Email this pageExecutive Summary - Promoting a Positive Mortgage Insurance Environment for New Rental Construction

Prepared for:

Research Subcommittee
Housing Supply Working Group
Ontario Ministry of Municipal Affairs and Housing

By:

Greg Lampert and Steve Pomeroy

March 2002

This report has been prepared on behalf of the Research Subcommittee of the Housing Supply Working Group (HSWG) – a joint government-industry advisory group established to identify rental housing supply problems and solutions. The HSWG is co chaired by the Ontario Ministry of Municipal Affairs and Housing and industry representatives.

In May 2001, the HSWG released an interim report, Affordable Rental Housing Supply: The Dynamics of the Market and Recommendations for Encouraging New Supply, which called for action to encourage much-needed new rental investment. Among other things, the report recommended examination of the mortgage insurance practices of Canada Mortgage and Housing Corporation (CMHC) with respect to new rental housing (e.g. insurance fees for high-ratio loans and the determination of lending value for rental housing) and the feasibility of the Province facilitating the provision of mortgage insurance for rental housing construction – either directly or in partnership with CMHC.

This report is one of three companion reports intended to address issues raised in the HSWG interim report and are background reports for the HSWG’s second report: Creating a Positive Climate for Rental Housing Development Through Tax and Mortgage Insurance Reforms. The three reports include:

1. Options for Changes in Federal Taxes to Encourage New Rental Construction – development of a framework for the identification and analysis of potential changes to the federal tax system that would strategically improve the climate for new rental investment in Ontario;
2. The Context for Private Rental Housing Production in the US – identification of the most significant tax and housing-related program levers impacting new market rental development in the US, how they work, how they generate capital for new market rental housing, and the potential for using such mechanisms in Canada; and
3. Promoting a Positive Mortgage Insurance Environment for New Rental Construction – examination of CMHC’s underwriting practices and mortgage insurance fees for rental housing, and identification of options for the Province to promote improved access to mortgage insurance for new rental housing projects – this report.

This report examines CMHC’s mortgage insurance premium structure and related underwriting criteria – both those which applied in the past, and the recent changes. In addition, it investigates rental lending practices in the US, and explores possible alternatives whereby the Province might assist in promoting improved access to financing for rental projects.

Mortgage insurance is a key element in securing financing for new rental development. Key industry stakeholders, including lenders and potential investors, view CMHC mortgage insurance with mixed feelings. On the one hand, CMHC insurance provides access to high-ratio financing, lower interest rates and greater leverage than would otherwise be possible. On the other hand, the process and associated negotiations are seen as unnecessarily difficult and uncertain. Stakeholders would like to see a more streamlined process with a greater degree of flexibility in CMHC’s underwriting practices – and lower fees.

In the absence of the actuarial analyses behind CMHC’s mortgage insurance fees and underwriting criteria, it is not possible to provide comment on whether these are reasonable, given the (substantial) risks associated with loans on new rental housing projects. CMHC has a mandate to provide mortgage insurance ‘on a commercial basis’ so the fees and other requirements no doubt reflect this. However, according to stakeholders, the larger issue is one of appropriate public policy and CMHC’s other mandate to facilitate the effective functioning of the housing market – including the rental housing sector. Stakeholders question why CMHC’s mortgage insurance function should be retained in a publicly-owned corporation if its commercial mandate means it is restrained from facilitating the financing of new rental housing – a clear public policy goal of the federal government.

CMHC has responded to criticism of its mortgage insurance underwriting criteria and fees by introducing changes effective in March 2002. CMHC has reduced the fees for 85% LTV (loan to value ratio) mortgages slightly (from 5% to 4.5%), while fees for 71%-80% LTV mortgages are higher. There are also substantial changes to CMHC’s underwriting practices with respect to loans for new rental housing – through the use of ‘market-derived’ capitalization (cap) rates and modifications in the required debt coverage ratios (DCRs) for new rental loans.

The adoption of a market cap rate is a significant improvement from the previous ‘official’ policy of using a minimum 9% cap rate. However, the changes in the minimum DCR requirements threaten to undermine the effect of using market cap rates in strong rental markets (with low cap rates) such as Toronto and Ottawa – and will actually reduce the volume of financing available for new rental projects below previous levels if (as expected) mortgage interest rates rise from their current very low levels. At present, if rental investors attempt to ‘lock-in’ interest rates for when a project is completed, the new DCR requirements may restrict the size of the mortgage to less than what would be available using the previous underwriting criteria.

The system for financing new rental investment in the US provides useful insights for Canada. In the US, mortgage insurance is not available for most private rental projects. Risk is managed and reflected largely in the form of higher interest rate spreads over long-term government securities than are common in Canada with insured loans. Most rental project financing is facilitated and influenced by a much larger and more sophisticated secondary mortgage market.

In the main, US rental developers cannot secure greater than 80% LTV loans and typically lenders require DCRs similar to those recently introduced by CMHC. The major difference in the US is that most loans are non-recourse – i.e. personal covenants and guarantees (required for CMHC-insured loans) are not typically required in the US.

If the Province considers that the recent changes in CMHC’s mortgage insurance practices are not sufficient to facilitate access to mortgage financing for rental development, a number of options are available:

• Continue to press for more flexible financing terms for rental development;
• Partner with the federal government to provide improved service (by sharing risk);
• Form a Provincial mortgage insurance operation; or
• Explore private sector partnering alternatives to CMHC mortgage insurance.

Of these options, the first two appear most feasible. Pressing for more flexible financing terms for rental development could take several avenues:

• Analysis of the risks of rental mortgages – without access to CMHC’s actuarial analysis, it is not possible to undertake a comprehensive assessment in this area. However, a review of the package of risk mitigation measures employed by CMHC (substantial mortgage insurance fees, strict underwriting criteria, rental achievement holdbacks, and guarantees from investors) suggests that there may be a case for some flexibility whereby, if CMHC has adequate security (e.g. the project itself and ‘iron-clad’ guarantees), perhaps some of the other risk mitigation measures (e.g. DCR or fees) might be relaxed to some extent.
• CMHC’s mandate – stakeholders question why CMHC’s mortgage insurance functions should be retained in a crown corporation if the Corporation is unable to promote the broader public policy goal of facilitating rental investment by taking on more risk. Given the evident profitability of CMHC’s mortgage insurance operations, and the lack of new CMHC-insured rental housing loans, there would seem to be some room to manoeuvre by taking greater risks on rental mortgage insurance.
• The Bank Act – at present, federally chartered lenders are not allowed to make property loans in excess of 75% of property value without mortgage insurance. With no competition, this means that CMHC is the only option available for borrowers seeking high-ratio loans. In the US, lenders regularly provide financing equivalent to 80% of property value without mortgage insurance. It may be time to revisit this requirement and allow lenders to take on the additional risk associated with high-ratio loans without requiring mortgage insurance. This would permit the market to price risk and would provide an alternative risk assessment to that undertaken by CMHC.

Alternatively, the Province could negotiate a risk-sharing partnership with the federal government to facilitate improved access to mortgage insurance for new rental projects. The partnership could utilize CMHC’s existing underwriting infrastructure and expertise to provide a sound basis for the risk assessment of rental projects but, at the same time, create the opportunities for additional flexibility on maximum loan levels and/or lower fees – through Provincial guarantees.

To receive a copy of the complete report, please contact:

Housing Policy Branch
Ministry of Municipal Affairs and Housing
14th Floor, 777 Bay Street
Toronto, ON M5G 2E5

Tel: 416 585-7544
Fax: 416 585-7607