As a real estate enthusiast, I am constantly educating myself on the economic, social and political landscapes, both domestically and internationally. This constant focus helps me keep track of the intricacies that affect my business environment.
As a lender, I also connect these same factors to mortgage products and interest rates. I tend to be asked many times: “Where do you see interest rates going?” That is a valid question but one that cannot be easily answered. My most common and humorous answer is: they can go up, they can go down or they can stay the same.
While these answers are all true, I usually focus on a different question: “What are you trying to achieve with your asset?” While not as transparent a question as the interest rate question, understanding your asset’s market position can help you determine whether current rates are indeed what should be your top concern.
Choosing the right mortgage is critical to determining your interest rate and your investment objective. By choosing the right product, you can maximize your return on your investment.
The borrower’s objectives
While understanding where interest rates may be heading and what factors affect them, understanding what objectives a borrower has is more critical in obtaining the right product and interest rate for your mortgage.
Keep in mind that commercial mortgage rates are separate from single family mortgage rates and that there are different bases on which the rates are calculated and each transaction has separate factors which also affect the interest rate. Most commonly the supply and demand for credit directly affects the rate.
In theory, the higher the demand for credit the higher the interest rate. However, in this market that theory may not apply. In my previous article on the difference between lending value and purchase price I discussed that there is currently an abundance of capital looking to acquire commercial property.
Therefore you might think that due to heightened activity, interest rates would be higher because lenders have limited funds to lend out in the marketplace.
However, in this market the opposite sometimes occurs – lenders look for the highest quality asset to lend their money out and as lending competition increases, interest rates may drop as lenders bid for placement of their funds in the market.
Inflation also affects interest rates. When inflation starts to rise, lenders look to charge higher interest rates since the time value of money erodes the value of money at a faster pace. Thankfully, in this environment monetary policy has been effective and inflation has been kept in check, still coming in below two per cent in Canada. There is less inflationary risk to the market interest rates due to current low levels.
While we understand some of the basics that affect interest rates, as a lender it’s critical for me to understand the asset and the owner’s objective and how it relates to the larger picture. That larger picture might be a repositioning of the asset for cash flow increases or it could relate to stability of income and cash distributions. Once the lender understands this, he can suggest the right product and provide the appropriate pricing based on the risk to the transaction.
Short-term vs long-term interest rates
All lenders have various benchmarks that affect how they determine the interest with the most common ones being Government of Canada Bonds, Canada Mortgage Bonds and the prime lending rate. Each has pros and cons and can be suggested to a borrower depending on the product or mortgage the property owner is seeking.
Take, for example, the purchase of an ineffectively managed retail asset. Let’s assume the property has a vacancy as high as 30% and the existing tenants are paying a rental rate that is lower than market. The property has excellent exposure on a main thoroughfare, but requires some capital expenditure to reposition the asset and attract new tenants. A creative buyer sees the potential and the value of purchasing the asset.
While not irrelevant, the interest rate is not as critical for this asset. What the owner would be looking to achieve is securing as high a leverage as possible in order to use his own equity to reposition the asset in the short term. The owner would not be looking to lock in a mortgage product for a long term because they would lock in the unimproved value of the asset.
They would then have difficulty trying to recapture the added value that they have achieved with the property after repositioning.
The owner would obtain a shorter-term mortgage, most likely a one- or two-year term with an open to refinance privilege, then reposition the asset and refinance the mortgage on the property into a new longer-term mortgage. For this reason, the longer-term interest rate is only relevant at the time of refinance.
Other scenarios do exist, and it may be such that longer-term financing may also be the right product. The key is simply to find the right product for your asset and not to focus solely on interest rate. Choosing the wrong mortgage for your property could be more costly in the long run than trying to project where interest rates are heading.
Darryl Bellwood is a Director of Commercial Lending with First National Financial, Canada’s largest non-bank lender. He is active in most markets in the country with a focus on investment real estate. All feedback is welcome and he can be reached at [email protected].