Introduction
Historically, there is a known correlation between cap rates and bond yields too. So in this video, let’s see where cap rates are headed by taking a deeper look into how they relate to bond yields.
What Are Cap Rates
Relationship Between Cap Rates & Bond Yields
Generally, when you look at different investment opportunities, you’d use the risk-free 10-year government bond yield as the base line, and you’d stack all other investments against it. The cap rate on investment properties would be higher than the risk-free rate, and that’s because you’re compensated for taking on a higher level of risk.
And when you stack the cap rate against the 10-year bond yield, you will see a consistent spread between the two. When bond yields are higher, the cap rates would need to be higher as well. And when bond yields fall, then cap rates will also fall.
Spread Between Cap Rate & Bond Yields
Most people automatically assume that the spread between the two will be the same throughout. But when you look at historical data, it turns out it’s actually not.
As you can see, when bond yields are lower, the gap widens; when bond yields peak, the gap compresses. At the moment, we haven’t actually gone past the peak set in June, despite all you hear in the news with bond yields spiking.
And more recently, we just saw Australia slow down rate hikes to 25 basis points, and that was smaller than expected; Poland paused rate hikes; and the UN and other investment experts are puting pressure on central banks to slow down interest rate hikes to prevent a hard recession.
So based on all of this new stuff that’s happening, we believe that 10 year yields have peaked at this point. Going back to the cap rate chart, the spread at the peak is around 2.25% higher than the 10 year bond yield. Right now, 10 year yields are close to 3.25%. So, based on historical trends, cap rates for multi-family homes might peak at 5.5% across Canada.
Cash Flows, Cap Rates, and Bond Yields
If you don’t think history will repeat itself again this time around, here’s another way to look at things to help you understand why the spread compresses when rates peak. Here’s the thing: investors don’t usually buy real estate with just cash.
So instead of just looking at cap rates, they’re also looking at cash flows after you put off your mortgage payments each month. And what happens is that when interest rates are higher, the spread between cap rates and interest rates can be compressed to maintain a similar level of cash flows.
To understand this, let’s head over to a mortgage calculator. When interest rates are lower, you can see that the principal paydown is around 2% of the property value. In other words, you’d need roughly a 2% spread between your interest rate and your cap rate to have break even cash flows. If we bump up the interest rate to 4%, the principal paydown portion drops to around 1.4%. And if interest rates get to 5.25%, which is where they are now, the principal paydown drops closer to 1.1%.
Basically, because the principal paydown portion goes down when interest rates go up, this is the big reason why the gap between cap rates and bond yields can compress when we’re at peak rates.
Other Factors That Influence Investor Decisions
Now, the next thing you have to keep in mind is that investors know that interest rates fluctuate over time—really, even though you enter at high interest rates, you’re not actually stuck with them forever. So, as long as the price is right and the numbers still point to strong cash flows, investors would be willing to take a temporary hit on slightly lower rent yields to benefit permanently from deep discounts.
The current market in Toronto is still very weak and after another scare from September’s rate hike and a hawkish sounding Bank of Canada, a lot of buyers got scared off again. Honestly, it’s really less so because of fundamentals and more so because of fear. But this also means that if you’re buying these days, there is a chance that you can get better than normal deals, much better than the average 25% drop from the peak that we’ve seen so far.
And the numbers are still strong for investment properties in Toronto. You can get similar cash flows even at higher interest rates, and you benefit from huge discounts. Right now, we are back to early 2021 prices at least. When prices rebound, you end up much better off compared to everyone who’s bought since then.
How We Can Help
We’re a real estate sales brokerage that focuses on real estate investing in Toronto, and this is what we invest in ourselves too. When you work with us, we’ll take the time to learn more about you, teach you all about real estate opportunities in Toronto, and eventually match you up with the one that best fits you.
After we help you buy it, our team also provides renovation guidance, leasing and property management if you need it. Just connect with us if you want to learn more about our services!
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