How to navigate rising rates, tighter mortgage qualifications and softer valuations

We all know by now that things are changing in the real estate market. 

I love this quote by writer H. Jackson Brown:

“When you can't change the direction of the wind – adjust your sails,” 

That is exactly what we need to do as real estate investors right now. Changes are happening on many fronts, and we all need to adjust our sails to navigate the new waters, keep the momentum going and reach our destinations.

Here is a summary of the fundamental changes and what you can do as an investor:

Change #1: Rising rates

Clearly, the Bank of Canada is on a mission to combat inflation and is using the rate policy as a tool to do so. The prime rate has increased several times in 2022, with the last increase in July by 1%.

The media is scaring everyone and making it sound like the sky is falling. Yes, the rates are rising, and the prospects of a recession are rising. These are things you and I cannot control. What we can control is how we navigate the waters ahead. It is important to remember that rate increases will stop once the BOC gets a handle on inflation. While no one has a crystal ball, indicators show that we are yet to see another 1.5% - 2% increase by early 2023; then, we will stay there for a while, a period of 18 - 24 months before things start to ease up again.

So, what can you do here to navigate:

Now is the time to sit down with your mortgage advisor and assess the impact of rising rates on your cash flow and portfolio and discuss the best ways to navigate your case. There are various tools and strategies that you can utilize, including: 

• Locking into a 1 - 2 years fixed rate (5 years is not recommended at the moment as the gap between a 5-year variable and fixed is about 200 points, and you would be locking in at the peak of rates for the next 5 years).
• Debt consolidation strategies include replacing high payments (such as car loans, investment loans and unsecured loans) with cheaper debt (secured lines of credit or lower rate mortgages).
• Re-amortizing loans by extending the amortization to reduce the monthly payment.
• Convert to capped rate mortgages; the monthly payment stays stable as rates rise but more goes towards interest versus principal.
• Restructuring your mortgage into a mortgage (principal and interest payment) and a secured line of credit (interest-only payment) can reduce the monthly payments and ease the pressure on your budget. Some products allow you to re-convert the line of credit to a mortgage anytime.

If you are a commercial real estate investor in the midst of a renovation/construction and looking to refinance 12 – 18 months out, we must assess the impact of rising rates on your future equity take-out. Increasing rates for both Government of Canada and the Canadian Mortgage Bonds will directly impact the Debt Coverage of your property and, therefore, the loan amount the property qualifies for. 

Do not wait until the time comes to discover that you can not take out the equity you initially planned for or that you are running into a shortage that you can not pay off existing liens on the property.

Change #2: Tighter mortgage qualifications

As the rates continue to rise, the qualification bar the residential lenders use to approve borrowers for mortgages will also rise because, under the Stress Test rules, lenders will qualify the loan request at the higher of the Bank of Canada qualification rate, which is 5.25, and the mortgage rate you are being approved for plus 2%.

After the recent July rate increase, the qualification bar has exceeded the 5.25 benchmark for the first time. This means qualifying for less than you wish for, injecting a higher down payment or shifting your deal from an A lender to a B or from a B to a private lender.

You can utilize various debt management and income-generating strategies to help maintain your borrowing power.

Debt management strategies

These are strategies that focus primarily on reducing the monthly payments on your balance sheet in the eyes of the lenders to help ease up the pressure on the lending ratios.

The fact that you are paying an interest-only payment on a loan or that you have an interest-free loan with a six months grace period does not mean that the lender will take that into the calculation. Lenders have their own ways of running the numbers. As a result, re-shuffling some debts through consolidation or re-amortization can have a huge positive impact on the numbers.

A simple example on this topic: is a $20,000 balance on a Home Depot card that you used for renovations and that you are currently not paying anything on because you got a 3-month no-pay promotion. In the eyes of some lenders, that card is costing you 3% per month (i.e. 600 dollars)

Another example is a car loan or an RRSP loan, where your monthly payment is high, and you have a small balance left on the loan. The lender does not care about the small balance. They care about the monthly obligation.

Debt management strategies can help you declutter your balance sheet and open up the room with the lenders to maintain your borrowing power.

Income strategies

The other tool is income related, where we can look at ways to add income to your application by utilizing higher rental income or supplementing your income. This includes: using higher rents on your application through an appraiser’s opinions of what a property can rent for. This can help the numbers in some cases where you have a vacant unit or you are charging below market rents and where the market rents are higher. 

In regards to your income: we can look at ways to pay yourself more from one or more of your businesses if you are an entrepreneur or add a guarantor to the deal or partner to help the numbers.

Change #3: Softer valuations

Demand in some markets has cooled as rising rates and tighter mortgage qualifications impacted affordability. In return, it has affected what houses are selling for and the time on the market to sell. For investors, this presents both a risk and an opportunity. 

On the risk front:

If you are in the midst of doing a BRRR  (Buy/Renovate/Refinance/Rent), adjust your expectations in regards to the values on exit and revisit the refinancing options and numbers with your mortgage advisor to ensure you are well positioned to exit the deal.

Suppose you have private money on one or more properties and have taken a high leverage position to purchase the property and renovate it. In that case, it is best to exit that expensive money now while the values are relatively holding up. 

Some clients may need an equity partner to step into the deal to help exit the private money if the funds from a refinance are insufficient to clear the debt. 

Planning and exploring your options are key to heading into this new cycle.

On the opportunity front:

If you have equity in your properties, you should line up the equity through secured lines of credit (increase existing lines or set up new ones) while property values are still holding up and the qualification bar is still manageable. 

Do not wait to line up equity when you need it. Do it when you do not need it and have it in your back pocket. The next 12-18 months will present buying opportunities for investors, and those who got their ducks in a row will benefit. 

If your renewals are six months out, do not wait. Take the time to revisit your options, including your equity in the property and the terms available to you now versus six months out.

And finally, take time to clean house now so you can still qualify in the future if you want to continue growing your portfolio. By cleaning house, I mean: getting rid of any expensive debts or mortgages like private mortgages.  

If you are concerned about the environment ahead and need guidance on how to ride the wave, position your finances to ease up any cash flow pressures, or jump on the real estate opportunities the new environment will present, contact our team for a complimentary planning session. We will help you move forward with clarity and confidence.

Dalia Barsoum is the founder of Streetwise Wealth, a boutique real estate advisory firm and Streetwise Mortgages, a multi-award-winning brokerage specializing in income property financing and Canada's #1 small markets broker (AKA rental markets) as ranked by Canadian Mortgage Professionals. 

She is the best-selling author of Canadian investor financing: 7 Secrets to Getting All the Money you want, a columnist for Canadian Real Estate Wealth magazine and has been recognized as a Global 100 mortgage professional, one of Canada’s top 10 brokers and a woman of influence.

Through strategic real estate financing advice and sophisticated deal structuring solutions,  Dalia and her team have helped thousands of Canadians kick start their real estate investment journey and take their portfolios to the next level while managing risk. With a specialty in scaling up portfolios, the brokerage offers investors sophisticated deal-structuring advice and services that help optimize capital structure to grow wealth, coupled with various sources of capital (i.e., institutional, alternative, and private funding for residential, multi-residential and construction projects).