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Wobbly Market Boosts Real Estate Financial Risk Concerns

10/05/2016


​Canada’s real estate and construction firms can take action to mitigate risk of restructuring or insolvency

Anxiety is making a comeback in Canada’s real estate and construction industry. Low interest rates, abundant financing and a booming energy sector have fuelled development across the country for many years, but the winds are beginning to shift. Prime land and development opportunities are harder to find. Costs are rising as governments raise fees and charges in an effort to rein in debts. The dramatic slump in energy prices has brought Alberta’s rocketing economy back to the ground. Concerns are rising about an oversupply of commercial space, the struggling retail sector, ever-increasing consumer household debt, and their implications for real estate and construction overall.

As clear skies and calm waters give way to stormier conditions, Canada’s real estate and construction companies could find themselves facing greater financial challenges. For some, those challenges could tip over into formal insolvency or restructuring. Yet companies can take proactive measures to forestall such a crisis. Understanding the current and emerging risks they face can enable firms to take steps to mitigate and manage those risks, ride out the business challenges ahead—and, more importantly, position themselves to capitalize on inevitable distressed-price acquisition opportunities.

The many drivers of financial risk in real estate​

After years of solid growth in Canada’s real estate sector, it’s easy to overlook the fact that real estate is still a business fraught with risk. There are no shortage of external factors that can push a company into financial difficulties. Macro-economic factors—falling commodity prices, changing interest rates or a prolonged period of regional recession—can quickly and drastically change a company’s outlook and balance sheet. Governments can cut infrastructure spending, eliminate key tax credits or introduce new fees or taxes. Environmental legislation and other regulatory changes can quickly throw development plans into disarray. A natural disaster or other unforeseen event can disrupt a company’s ability to do business. Overbuilding can cause companies to stumble when buyers don’t materialize.

In other cases, internal factors drive companies into distress. Employee turnover could rob a firm of key executives, managers or staff. An inexperienced management team might skip vital due diligence on a project; a distracted team might overlook a key indicators that something’s going wrong. The business model could be misaligned with the company’s strategy. A company may struggle to deliver timely, accurate and consistent financial reporting. Or a firm may simply be struggling with performance issues—from ongoing losses to poor cash flow and a steadily deteriorating balance sheet.

These are perennial issues, of course, that can create problems for companies at any time. When business conditions grow more challenging, it’s important that firms pay close attention to new, unfamiliar or unexpected areas of risk.

Emerging areas of concern

A number of real estate subsectors are showing signs of strain in the current environment, and could pose a growing risk to some real estate and construction firms across the country. Those with exposure to these areas of emerging risk would do well to invest time in better understanding the nature of the risk to their organization.

Overcapacity in condos, resort properties

While the condo booms in major markets—especially the Greater Toronto Area—seem to regularly defy naysayers, there are signals of distress in other markets. We’re seeing an increasing number of court filings for condominium developments and resort properties on the fringes of the GTA and elsewhere in Ontario, for example. Economic worries and cost overruns are at the root of many of these filings, to be sure; others, however, are the result of developers’ overestimation of market demand.

Retirement/seniors housing woes for smaller properties

While Canada’s aging population will drive demand for retirement housing, the companies invested in this sector are discovering it’s hard to generate the revenues need to maintain operations—much less achieve any margin. The problem is particularly acute for owners of smaller properties, as it’s becoming increasingly apparently that to be successful and absorb the management costs, seniors properties will need to be much larger than is commonly the case today. It’s unclear how this will be resolved, but in the short term a number of firms are likely to struggle.

Land syndication: Anxious investors a worry

Not surprisingly, lots of people want to take part in a real estate boom. But it’s hard for most individual investors or smaller companies to afford a sizeable piece of land or built property on their own. Land syndication allows these smaller investors to pool their funds and gain a share in a larger project—as well as a share in a potentially lucrative return on their investment down the road. There are many land syndicates across the country, and most are operated by reputable firms. But some individual investors don’t take the time to do proper due diligence, and find themselves dealing with a syndicate that has sold them the dream, but not much of a chance at a solid return. Should interest rates rise or the economy continue to wobble, anxious investors may try to pull their funds out of syndicates—only to discover it’s not easy to do so. If the trickle of exiting investors becomes a flood, syndicates across the country may find themselves reaching their breaking point.

Retail woes spell trouble

The retail sector is undergoing tremendous upheaval. Digital and mobile technologies, data analytics, online shopping and rapidly changing consumer behaviours and expectations are forcing retailers to rethink the way they engage, serve and sell to their customers. The shift is changing retailer’s real estate needs, from square footage to the number of locations.

As retailers struggle, and some simply succumb, landlords and property owners are facing significant challenges maintaining occupancy levels and pricing. Tenants are searching for rent reductions, lease changes and smaller locations. Landlords whose anchor tenants disappear suddenly face the prospect of losing their other tenants, who were originally lured by the now-departed anchor. For one property owner, the prospect of losing a major retail tenant was so daunting, the company actually funded the retailer’s restructuring. Unfortunately, smaller property owners are unlikely to have the resources to do likewise for their tenants, and a string of retail failures could spell severe trouble for these landlords and their investors.

As challenges grow, firms need to mitigate their financial risks and build liquidity

Canada’s real estate and construction sector faces stiffer headwinds than it’s experienced for some time. Many firms will encounter increasing financial risks as a result of broader economic issues and subsector-specific challenges such as those we’ve outlined above—and some will find those risks turning into full-blown crises requiring restructuring or insolvency proceedings. But rising risks today don’t have to mean financial distress tomorrow. Real estate and construction firms can take steps now to minimize the potential of running into a serious solvency issue down the road.

First, it’s vital that companies understand the full range of financial, operational and other business risks they face across the enterprise—both current and emerging. A robust enterprise risk management framework can provide a structure to help companies bring risks out into the open, under the full view of management. Once uncovered and identified, firms can explore each risk in more detail, prioritize them and develop strategies to mitigate and manage those deemed most important.

As well, real estate and construction firms should concentrate on improving liquidity overall, to enable them to respond more nimbly and effectively when business conditions become more challenging. Management should look for ways to bring spending under control, boost cash flow and de-leverage the company wherever possible. Finally, management should make sure it stays in regular contact with the company’s investors and lenders. Being clear and transparent about how the company is doing builds trust, which can make all the difference when business gets tougher.

Strengthening balance sheets and improving both liquidity and available financing will also enable companies to capitalize on opportunities to acquire financially distressed properties or businesses at significant discounts. These opportunities, whether forced by lenders or other factors, are inevitable when business conditions grow challenging. However, they’re only available if the purchaser has the cash to close the deal quickly after very limited due diligence.

Managing risk today can prevent insolvency tomorrow

Canada’s real estate markets are beginning to show signs of strain, and it could spell significant challenges for real estate and construction companies across the country. Firms that don’t take the time to fully assess the financial and other business risks affecting their entire enterprise—and take steps to address those risks—could find themselves facing a significant crisis that could push some towards restructuring or insolvency. However, companies can avoid that fate, by understanding their full risk picture and by taking important steps to improve liquidity and debt levels overall. Mitigating tomorrow’s challenges today can help real estate and construction firms navigate the stormier waters on the horizon and seize unique opportunities along the way.

This is the fourth in a series of MNP perspectives on risk management aimed at Canada’s real estate and construction companies which explored enterprise risk management, fraud risk and restructuring and insolvency risk.

For more information contact Jerry Henechowicz, CPA, CA, Licensed Insolvency Trustee​, CIRP, Senior Vice President, Corporate Insolvency, at 416.596.1711, [email protected] or your local VFLS Services advisor.