In a previous post, I discussed interest rates and their effect on real estate values. I argued that they did indeed alter buyer perceptions, and consequently value and price. But what about absolute interest rate levels? Is easy money coming to an end?
Many lack any experience of high interest rates
In a June 5, 2017 Globe and Mail article entitled Remember When: What have we learned from the 1980’s and that 21% interest rate?, author Richard Blackwell quotes CIBC World Markets deputy chief economist Benjamin Tal “We have a generation of Canadians who have never experienced high, or even rising, interest rates,”. He goes on to say “For them, those extremely low interest rates are a given.” Are interest rates likely to test those levels in the future? Likely not, for a host of reasons. First, inflationary pressures seem not to be as prevalent. Yes, you could argue there is price volatility, and a quick trip to the local gas station will confirm that opinion. However globalization seems to have had a positive impact over the past several years. The article states that “Low-priced imports from developing countries have helped keep domestic prices down, and that situation is not likely to change significantly in the next while.” Second is the shifting demographics in Canada, baby-boomers are aging and downsizing and exiting the housing markets. Demand for funds, while still robust, is tapering off.
Is easy money coming to an end?
If inflationary pressures are generally in check, and aging baby boomers are inevitably curtailing spending, are we in for an extended period of low interest rates? Not so fast. In a recent Reuters article entitled Tide about to turn for markets as easy-money decade comes to an end, authors Sujata Rao and Dhara Ranasinghe suggest that “While markets reached dizzying heights during the easy-money era, that flood will dry up the the end of the year. For the first time since 2011, the central banks are expected to suck out more cash in 2019 than they pump in.”
Implications for Property owners
If the era of low interest rates is ending, what will rising rates mean for for commercial real estate buyers? One of the most important considerations in real estate acquisition is cash flow, both current, and anticipated. The absolute level of interest rates, and consequently mortgage rates, speak directly to the performance of commercial real estate. Why? Because of the direct impact on the present value of future cash flows. Your cash flow after debt repayment is eroded by increasing interest rates, and strangled by absolute high interest rate levels. High interest rates lessen future cash flows, which lowers the value of the asset.
Historically inflation rate increases often happen in tandem with interest rate increases. Inflationary pressures seem not to be in evidence, at least not to the degree as we’ve seen previously. One interesting byproduct however, is that while property owner cash flow may erode, inflationary pressures often do increase the value of hard assets. So while increasing interest rates and inflationary pressures erode cash flows, savvy investors often turn to real estate as it has an uncanny ability to whether the storm of inflation.
Written by Allan Jensen