The Global Economy
A very clear global economic landscape is emerging and it is one that indicates that the global economy is slowing. Even China's growth has slowed to its weakest in 24 years. To combat this weakness and stimulate their respective economies Central banks are all slashing interest rates. The US is the one nation that claims they are in growth mode and have recently been hinting at rate hikes, however, the Fed's Chain Janet Yellen went on record today and stated no raises for at least the next 2 meetings.
The Local Economy
The Bank of Canada surprised the markets just a few weeks ago with an unexpected rate cut in response to the plunging price of oil. Some analysts expect another rate cut is just around the corner. As a result the Canada 5 year bond yield is at historic lows and it looks like it may be headed even lower. We can expect this low interest rate environment to stick around for at least the next 18 to 24 months.
How Does This Tie Into Real Estate?
Canadian bond yields are used to deterine the ultimate cost of funds or interest rates that consumers will pay when borrowing money from financial institutions to purchase commercial real estate. So while it may be counter-intuitive, a slowing economy could be beneficial for the astute real estate investor. The caveat is if the economy goes into a full blown recession all bets are off.
Interest Rates
Commercial interest rates are at historic low in Canada. You can secure financing for multi-unit residential properties anywhere between 3% to 4% for a 5 year term. The low interest rates would have you thinking its a no brainer to buy real estate and just rake in the profits. However, nothing is ever that easy.
The Correlation between Interest Rates, Market Caps and Real Estate
An inverse relationship exists between interest rates and the price of real estate. As interest rates go down, the price of real estate goes up and vice versa. On the other hand, there is a direct relationship between interest rates and market caps. This relationship is the more signficant one for income property investors. Typically interest rates and market caps move in unison. So while interest rates may have come down, market caps have also come down, which in turn means that the price of real estate has gone up. To give it some context, 10 years ago commercial interest rates were approx. 6% and cap rates in Toronto were approx. 8%. Today, interest rates are approx. 3.5% and cap rates are 4.5%. This is what we call market cap compression.
Market Cap Compression
Market cap compression is much more prevelant in big urban centres. In cities such as Toronto, Vancouver and Calgary cap rates are typically between 3.5% to 4.5%. In smaller urban centres such as Kitchener/Waterloo, Oshawa, Barrie and Hamilton cap rates range from 5% to 6.5%. Thus the greater opportunity to benefit from low interest rates.
CMHC Insured Mortgages
If interest rates weren't already low enough for you, enter CMHC insured mortgages. Although you pay a premium to have your commercial mortgage insured, investors still come out way ahead in the long run. In exchange for insuring your mortgage, financial institutions offer investors discounts on their interest rates for the life of their mortgage. As it stands today, a 5 year CMHC insured mortgage can be had for under 2%. For those that are concerned about rising rates in the future, you can lock into a 10 year term for just under 3%.
Smaller Urban Centre Real Estate + CMHC Insured Mortgage = Wealth Creation
At this point it's not rocket science. Instead it's simple mathematics. Purchase a multi-unit residential property in a smaller urban centre with a cap rate of 6%. Pay 2% on the interest rate. That leaves a 4% spread for the investor. That 4% spread translates into cash flow and long term wealth creation for the astute investor.
Author: Paul Kondakos, BA, LL.B, MBA - Professional Real Estate Investor - RealtyHub Founder