To invest or not to invest? High inflation business real estate considerations

May 26, 2022

With 31-year record high inflation rates coinciding with Metro Vancouver industrial land scarcity, expanding businesses are facing a question of whether buying or leasing is the best path forward. In Surrey EconomIQ Insights Podcast Episode 06, we gain sit down with Ed Michielsen, Vice President of Business Banking and Leasing with Prospera Credit Union to cover hot topics from investment opportunities, risk management, and how to to weather the inflation storm. 

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Podcast Summary

Is now a good time to take a mortgage or continue leasing?

  • Current lease rates and market rates have not adjusted.
  • The asset you are looking to buy today has limited supply, but high demand. While the return on that today seems low, the truth is that market rates are likely going to go up to offset increased costs, which is really interest rates.
  • Investing in real estate may not look as attractive today and it may require lower leverage to service the debt as an investment, but the likely scenario is that without leverage, you won't get a decent return on your equity.
  • If you wait for tomorrow, they're not making anymore land so that scarcity doesn't change.
  • While you can't leverage the way you could a year ago when interest rates were record lows, you still have a leverage point where it's buyable and you can service it and then re-leverage it again.

Risk Management & Tolerance Considerations

  • Some questions to ask yourself is: What is your comfort level on debt? What is your current financial situation?
  • If you have sustainable cashflow and sustainable strong working capital liquidity and you're willing to take some risk, could be a good option for getting a sustainable asset.
  • In the long run, it's sustainable because we know that time heals all mistakes in real estate.
  • Is there a chance it's a wrong decision right now in the moment? Maybe. There's always the risk, but if you do it with strong working capital, strong cashflows and debt service, you can sustain it.
  • Bankers, lawyers and accountants are three good advisors, but if the banker becomes the lawyer or accountaint, or the lawyer pretends to be a banker or accountant, or the accountatin pretends to be a banker or lawyer, you should run. You need advice, but at the end of the day, you know your business best as the owner, so you should have a good idea.
  • When it comes to risk mitigation on the banking side, there's a stress test that is used, based on each industry. Some businesses don't require a strong working capital, but there is a debt service covenant that's applicable.
  • Typically it's cashflow that everyone relies on and the sustainability of that cashflow. That's what really powers the decision.

Should businesses get into the real estate business?

  • It's about diversifying your portfolio
  • An operating company looks at all the capital they need because it's the mothership that produces the profit to pay off the real estate. But from a diversification perspective, you're paying yourself over 25 years as a landlord.
  • It comes down to financial position - if you can come out with the down payment and not impact your operating company, it does makes sense to diversify
  • In 25 years, instead of paying your landlord for the building, you've paid yourself for the building and you'll walk away and leave the legacy for the next generation or have a retirement package
  • Surrey remains a great location for investing in industrial real estate. You look at the Lower Mainland - they're not making much anymore.
  • Surrey still has some industrial real estate and it's reasonably priced and affordable. When you go further west, it's even more challenging to be viable.
  • If the operating business is strong and can support the down payment, it's extremely valuable and diversifies risk.
  • For example, if a global trend makes a business redundant, you still own the real estate, so you've lowered your risk as a business owner.

Are interest rates the best solution?

The bank of Canada and US Treasury is likely going to be increasing rates two more times. From a practical perspective, it seems we all know inflation is being driven primarily because there's a supply chain issue and people expect if the supply chain constraints go away, inflation will go away. If so, are interest rates the best solution?

  • Governments have little else they can do. They need to try to cause a soft landing, but the only way they can stop that inflation is to raise interest rates and almost force a recession to get that balance back down. 
  • Today, consumers are going to have to make that choice - am I going to pay my rent or am I going to buy that car? Am I going to buy groceries or am I going to go to the movie theatre? 
  • Those are decisions that consumers, particularly as mortgage owners or renters, need to make. Household goods and energy costs - there's little you can do to control that.
  • The answer is that the government needs to do it. The good news is that with record levels of government and consumer debt, this could be over soon. You can only go so high before it becomes unsustainable.
  • This time around is different from the 70s, where interest rates were at 20%. If you look at the levels of debt loads back then, they weren't that high because most people took a more conservative approach; someone paying two times their annual salary for their house was crazy. Today, people are paying 10-15 times their annual income for a home. Governments today are writing cheques that the next generation can't even cash. 
  • So the good news may be that rates can only hit so high and it will be forced to go the other way. The bad news is that we may see a big recession out of that.
  • If you're in a sustainable industry where you have competitive advantage and good relationships, you'll be fine. The businesses back then that had sustainable cashflow, acceptable levels of leverage and strong working capital made it through and actually came out stronger. But to do so, they needed a strong relationship with a good banker, good lawyer and good accountant.

How to weather the storm

  • It comes down to business model. Take a look at it and ask yourself, "What is sustainable cashflow?"
  • Also ongoing and increased need to be agile with a sense or urgency. Business decisions will need to be made quickly with a long-term sustainable perspective. If you wait too long, there could be unintended long term consequences because we're in uncharted territory
  • Economists are the world's worst weathermen. No one knows what's coming and with this level of uncertainty and the speed with which changes come, businesses need to have the agility and urgency necessary to make those decisions.

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