Commercial Real Estate Investments in an Era of Rising Interest Rates

by Trevor Clay

Values for investment grade commercial real estate across Canada have been on a strong positive trajectory for the past decade. The pace of this growth certainly varies between markets, however, overall, the trend has certainly been upward.

This trajectory is driven by the simple economics of supply and demand. There is an abundance of local and international equity that wants to invest in the Canadian real estate market and there is simply not enough quality product to satisfy it.

Layered on top of supply and demand has been an era of low interest rates and a strong debt market that has served to further fuel the fire of rising values. The result of a combination of these factors has been capitalization rate compression to historical lows.

The impact of this in a market like Winnipeg has been that “B” and “C” quality real estate has been selling at “A” quality pricing.

While debt markets remain strong, central banking policies have now begun to turn the dial back up on interest rates in an effort to curb inflation. Interest rates for most commercial real estate loans are priced off of the 5-year Government of Canada Bond which has increased 30 basis points since the beginning of 2018, a 15% increase in 4 months. Common wisdom is that there are more near-term interest rate increases ahead.

The impact of rate increases over the past 12 months has been significant with a full 1.00% increase on most commercial loans as compared to what was previously available.

While this has not yet had a proportionate impact on capitalization rates, as rates continue to climb, its influence is inevitable. The impact on institutional level assets in core markets like Toronto and Vancouver will likely be less as financing is less of an issue but for properties under a $10 million value, vendors will feel a real effect on their valuation.

There is still time to consider selling as current interest rates still provide positive leverage to investors. The question is, for how long?

(Trevor Clay is the chair of the Commercial Division Executive Council of WinnipegREALTORS®.)