Rising Interest Rates: What Would This Mean for Investors?
In recent weeks, speculation over the Bank of Canada’s intention to raise interest rates has dominated much of the conversation in financial circles. At this point, it appears it’s more a question of when than if. There is now fairly strong sentiment from economists in the know that rates are poised to tick upwards for the first time in seven years on July 12 when the Bank of Canada next reviews rates. Whether it does happen later this month, later this year, or at some time beyond, when rates do rise, there are a number of potential implications for real estate investors. While it is challenging to determine the extent to which rising rates will impact the markets as interest rates are only one of many variables, we thought we’d highlight a few potential outcomes that could have implications for real estate investors:
1. Cap rates will rise: Rates of return on various asset classes are essentially comprised of the risk-free rate + a risk premium. The risk-free rate is theoretically the rate of return an investment with no risk of loss would command over a given period of time. Think T-bills or Government of Canada Bonds, depending on time horizon.The risk premium reflects the expected return that would be required for an investor to take on the added risk inherent in a particular investment or asset class. For example, junk bonds would require a higher risk premium than Government of Canada bonds in order to attract investors to make the investment. In other words, they would require a higher return to compensate them for the added risk. As the economy is ever changing, the risk premium between asset classes fluctuates. However, the risk-free rate component of total required rate of return is basically consistent across asset classes. Therefore, when interest rates rise, the risk-free rate rises, and therefore the overall total required rates of return rise. Capitalization rates in real estate are included in this equation. As the total return on other assets classes rise, stemming from increasing interest rates, real estate investors will expect a higher rate of return as well.
2. Valuations on income properties may drop: The most common way to value income producing property is using the income approach. Simply put, you capitalize the Net Operating Income (NOI). NOI / Cap Rate = Property Value. Therefore, if interest rates rise and cap rates rise, using this equation property values go down. For example, if your NOI is $100,000 on an apartment building at 4.5% cap rate in Nanaimo, your implied property value is $2,222,222. If cap rates on apartment buildings rise 1% resulting from a string of interest rate increases over the next year or two, the implied property value declines to $1,818,181, a substantial decrease. Now, there are those that argue that rising interest rates do not have a significant effect on property values, because interest rates are adjusted upwards when the economy is expanding to keep growth/inflation under control. Strong economic conditions would imply rents should be increasing, which would be increasing the NOI, possibly offsetting the impact of rising cap rates on valuation. I don’t buy it…while this may be the case in larger cities, real estate is location specific. There are regional disparities. Smaller communities such as Nanaimo can be impacted by local economic conditions, which would have a larger impact on rents than the macro-economic conditions in Canada on which interest rate decisions are made. Further to that, I would argue that current Canadian economic conditions are not all that impressive, and it is the over-inflated real estate market that is largely driving much of small-town Canada, as well as playing a prominent role in major centres such as Vancouver and Toronto. In fact, it is this overheated real estate market that is driving much of the talk surrounding increasing interest rates in an effort to slow down the astronomical price increases we have been experiencing. Enough said, as interest rates rise, valuations have a good chance of moving downward.
3. Residential buyer demand will decrease: In short, more people today qualify for financing on homes at higher price points than they will when interest rates rise. The average home price in Nanaimo has increased 43% since January of 2015. This has priced a good percentage of home buyers out of their preferred neighbourhoods and some buyers out of the market altogether. At the time of the most recent census, the average household income in Nanaimo was $65,690. Based on CHMC’s guideline of 32% GDS, this would suggest your total housing cost including mortgage, taxes and heat would need to be no more than per month $1,751 per month, likely leaving your mortgage payment around $1,400 after taxes and heating are considered. Currently, the benchmark qualifying rate for insured high-ratio mortgages is 4.64%. Therefore, the average household in Nanaimo would qualify for a mortgage of $249,900. Did I mention the average house price in Nanaimo was $526,000…Concerned anyone??? So what does a quarter point uptick in rates qualify you for? $243,500. A full point? $229,000 or 8.4% less than before. With recent price increases, a good percentage of buyers are red lining, which would suggest as buyers qualify for less, demand will fall. When demand falls, prices fall. But, isn’t that the point of the exercise…raising interest rates to get housing prices under control.
4. Demand for residential rentals may rise: If you can’t qualify to purchase a home, what do you do? You need somewhere to live. While you rent of course. More rental demand with a relatively fixed supply of rental apartments equates to rising rent levels. Not much more to say here.
There are so many variables impacting the real estate market that it is difficult to predict with certainty how rising interest rates will affect the market. For example, the internet has opened our real estate markets to an ever increasing number of international buyers which has never before been the case. Will the increasing international demand offset the domestic buyers priced out of the market or qualifying for less when purchasing? Hard to say… What we can say with relative certainty is that interest rate movements are likely to be a prominent story over the next 48 months that will most certainly impact the market. We’d strongly recommend that investors factor in the potential implications when exploring a purchase. For sellers not looking to hold long term, but rather looking to maximize your gains, now may be a good time to review your holdings. Trying to time to the top of a market is an extremely risky proposition and you have the Bank of Canada clearly suggesting rates are poised to rise, with potential risks outlined above.
If you are considering an investment in real estate, put our full-service advisory team to work for you. Contact us anytime for your complimentary consultation at 250-751-0804