference between the two CMBS markets, however, is health – especially right now. According to Ho, Canada's market has derived its strength from a general investor – and even borrower – aversion to such risky deal structures as sky-high loan-to-values, interest-only and pro-forma underwriting, all of which, of course, have been looked upon with widespread suspicion and disdain in the U.S. only after the subprime residential meltdown and corresponding CMBS troubles.
{openx:14}Perhaps not surprisingly, over 10 years and over $20 billion of bonds outstanding, only about six or seven loans in the Canadian market have run into default – technical or otherwise – and no losses have occurred, he added. Cashflows have been 100% on schedule.
But despite the recent tax break that has made this alternative CMBS market more accessible, U.S. CMBS players looking north for refuge from credit woes must still keep in mind certain regulatory considerations, the panelists pointed out. In particular, the Canadian Bank Act requires banking activity performed by foreign firms and their affiliates to be done only through an authorized branch or Canadian subsidiary.
Whether CMBS structuring and securitization are considered ‘banking activities’ will depend on a number factors specific to each transaction and the parties involved.
E-DEALMAKERS
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