Canada’s central bank has been raising interest rates resulting in higher mortgage rates. The rise in interest rates is the senior government’s response to rising inflation which is near 40-year historic highs. Canada’s annual inflation rate rose to 8.1% in June. On July 13th, 2022, the central bank raised interest rates a full percentage point (500 basis points) resulting in an overnight rate of 2.5%. Prime rates at major Canadian banks on July 23, 2022 are running at 4.7%.

Banks have been increasing residential mortgage rates with fixed rates at or above 5.15% and variable rates above 4.24%. A full percentage point less can be secured from discount brokers. The consequence of mortgage rate increases, and rising inflation has been falling Canadian housing sales and prices. This has been generating a lot of media attention. But what about the impact on commercial real estate?

In commercial real estate there is a distinct relationship between cap rates and interest rates. The cap rate is a metric that describes the relationship between a property’s net operating income (NOI) and the current market value. The formula is CAP=Net Operating Income/Value.

Canadian commercial mortgages are based upon the Bank of Canada 5-year bond rate. Bond yields have risen from less than 1% in July of 2021 to over 3% in July of 2022. Canadian Government Bonds are considered “risk free” compared to mortgages which are risky investments. To make up for the risk, a risk premium is added to the mortgage rates above bond rates. Typically, the spread is 2% to 4%. Presently, five-year conventional commercial mortgage rates are running 5.65% to 9.65%, while a five-year CMHC rate is 4.55% to 6.65%. Historically, increases in long-term bonds tend to drive cap rates higher which will have a negative impact on commercial real estate prices as the cost of borrowing increases.

However, it is important to keep interest rates into perspective as they are nowhere near rates of the early 2000’s 1990’s, or the near 20% rates of 1980’s. Similarly, it is important to remember that cap rates are not only influenced by interest rates, but supply/demand and growth expectations play a key determination. Finally, many analysts are expecting central banks to stop or reverse recent interest rate increases as concerns about the economy grow.

In the current environment demand for industrial space and multi-family and seniors housing has been strong at the Ontario and national levels with historically low vacancy rates and rising rental rates. Sarnia-Lambton has a limited amount of space available in buildings over 10,000 sq, ft and especially in new construction. Locally, industrial cap rates are running 5.0% to 6.5%.

Retail has improved since the pandemic but rising inflation and concerns with a potential recession will stifle demand. Local cap rates are running 6.5% to 7.5%. Failed restaurants and other businesses which were casualties of covid are candidates for redevelopment opportunities.

To mitigate the risks of higher interest rates business can take steps. Here are few possible suggestions. I would be interested in hearing others.

Businesses can look at trying to refinance their loans. This can help lower monthly payments and make it easier to improve cash flow or qualify for new loans. Timing is important as interest rates rise refinancing maybe become more difficult.

Landlords can screen for high quality tenants to reduce the risk of tenants defaulting on leases, as they cannot meet payments.

Landlords can raise rental prices to minimize the impact of rising inflation.

Landlords can attract new investors as historically real estate has been seen as an inflation hedge. This is especially true for high-quality real estate with stable income streams.

Tenants can ask landlords for a lease extension/ renewal at their current rental rates or with a modest increase. Some landlords may be agreeable if they believe it will be more challenging to find new tenants if a recession is in progress

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