Volatility in the Capital Markets is Helpful to Apartment Investors

Article by Dru McAuley

Recent developments in the financial markets have meant a return to the dreaded “V” word – volatility. Markets are currently being influenced by the economic crisis in Greece, which has implications for other Euro zone countries such as Spain, Italy, Portugal and, more recently, Hungary. The resulting market turmoil has caused investors to flee to “save haven” instruments like the bond markets of North America.

An immediate local beneficiary of this shift to the bond market is the property market. Demand for bonds increases their price, which decreases interest rates. Bond prices and bond yields move inversely.

As we all know, real estate investing is a capital intensive business which can feature a large degree of leverage. This is particularly true of the apartment sector in Canada, where investors can borrow up to 85% of a property’s value with CMHC insured mortgage financing. The effects of the “credit crunch” through 2008 and 2009 saw a very limited amount of mortgage debt available for several asset classes, including office and retail properties, for example. However, the availability of CMHC insured financing for apartment buildings allowed this sector to avoid a credit crunch. Capital for apartment mortgage debt continued to be available at historically low rates, which in turn led the sector to perform very well, considering the economic fallout in other areas of the economy.

Prior to the Greek crisis (which commenced mid-April, 2010), rates in Canada were starting to increase as the North American economy appeared to show some signs of stability and a cyclical recovery was starting to take root. Five and ten year Canada Mortgage Bond yields had increased about 80 and 50 basis points, respectively, from the end of November 2009 through to mid-April 2010. The Canada Mortgage Bond is the primary rate-setting instrument for CMHC insured mortgages.

The current Euro zone crisis has seen the five and ten year Canada Mortgage Bond yields decline about 35 and 25 basis points, respectively, since mid-April.

The recent decline in rates has extended a bit of a windfall to the apartment sector, which could last a while as markets continue to be skittish over events in Europe.

This is a timely advantage to apartment investors as this renewed period of lower rates helps to offset the effects of the HST that are about to take effect.

An extended low interest rate environment will also lend support to apartment values generally and should continue to fuel an active mortgage market in the apartment sector.

As mentioned above, low rate, CMHC insured financing is the key. In this regard, it is worth noting the following:
- in Southern Ontario, including the GTA, CMHC will typically require 4 to 6 weeks to approve an application. Healthy volumes and summer holidays could see this timeline increase but, nevertheless, it is a reliable indicator and conditional financing periods in purchase agreements should be structured accordingly;
- In buildings with underground parking garages, we have seen CMHC underwriting frequently call for a condition report on the garage. Again, this should be factored into time lines.

As for future rate movements, it is pure crystal ball gazing (which I am not qualified to do) to predict where rates might be a year from now. However, recall that rates were increasing “naturally” prior to the current Greek crisis. Should markets become convinced that the Euro zone matter has been satisfactorily managed, it seems plausible that rates could revert to an upward trend. Accordingly, the comparatively low borrowing rates currently available could be a small window of opportunity for apartment investors.

With this in mind, prudent investors are aggressively seeking acquisitions and are also reviewing the prospect of incurring prepayment penalties on loans maturing within the next 12 months in order to lock in renewal rates early for extended mortgage terms, or to increase loan balances, for extended terms, in the current low rate environment. A variety of factors will influence how feasible it is for borrowers to incur prepayment penalties.

The current interest rate environment has been good for the apartment market. Early renewals are one more option in a borrower’s favour.

For More Information:

Dru McAuley
First National Financial LP

Back to Articles Menu