What Current Interest Rates Mean for the Commercial Real Estate Market

Early in March, the Bank of Canada slashed interest rates to 25 basis points in an effort to stabilize markets and the economy. In addition, the government announced Fiscal Stimulus and emergency relief loans to help citizens and struggling businesses with cash to meet immediate needs.

Low interest rates incent homeowners and companies to take on additional debt, or refinance existing mortgages. Historically low rates have led to an increase in new mortgage loans. Banks reported a 14% increase in new loans in the first quarter of 2020 compared to the same period last year. Refinancing increased by 21% in the same period. During this time, mortgage debt has begun to undergo significant growth, due in part to the deferral of payments allowed by the big six Canadian banks as part of measures taken to help clients adjust to the pandemic. While payment deferrals will provide a cushion for many hard hit businesses and homeowners, a rise in corporate and household debt adds additional pressure on the economy and banking system.

Sectors most vulnerable to the pandemic, such as retail or hospitality, are expected to continue to have high delinquency rates. In the second quarter of this year, commercial mortgage delinquencies were up 2% on average, with the majority concentrated in the hotel and retail sectors which faced delinquency rates as high as 24.3% and 18.1% respectively. If delinquency rates continue to climb, properties can snowball into foreclosure. If they manage to stagnate, many businesses and owners who face maturity on their leases in 2 – 3 years would still be severely sensitive to rate increases. Due to the weakened position of many companies as a result of pandemic prevention measures, the commercial real estate market is increasingly more sensitive to rate pressures.

The effects of the pandemic on cash flows will have a long-lasting effect which could make it difficult for over-levered companies to pay off mortgage debt. This effect will further be magnified if excess fiscal stimulus leads to an inflationary effect, triggering a hike in interest rates. At current debt levels, even a 50-75 basis point increase in rates can have a significant impact on companies which are already struggling to generate cash flow. Consequently, it will be important for businesses to constantly monitor their debt levels and ensure that they can service their mortgage despite a decrease in cash flows and a 50-100 basis point rate hike.

Although the immediate shocks of the pandemic on both the residential and commercial real estate markets are palpable, long term consequences are yet to be clear. An analysis of the current positions of homeowners and business owners shows that both markets are increasingly susceptible to future rate changes, as a result of weakened financial positions, increases in debt, and temporary reliance on current market conditions. Despite these risks, effective fiscal and monetary policy can see Canada’s real estate market through the coming years.