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The gap between CRE financing and returns is narrowing

The markets are pricing in five, quarter-point interest rate increases in 2022 which will result...

The markets are pricing in five, quarter-point interest rate increases in 2022 which will result in commercial mortgage rates ranging between four to over five per cent.

What will be the consequences of this increase to the commercial real estate investment market?

Let’s first look at how it affects cash flow and debt servicing.

I’m going to assume the loan amount is equal to 75 per cent of the current market value, which is the highest loan-to-value (LTV) ratio usually available for commercial, non-owner-occupant property.

Financial institutions typically require 25 per cent surplus net cash after servicing a monthly principal and interest mortgage payment.

That amount of surplus cash would be easily achievable if a commercial real estate asset was performing with a seven per cent cap rate and interest on the mortgage was payable at around 3.5 per cent. In that example, that net income required to service the mortgage would be more than enough to satisfy the bank.

Shopping higher returns

It is much more difficult to satisfy your financial institutions’ lending requirements when commercial mortgage rates are 4.5 per cent and cap rates are 6.25 per cent. That 1.75 per cent spread is simply not great enough to generate the required surplus cash.

Typically, a 2.5- to three-point spread between cap and interest rate is required to achieve 75 per cent LTV.

The obvious solution is to find property that offers a cap rate more than seven per cent. That may be achievable in our secondary Saskatchewan markets, but is very difficult in our major Regina and Saskatoon markets.

You’re thinking, logically, cap rates will therefore need to increase in those major markets for trades to take place.

Theoretically, that is correct. However, historically the reality is that once the market has valued a property at a price, the owner of that property is not readily willing to accept an amount much less.

Try the math

Let’s look at an example. What is the change in valuation of a $5-million property based on a 6.25 per cent cap rate when that value, due to above-mentioned factors, is altered and now based on a 7.5 per cent cap rate?

If your answer was just over $535,000, you’re correct.

This example illustrates a drop of more than 10 per cent in the value of that asset.

You can see why most owners would rather hold on and wait until the market returns.

The moral of this story is if you’re considering investing in commercial real estate soon, now is the time. Once rates go up, there will be far fewer properties available from which to select.

Your strategy may be to wait until cap rates rise.  That might work, but it’s very difficult to predict when that will happen.

Conversely, there has never been a better time to cash out of your Saskatchewan industrial and retail commercial real estate.

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