For those looking to put their money to work, the real estate market is looking like less of the sure bet it has been for the past decade.
As the cost of borrowing soars and property values slump, challenges are starting to compile for property investors, who are seeing their margins squeezed as costs rocket.
Nerses Sraidarian, Broker of Record and owner of Big City Realty, which specializes in both real estate investors and end user buyers, says he’s been preparing clients for rising interest rates since February by encouraging greater liquidity, as it became clear a rising rate environment was inevitable. All the same, he says, investors are showing their nerves, especially following the surprise 1% hike from the Bank of Canada.
“We got a lot of phone calls; rates are going up and we knew rates were going to go up, but yesterday, everybody was expecting 0.75%,” he says. “That extra quarter of a percent -- though it may not make that big of a difference in people’s payments -- it’s consumer sentiment. There’s going to be a lull for the next two to three weeks as people get to digest the new rates, then things might start moving again.”
Overall, he says that ever since the Bank of Canada embarked on its hiking cycle, investor client appetites have started to change, reflecting a shifting focus to cash flow rather than market appreciation.
“Some investors are buying smart. We have a lot of people, let’s say they used to buy pre-construction condos here and there. In this market, they want to buy something where they can hedge their risk,” he says, such as properties with good conversion potential, or where one unit can be turned into two.
“Regardless how high the rate goes, rents are going up alongside the rates so… to pick up a one-door property and turn it into two and rent it out to two different tenants, you’re going to be cash-flow positive or neutral in the worst case scenario,” he adds.
However, about half of the prospective client pool have resorted to a holding pattern, as it remains uncertain just where interest rates and home prices will settle.
“There’s a good 50% of buyers, investors, whatever, that regardless of what we tell them, even despite them having access to money, they’re still trigger shy because of the big unknown -- how long is this going to go, how long are prices going to go down,” he says.
A Return to Recession-Era Strategy
Mikael Kurkdjian, Partner and Broker of Record at Baron Realty, says today’s interest rate environment resembles that of the late 2010s -- and for that reason, he’s seeing the return of late aughts investor tactics as some look beyond real estate for the greatest returns.
“It changes things, because interest rates today are where they were in 2010; if you go back into history, the five-year bonds were maybe at 3.2% -- and today they’re in the same range,” he says. Back then, sellers -- especially those with years of built-up equity -- would often take the route of liquidating their real estate and plunk the proceeds in a high-interest savings vehicle such as a GIC or bond, which had rates in the 4-5% range.
“I think we could come back to that market,” he says. “[Investors] may say, ‘You know what, maybe I’m not selling at the top, top price because rates are higher, but the funds I get at liquidation and put in the bank, with a five-year GIC from RBC,’ … that could make sense for them.”
Savvy pivots aside, today’s rising rates do signal pain for some borrowers. A key issue, Sraidarian points out, is that many with variable rates with static monthly payments are teetering closer to their “trigger rate”: the point where their payments will no longer cover even the interest on their loans, and will materially rise.
“For everybody who’s taken out a mortgage in the last six to 12 months, the bank would have to go back and say, ‘You need to increase your payment by $300 - $400, just so that you’re covering your interest payments and you’re not going back every single month.’ I feel like if and when that happens, that might change things up for people that are kind of on the border, that’s one thing we are watching for,” he says.
Those who bought in the precon market at its peak two to three years ago -- when projects were priced 30 - 40% above the resale market -- are also being squeezed, as rising borrowing costs combined with softening property values raise the risk of appraisal gaps and the inability to close. However, he says, while there are considerably more assignment sales on the market, at prices close to their original sale price, he has yet to see this group absorbing losses.
“It’s Catastrophic for Borrowers”
Short-term borrowers are also bearing the brunt of the same bond market that’s proven to be a boon for savers, says Kurkdjian, who points out that today’s five-year yield is hovering between 3 and 3.5% -- well above the Bank of Canada’s policy rate of 2.5%.
“What this does is it really penalizes the short-term borrowers,” he says. “Those bonds, let’s say a year and a half ago, January 2021, they were at 0.69%. Today, it’s at 3.56%. So someone taking a five-year mortgage a year and a half ago, they were paying 1.69, maybe 2%. Now they’re paying 4.5% interest rate. So that’s catastrophic for the borrowers, who are not going to sign a five-year term as of today.”
He says that due to the ongoing inflation fight, the Bank of Canada’s hands are largely tied to “demand destruction”, with their only resort being a hawkish approach to monetary policy. “But what demand destruction does is it really hits the smaller companies, the small inventors, guys who were buying properties for four or five, six million bucks; they’re not the ones who are on the stock market, you know? If you’re a bigger company, if you’re a bigger fund, you can raise capital and so forth, but for smaller investors, them raising capital is putting in their own sweat equity.”
“It definitely has an impact on the smaller guy, and smaller companies.”
At the end of the day, says Sraidarian, panicked borrowers can take comfort in the first rule of real estate investing: stick to your long-term horizon. He points out that the market fundamentals, such as tight inventory, remain strong.
However, the segment continues to watch the Bank of Canada’s next moves closely, given there isn’t that much leeway before higher rates become unsustainable.
“We don’t have a lot of overleveraged desperate property owners as of right now, but you know, if you increase the rate by another 3 - 4%, it’s a different ball game altogether.”