[ Finance ]
Today’s
Interest Rates and
Tomorrow’s
Growth
By Barrie Battley
The current economic situation has delivered historic low interest rates resulting in many apartment owners opting for mortgage loans with 10 year terms or longer, to mitigate the very real risk of rising interest rates. However, the freedom to access built up equity in the future, through refinancing, can be severely limited by prepayment penalties. Today’s borrowers do have an option available to access additional capital under these circumstances. No one can predict precisely when interest rates will attain their lowest level during this current economic cycle. The competing factors are much too varied for even the most sophisticated forecasters to pinpoint when this will occur. All we can do is look at the past and try to determine the future. Mortgage interest rates for terms ranging from one to 10 years have been relatively stable for the past 5 or 6 months; during that period they have only varied by a total of about 50 basis points (1/2 of 1%). Interest rates have not yet risen significantly because central bankers from around the world are still very much concerned about lackluster global economic performance. Economic and political troubles still abound in Europe, especially in Greece, and there has been a definite slowdown in China. However if we assume that we are not facing an economic Armageddon, then there is only one direction in which interest rates can go and that answer is UP! When rates eventually do increase, the move will most likely be quite rapid and without much or any forewarning. In past economic cycles, interest rates have quite often risen by as much as 50 basis points at one time, only to be followed by another similar increase in as little as 60 days.
22 may / june 2012
[ Finance ]
With a long term mortgage, the apartment owner could enjoy another huge future benefit. In order to mitigate this risk, apartment owners may consider opting for a 10 year term mortgage. By doing so, they will be protecting themselves from one of the most important components making up cash flow risk. With a long term mortgage, the apartment owner could enjoy another huge future benefit. If the owner decides to sell his property during the loan term and the interest rate on his mortgage is considerably lower than prevailing market rates, the landlord could achieve a higher than normal selling price provided the purchaser qualifies to assume the existing charge. In other words, there is embedded value in assuming a mortgage with a lower-than-market rate of interest. However, some longer term mortgages may not provide the landlord with the flexibility to re-finance mid-term. Many conventional mortgages do not permit prepayment and none of them offer an increase under the existing charge. Some longer term loans have clauses in the mortgage document prohibiting any additional second mortgage financing. Because property values usually increase over time, borrowers who think they may require increased leverage in the future need to discuss their requirements prior to signing the mortgage. Some conventional lenders and most CMHC lenders are now providing “yield maintenance “clauses in the mortgage documentation. The “yield maintenance” clause allows the borrower to prepay his mortgage prior to maturity by discounting the sum of all the remaining mortgage payments by the current Government of Canada bond yield having similar maturity. Since conventional mortgage rates for most multi-family properties are determined as a spread over a similar Government of Canada bond in a range of 150 to 250 basis points, any resulting prepayment could become quite costly to the landlord. Borrowers seeking increased leverage through re-financing need to rethink this option. One significant option for an apartment owner requiring increased leverage is to select a mortgage which does permit second mortgage financing. The future secondary lender will usually require a new appraisal and an environmental site assessment update, as well as recent financial and operating statements in order to make the assessment of value for the property under consideration for mortgage purposes. Conventional second mortgages are restricted to 75% of value and a 1.20 times debt service coverage. Most often the interest rates on a conventional second mortgage are several hundred basis points higher than first mortgage rates at the time of refinancing.
24 may / june 2012
Any landlord who may require increased leverage in the future should consider obtaining a CMHC insured first mortgage at the outset, allowing a possible conventional second or CMHC insured second refinancing at a future date. Although obtaining CMHC insured financing can be time consuming and has an upfront cost, it can be worthwhile in the long run because CMHC insured mortgage rates can range from 50 to 150 basis points lower than conventional rates. With a CMHC insured first mortgage, the borrower has the option to obtain CMHC insured second mortgage financing when their cash flow increases during the 10 year term. Most CMHC mortgage Special Conditions to Funding will state the following, “The borrower will not register any subsequent encumbrances without the prior written approval of the Approved Lender. Such approval will not be unreasonably withheld.” The advantage of CMHC insured second mortgages is twofold – the borrower can obtain financing up to 85% of value, and also enjoy second mortgage rates very close to those of a first mortgage. The only real disadvantage of proceeding with CMHC insured first and second mortgage financing is the mortgage insurance premiums that a borrower will be required to pay. CMHC will require a premium for both loans. However, the premium on the first mortgage is usually more than offset by the interest rate savings, and a premium rebate is available to those borrowers requiring second mortgage financing within the first seven years of funding of the first charge. In summary, borrowers, especially those who consider themselves as investors and acquirers, should consider opting for 10 year or even longer term financing rather than shorter term loans. They should insist that the mortgage terms provide for yield maintenance and allow for second mortgage financing. Borrowers looking to obtain long term mortgages should definitely consider CMHC insured mortgages. If they qualify for insured financing, the cost of the mortgage premiums is usually more than compensated through lower mortgage rates on both the new first and the possible future second mortgage borrowing. RHB Barrie Battley is Senior Vice President of Business Development for Peoples Trust Company. Peoples Trust is a federally chartered financial institution headquartered in Vancouver with branch offices in Toronto, Calgary and Vancouver. You can learn more about us at: www.peoplestrust.comi.