Bond rates up means prices down

The Canadian commercial real estate sector has been on fire for the last decade.  A good portion of that momentum has come from a prolonged low interest rate environment combined with a lack of suitable alternative investments for investors to park their investment dollars.

The overheated market may be coming to end as Canadian bond yields have started to move northwards in rapid succession, quicker than any expert anticipated.  For the commercial real estate investor bond yields are significant as they determine the ultimate interest rate for the mortgage. 

The formula is as follows:

5 year bond yield + premium charged by financial institution = commercial mortgage rate

As the yield goes up, so do mortgage rates.  It's that simple.

The real question is what does this mean for investors?

To answer this question, one must understand that there is an inverse relationship between mortgage rates and property value.  As mortgage rates go down, property prices go up.  As mortgage rates go up, property prices go down.

The real problem lies in the fact that there is a lag between the movement of the two, especially when the market experiences aggressive moves like the recent one in the bond market over the past few weeks.  So while bond rates, and ultimately mortgage rates may have already moved up, property prices are pretty much still sitting unchanged.

Assuming that the move in the bond market is more than just a blip and is becoming a trend, investors need to be weary of making purchases during this period as they may end up over paying for a property which has a purchase price based on a lower interest rate environment instead of being based on the current higher rate environment.

In practical terms, we've seen the 5 year bond yield increase almost 80 basis points in just the past 4 months, which directly affects new mortgage rates.  However, we have not yet seen a corresponding drop in prices that have practically remained unchanged over the same 4 month period.  If history holds true, if bond yields continue to hold or rise, we should start to see a decrease in property prices.

As such, the most prudent course of action for the commercial investor in the short term may be to sit on the sidelines to see if either bond yields pull back or if real estate prices pull back as one of the two has to happen to put the commercial real estate market back into equilibrium.

Author: Paul Kondakos, BA, LL.B, MBA - Professional Real Estate Investor - RealtyHub.ca