Bond Yields Fall After US Hikes Interest Rates! What This Means For Investment Properties In Toronto
Our current investment property market is actually pretty good if you’re buying with cash. Rents have seen double digit record jumps and prices have come down by double digits, so rent yields are actually a lot better compared to before the rate hikes.
But not many people can buy with just cash. Most investors borrow money to buy investment properties, and rising interest rates have been cancelling out the benefits of rising rent yields. So for most investors, the rental income numbers don’t actually look as great. And then, when the general consensus is that Canadian real estate is going to see a historical correction, it doesn’t make a lot of sense to buy these days.
Now we are starting to see very early signs that things might be approaching a bottom because bond yields have been dropping, which means the bond market expects interest rates to come down. So in this video, let’s take a deeper dive into this.
How interest rates affect real estate investments
Before rate hikes started happening, a 4% cap rate was considered amazing. In case you don’t know, the cap rate is the net rent yield you get on a property by taking your net operating income (calculated as your annual rent minus annual operating expenses) divided by the market value of your property. When mortgage rates were around 1.75%, you’d be cash flow positive by $500 per month at a 4% cap rate.
Now market conditions have changed quite a lot since then. Apartment rents in Toronto have shot up around 10%, and it’s very possible to see a 20% discount compared to before. So, that takes cap rates to over 5.5%, and that’s why rent yields look a lot better if you’re buying with cash.
But if you’re buying with borrowed money and you’re using a future proof interest rate of 5.5% based on another 100 basis point rate hike this year and 50 basis points more next year, then cash flows are still lower than before, still positive but closer to $100 per month.
So right now, one of two things might happen from this point on:
- Prices might have to adjust down more, which a lot of people are betting on to take cash flows back to the $500 per month mark. This means prices will have to come down another 10% for cash flows to look similar to before the rate hikes.
- More investors will get used to lower cash flows because they understand higher rates aren’t forever and take the view that cash flows will improve when rates come down. And if interest rates don’t go up as much as expected because of a looming recession, then cash flows will improve sooner than expected.
What's happening to bond yields?
We saw the US Fed hike rates by 75 basis points last week. But instead of seeing longer-term bond yields rise, they actually dropped. In fact, Canada’s 5 year bond yields are now down 100 basis points since the peak in mid June.
Here’s the thing: Even though we do expect central banks to continue their hiking rates, it’s not anything new and has already been priced into the market.
The “new” news that the market is focusing on these days is more clear signs of a recession. With the latest US GDP data showing two consistent quarters of contracting, a recession is looking more and more likely, and so interest rates will need to come down if that happens.
What does falling bond yields mean for Toronto real estate investments
We’re reaching a point where the market is getting split. There might still be deals, but you’re going to see fewer of these once more people expect interest rates to start stabilizing and then come down. So if you buy at 10% off today’s prices and cash flows look great at 5.5% interest rates, then cash flows might end up even look better if actual rates end up being lower than that.
And what’s more, if the general market starts using lower interest rates soon for buying decisions, then this means we might see a quicker price turn back up than expected. For example, if the general market starts using a 5 year average variable rate of 4.5%, similar to the recent 100 basis point drop in 5 year bond yields, then prices can come up 12% from the price you bought at to keep the cash flows the same. It may still be too soon to tell for sure, but we are definitely seeing early signs that a real estate investment property bottom might be coming soon.
And here’s my last final note, which is that this drop in bond yields is a sign that’s specific to investment properties. In fact, we are likely going to enter a period of divergence between investment properties and end-user properties. Remember this. Investment properties do better in higher interest rate environments because rent yields also rise, and this will continue to balance the higher rates and keep holding power strong.
The 1.75% to 4.5% steep rate hike might actually be manageable for investors, but because end users have to absorb the entire impact of these higher rates, end user holding power is weakened drastically. As a result, we expect home prices to remain lower for a much longer period of time, even if average 5-year mortgage rates fall by 100 basis points.
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