INTEREST RATES and REAL ESTATE PRICES
(July 2004)

In the last few years both buyers and sellers have enjoyed the benefits of low mortgage rates.  Mortgage rates are generally based on Government Bond yields comparable to terms similar to the mortgage being contemplated with lenders adding what is called a spread to the bond  rate to calculate the mortgage price.  Mortgage rates rise and fall as bond rates rise and fall.  As well, the spread charged on the mortgage will change  from time to time.  Factors such as  the size of the mortgage, quality of the building and tenant(s) and generally the perceived risk affect the spread between the mortgage rate and the bond rate.  Multi-unit residential properties, particularly those which are CMHC insured have remarkably low mortgage rates.  Generally spreads of 1.5-2% are typical, those these numbers can be lower (for example with multi unit residential properties) or higher.

Not so long ago the cost of financing exceeded the revenue earned from a property and the overall return from investing could be reduced by financing.  As seen from the chart below, the spread between the yield on investment property and the cost of financing has grown dramatically.  An 8% return before financing can now become 11.7% with 65% financing and 14 % with 75% financing.  In fact, a recent industry survey of retail investors found that the current low cost of debt was the most cited motive for investing in retail property at current prices (75.9% ).

The spread between bond and property yields generally reflect the premium required by investors for the additional risk and effort associated with owing real estate.  Multi-unit residential properties have shown the smallest spread reflecting the perceived stability and low financing cost associated with that class of property.  Other categories continue to show higher spreads.  Still the existing spreads are historically high and seem to reflect a degree of perceived risk with real estate.  Although some have speculated on a developing “bubble” as a result of increasing prices, aggressive buyers have focused  on pursuing high-quality properties, with good tenants, good cash flow and good locations.  Unlike the late 80’s investors are still showing a greater degree of discipline.

The growing demand for real estate generated by the low returns on bonds and poor performance and perceived risk associated with the stock markets could support a narrowing of the spread  in the future.  That could occur as competition for real estate pushes cap rates down (and prices up), or help keep prices stable if interest rates rise.  Improving economic conditions will also help reduce perceived risk associated with real estate lowering the risk premium required by investors.  The same logic suggests, however, that multi-unit residential properties which already have the lowest spread between bond  and property yields, may come under pressure from interest rate increases and from any increase in perceived risk arising  from higher vacancy rates and a drop in rents or even changes being considered to landlord and tenant legislation.