Bond rates have dropped significantly since Jan. 9 with both the Canada Mortgage Bond (CMB) and the Government of Canada (GoC) bond being affected. Defying most predictions, the already low bond rates have sunk further. Below are the current yields as of Feb. 19 and how far they’ve dropped from Jan. 9.
GoC 5 year: 0.86% (-32%)
GoC 10 year: 1.47% (-14%)
How does this affect you? Many commercial mortgages are priced as a spread over bond rates; apartments over the CMB and commercial properties over the GoC.
The five-year rate on a mid-size apartment in Kitchener, Ont., that would have been 2.45 per cent on Jan. 9 is now 1.97%. While it can be difficult to get a clear reading, there doesn’t appear to be any corresponding cap rate compression as a result of the bond drop.
This means the property owner can benefit from the increased gap between their mortgage interest rate and the cap rate of the asset.
Using the same Kitchener apartment as a metric, your leveraged IRR over a five-year mortgage term and holding period would rise from 10.76% to 11.45%. Over a 10-year term/holding period the leveraged IRR would increase from 11.31% to 11.72%.
Large movement in one month
An additional 69 bps and 41 bps, respectively, in IRR, based on nothing more than waiting a month, is a large movement. You’ll also note the five-year term is offering a greater IRR increase as the five-year bonds have fallen further on a relative basis.
What if you’re not currently at your mortgage maturity? Does it make sense to pay the Interest Rate Differential (IRD) or defeasance penalty to take advantage of the low bond rates?
This is a question that has dominated most lenders’ time for the past several weeks, with clients calling daily. When the prepayment penalty is smaller than the interest savings over the remaining term of the mortgage, the answer is an obvious yes.
It gets a little murkier when the penalty is larger, as you now have to account for potential savings of locking in a rate on a new mortgage immediately or waiting for your maturity. Given that bond rates are at historic lows, the prevailing wisdom is that they should be higher if you wait 12-36 months.
You’re making a wager on how much higher.
I was examining this exact scenario for a client who owns an apartment in Brampton. He has 13 months remaining on his term and the IRD penalty was slightly larger than the savings over that time. We calculated his break-even point and determined he was betting interest rates would be at least 17 bps higher in 13 months.
Chose an immediate refinance
He was comfortable with this prognostication and proceeded with an immediate refinance.
Another client has 33 months remaining in a CMBS loan on his retail/office plaza in Markham, which meant a large penalty as it was calculated using defeasance. His break-even point was a 70 bps interest rate rise over the next 33 months. This is where it gets tricky, as predictions so far out are nebulous. He is still considering his options.
This is a unique situation to have real estate financing available so cheaply due to a bond rate drop, and the markets aren’t sure how to respond. Many lenders have begun instituting floor rates on certain mortgage products but it is far from industry-wide.
Cap rate compression is possible if the bond rates remain at this level for a prolonged period, although I will admit finance is just one of several determining factors. We don’t know how long this window of opportunity will last, but I would recommend spending a little time with a financial calculator and closely examining your portfolio.
Adam Powadiuk is a Business Development Manager 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 firstname.lastname@example.org.