No investor wants to see the interest rates increase from a cash flow perspective, especially after we have all gotten used to these record low rates for so long. Increasing interest rates usually will impact the property’s cash flow performance, and this is the reality we investors are currently facing. It is helpful to understand how we got here…
A Perfect Storm Leads to Rapid Inflation!
- Record low interest for an extended period of time lead to continued and strong demand for housing
- Economies across the globe shut down due to COVID restrictions
- Governments printing trillions of dollars out of thin air
- Governments then giving money out with no real controls in place encourage spending
- Government vaccine policies that affected many parts of the economic engines in their countries
- As economies opened up in conjunction with the lifting of restriction lifting, the infrastructures of many businesses were ill-equipped due to staff shortages
Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Inflation Leads to Interest Rate Hikes!
So what has happened so far and where do experts think the interests rates will end?
The Bank of Canada’s overnight lending rates have increased already 1.25% this year. Very likely in line with the US Federal reserve bumping their prime rate another .75 on June 16th Canada is likely to do the same on July 13th. How high can we expect the Bank of Canada rate rise to? From all my reading from several sources, the overnight rate is expected to increase to potentially a high of 2.70% from its current rate of 1.5%.
How Long and How Far Can the Interest Rates Increase?
Here are three forecast links:
Here is something to consider in answering the question. How high will the government permit the rates to increase and for how long before they economy breaks? It is no secret for these interest rate hikes in Canada and the US, it is the governments’ attempts to curb inflation. During the pandemic, the US and Canadian governments had massively increased the national debt in each country. This means that our countries have a strong motivation to not increase the interest rates beyond what is absolutely necessary and to bring it back down as quickly as possible, especially with another US election in 2024.
What Will Happen With Interest Rates and the Economy?
Does anyone know for sure what will happen? No, but if the policy makers consult with those that actually understand economics and the actual situation at all levels, we have a better chance of having a softer landing! What we do know is that it is not in the best interest of the current government to permit the Canadian economy to sit in shambles.
We also know that the many countries that manufacture and provide products worldwide are not firing up which is directly affecting the supply chain issues worldwide. It will take some time to get back up and running in a more consistent manner.
We also recognize that Canada is a resource-based country. We have what the world wants and so Canada and those resource provinces are poised to benefit as many of the countries recover their economic growth.
Lastly, we also know that Canada is growing through international migration and housing starts are not even keeping up with the current demand. Therefore it is likely to have a recovery like in previous tumultuous economic times. The various real estate markets across the country may correct to some level and then they will continue to grow as demand increases in each market. Understanding the market drivers (such as GDP) and influencers (such as Government policies and interest rates) are going to be more important during these bumpy times as real estate is a lagging indicator of the local and regional economies.
What Does this Mean for the Local Real Estate Market?
Over inflated markets will experience the greatest effects. Vancouver and Toronto have already seen a major shift and will continue to see a shift away from a seller’s market to a more balanced market and in some cases, even a buyer’s market for certain products. What can people financially qualify for with the mortgage stress test requirements and the new and increasing interest rates? History has shown that the properties with higher prices typically see the largest corrections properties, but at some point the corrections will level off and then prices begin to rise again.
With oil prices and production way up and almost at record level, Alberta as a province stands to benefit the most, and there is a high likelihood that they will actually have a surplus budget unlike most other provinces. However there will be pressure to increase production and reduce oil prices as supply increases.
Real Estate is the Best Hedge against Inflation
The good news is that history has shown that hard assets like real estate are the best hedge against inflation! Why? Property values increase as inflation increases and then the loan to value ratio actually decreases as a result of the increased values. Another reason is that rents generally increase as inflation continues.
The key thing to understand is can the rental income increase at the same or better rate in relation to the operating expense rate increases? This rent increase to operating expense relationship is especially important in markets that have rent controls like in BC, Ontario, Quebec, & Nova Scotia.
Can Positive Cash Flow Properties turn into Negative Cash Flow?
Because of the increased mortgage payment due to the increased interest rates, you rental income may no long be so positive or may even require you to supplement your property. If that does happen, it is important to remember that you may still be in a positive net income position, as your equity in the property is still growing each month because of the principal being paid down.
Understand the Market and Ask Smart Questions
When looking at investing in real estate and understanding the importance of positive cash flow, is it time to panic when the property’s cash flow turns negative? Not necessarily and you should ask the following questions:
- Is it solely related to this property’s performance?
- Can the rents be raised? If so when? Are there rent increase restrictions?
- Are there areas where the property’s expenses can be reduced?
- How much can you afford to financially support your property in a monthly basis?
- How long can you financially support the property?
- Is this a chronic or acute issue?
- Who can you speak with to get sound advice?
Bottom Line, Don’t Panic!
Remember, if you have already invested in your property, go back to reviewing the fundaments of the region and local economies and why you purchased it. Get informed and make informed decisions versus making an emotional reaction.
There are always opportunities with change for those who pay attention. If you are planning to invest, buy quality properties that have the right ingredients for success, and longevity.
I know several investors that have variable rate mortgages that are concerned about should they lock in to a fixed rate mortgage and have questions. Please read this should you go fixed or variable blog from my go-to ace investment mortgage broker Keaton Kirkwood in which he discusses the various mortgage considerations. So what do all these interest rate bumps mean for the individual investors that have questions regarding their mortgages? Don’t wait till it is too late to act, please consult with your mortgage specialist of if you don’t have one please contact Keaton Kirkwood.
We have been here before, with the rise and fall of interest rates and real estate. It will come back. Rental real estate is a critical component to diversify your wealth portfolio, especially with how versatile the market is now. Even with rising interest rates, it is more important than ever to invest in quality real estate to protect your assets and overall portfolio.