The returns of Nicola Wealth’s real estate funds in the first half of 2022 were music to the ears of investors worn down by the general grim fate of stocks and bonds. The Nicola Canadian Real Estate Limited Partnership rose 11%, the Nicola U.S. Real Estate Limited Partnership, 13.7%, and the Nicola Value Add Real Estate Limited Partnership, 11.6%. But Managing Director of Nicola Wealth Real Estate (NWRE), Mark Hannah, speaking at the real estate team’s Mid-year Update webinar, warned that the rapid rise in interest rates would ultimately impact property values too.
Since the last departmental update in February, he noted, the Bank of Canada overnight rate had risen 225 basis points. The conventional, five-year fixed mortgage rate had jumped from approximately 4.75% to 5.5% from 2.5% to 3.5%.
“That is a pretty significant change in a short period,” Hannah said. So far, it has not driven a noticeable change in real estate cap rates, at least not for the property types in which NWRE is concentrated. But we can no longer expect asset values to appreciate in the double digits on their own. And as more and more of our mortgages come up for renewal, higher rates will begin to weigh on returns.”
“Our NWRE Team has been planning for this moment as we knew eventually that interest rates would not stay low forever,” he said.
During the presentation, Hannah continued to explain that the key to ensuring NWRE’s funds stay ahead of rising inflation and interest rates is structuring leases to have built-in annual rent increases. By buying properties with below-market rents and improving them, NWRE has been able to raise rental income when leases mature and when we fill vacant space.
“We will not acquire properties where the rates are fully baked or above market, eliminating any opportunity for income growth,” he said. So far this year, the three real estate funds’ net income growth “has been, in our view, significant, and this has served us well to counterbalance rising cap rates in a higher interest-rate environment.”
NWRE’s debt finance group was on its toes too. When interest rates looked to rise from their COVID-19-era lows in late 2021, “our mortgage team went on offence,” Hannah said. “We renewed mortgages two and even three years in advance on properties where there was a low early renewal penalty. Still, the loan maturities are staggered over seven to 10 years, so we will not be overly exposed to spiking rates in one particular year going forward.”
The team’s build-to-own strategy, adopted five years ago, further enables NWRE’s real estate team to create value by building exactly the kind of properties that are wanted in locations where the alternative — buying a finished building — would not provide the kind of returns they seek.
“The bottom line is that we have an experienced real estate team who can make adjustments to changing environments and still achieve positive outcomes, and we have proven that once again, as evidenced by our returns in 2022,” Hannah said.
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