Interest rate volatility affecting investment real estate in Alberta

Reality has set in concerning Alberta’s investment market: it’s no longer as vibrant as we’d like it to be.

The provincial election in April brought in a government that is pro-business, but the outcome of the upcoming federal election in October is far from certain. Many buyers and vendors still have a disconnect of expectations on real estate investment opportunities in Alberta. Those investors who are showing confidence and making investments in our market will be rewarded in the future through significant cash flow, principal reduction and, in time, capital appreciation. Higher capitalization (cap) rates lead to positive leverage that is difficult to achieve in other major markets throughout Canada. In Alberta, the spread between cap rates and the cost of financing can equate to an excellent yield for investors.

That brings us to interest rates, which are among the most relevant factors in commercial real estate investment. Important as they are, interest rates also rank among the most difficult factors to predict and rely on consistently. In Edmonton’s capital markets (and those across Alberta), interest rates affect most financing assignments that we work on. Investors constantly base their investment decisions on the interest rates that they believe they will obtain after consulting with the debt capital markets team. In a volatile market, less compression on cap rates from market disrupters (such as private REITs) indicate that we are at the trough of an economic cycle.

It is well known that most lenders price their rates on the prime rate, the cost of funds relating to deposits, or as a spread over the Government of Canada (GOC) bond rate for any selected term. For the best assets with strong covenants attached to the transaction, tier 1 lenders such as life insurance companies and schedule A banks will usually base their five-year term rate on a spread of 140 to 180 basis points (bps) over the GOC five-year bond. Tier 2 lenders will usually base their interest rates on their respective cost of funds, resulting in a spread of 220 bps-250 bps over the GOC bond rate.

For example, a neighbourhood retail centre with a solid mix of tenants would trade in Edmonton in the 6.25% to 6.75% cap rate range, according to Altus. On this type of asset, the overall interest rate (based on the spreads listed above) would currently be 3.05% to 3.70%. This variance of 3.00% to 4.00% is attractive to many private investors in our market.

Lately, however, we have seen some Alberta lenders implement a floor rate around the current prime rate (3.95%). The trend in GOC bond rates through the first eight-plus months of 2019 has been volatile – to say the least. The wide swings that we have seen this year are reflected in the graph below. As indicated by the orange line, the yield curve today has inverted, as the five-year GOC rate was higher than the 10-year rate on August 15.

This trend could cause lenders to cut fixed interest rates relative to floating rates in the near future. Many investors prefer the certainty of a fixed rate when calculating their yields on a real estate asset. We are seeing interest rates on the A-class industrial, office and retail assets well under 4.00%, something that hasn’t happened in the last two years. This situation creates an excellent opportunity for many investors in Alberta to acquire industrial, office and retail assets at cap rates above 6.00%.

Conclusions:

• Investors: Be ready to set the interest rate.
• As the federal election campaign gains steam, interest rates may begin to rise and continue to rise towards the end of the year.
• Amid the downward trend in bond rates, the stock market has remained relatively strong.
• We are five years into the last economic downturn in Alberta, and lease terms should be coming due for many tenancies that were on five-year terms. How these are dealt with can provide more income certainty and impact investment decisions.

(Ron Dezman is a senior vice-president in Avison Young’s Edmonton office. Brennan Yadlowski is an associate in Edmonton. Both are members of the company’s Alberta capital markets team.)