Interest Rate Fluctuations and Economic Value

Dear readers, first of all, I would like to remind you that I am a commercial mortgage broker.

I’m neither an economist, nor a specialist in economic movements, nor even a diviner in the matter.

This text represents a personal opinion that I'm sharing with you on my short- and medium-term vision of the multi-unit real estate market and the impact of fluctuating interest rates on your real estate investments. I'm very often asked:

First, you must understand how interest rates behave in the market and above all, the difference between fixed and variable rates. Fixed rates fluctuate with the rate of Canada Mortgage Bonds (CMB – Commercial Bond Yields). The variable rate, on the other hand, fluctuates according to the decision of the Bank of Canada to increase or decrease its “key rate”. The CMB is the one that moves first. It's influenced by the economy and investor anticipation. As for the key rate, it fluctuates according to the decision of the Bank of Canada to influence the economy, the inflation rate and above all, to reduce the gap between fixed and variable rates. Thus, from February 1st, 2021, to February 28th, 2022, the CMB rose from 0.71% to 2.07%, an increase of 1.36%. It's easy to guess that the Bank of Canada will raise its key rate by at least 0.75% in 2022 due to the rise in CMBs and, above all, to slow inflation. To this end, on March 2nd, the key rate went from 0.25% to 0.50%. In summary, the CMB is a bit like a crystal ball of the Bank of Canada's decision to change its key rate. So, when you ask me if fixed rates will soon rise knowing that the Bank of Canada has raised its key rate, my answer is as follows: It's already too late… fixed rates have been rising steadily for 12 months already.

Will fixed rates keep rising in 2022? Before Vladimir Putin took on Ukraine, I would have told you that most economists at major Canadian banks were predicting a fixed-rate increase of at least 0.75% by the end of 2023. Today, nothing is less certain, because the volatility caused by the war blurs the cards and makes our crystal ball much blurrier.

What has happened to the economic value of your income properties since February 2021 and what could happen to this same value with a rise in fixed rates in the next year?

Before analyzing the fictitious case that I'm presenting to you, keep in mind that an economic value is a way of evaluating the borrowing capacity of a building. An economic value isn't a market value. To illustrate the impact of this change, here is an example that speaks for itself.

Fictitious case

–       12-unit building was purchased on July 1st, 2020 at the price of
–       Annual revenue increase of 3%/year
–       Expenses equivalent to 30% of gross income
–       30-year amortization based on CMHC loan

Thanks to this table, you understand that the economic value of buildings decreases as interest rates increase. So how do you explain that the price of buildings is always more and more expensive?

The price of a building and/or the market value is influenced by supply and demand. Thus, for the past two years, demand has continued to increase which, of course, has driven up prices. In 2019/2020, it made sense to pay between 10% and 15% more than an economic value. Today, buildings sell for between 25% and 35% more than their economic value. What will happen in a context where prices increase, and economic values decrease? Simple, the buyer’s down payment will again have to increase to such a point that, at some point, it will no longer make sense to pay as much for the return that a building can provide to its investor.

Currently, sellers don’t yet realize that the purchasing power of buyers is decreasing like snow in the sun. More and more buyers are already realizing that it no longer makes sense to pay so much. So, in the upcoming months, as fixed rates increase, we will see the market slowdown and prices decline. Already on Centris, we are seeing a slight price drop, which leads us to believe that the price of buildings can be negotiated at more affordable prices within the next 18 months.

In the meantime, dear income owners, what should you do? Simple, you must immediately refinance your buildings as much as possible before the next increase in fixed rates and then wait until prices are more affordable. Thus, you will take advantage of your current purchasing power to buy great future opportunities.

To contact us to refinance your income properties now, visit our website at www.multi-plex.ca