Investing in a Rising Interest Rate Environment

Rising interest rates are an opportunity for investors in residential mortgages. RiverRock’s Nick Kyprianou tells Michael Hainsworth it means less business for the banks and more business for Mortgage Investment Corporations like his.

Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

Michael Hainsworth:
Interest rates are on the rise as the Bank of Canada turns hawkish on inflation. By some predictions, we could see 100 basis points added to the overnight lending rate before the kids are out of school. But as Riverrock’s Nick Kyprianou points out, tighter borrowing restrictions can be good for investors — particularly for those invested in Mortgage Investment Corporations like Nick’s MIC. Kyprianou doesn’t lend money to residential mortgage seekers for more than a year — and that’s a good thing in a rising interest rate environment. But how high the moon? Kyprianou isn’t buying the 100 basis point prediction.

Nick Kyprianou:
I don't think it'll go ... It went up a quarter last month. It's really looking, or maybe this month, it really looks like they're going to push for the 50 basis points in April. And I think to go up another 50 before the end of the year would be pretty aggressive. There's lots of moving parts. And I always say when you do things like this, you have to also think about the unintended consequences of these actions, right? You just can't look at one thing, inflation being that one thing that they're focused on, and just focus on that exclusively. There's a lot of other moving parts to this. People's debts, the economy, government debt, all of these things play a role.

If the rates keep going up, rates go up for the government too. That means they have more cost every month to pay the debt, therefore they have less money to do other things. People's debt loads go ... People that are borrowing money go up. So all of these things play a factor. So there is unintended consequences. So I think that they'll do the 50 next ... It looks like they're going to do the 50 in April. And then I think they'll wait and see. I think that will be enough to kind of settle things down. Probably when you take out the cost of gas, that probably reduces the inflation quite a bit.

Michael Hainsworth:
So then what would bringing the overnight lending rate to pre-2020 levels within weeks mean for residential mortgages?

Nick Kyprianou:
Yeah. I think that what would cause it to happen, just the bank just being single focused. And the Central Bank being single focused and just keep moving up the rates. I saw this happen twice before in my life. I wasn't working at the time, I was in school, but my family was very involved in real estate. And I saw when rates went up to 21% in the early '80s and the implication of that on my own personal family. And then I experienced the rate increases that started in '89 and it went to '95, where rates basically went from 8% to 15% over that period of time. And we had a big ... I don't know if you were in Ontario at the time, but we had a big real estate recession and erosion of values during that time.

Now rates weren't the only trigger, there were multiple triggers during that span from '89 to '95. You had rates go up from 8 to 15%. You had unemployment over 12%. You had manufacturers leaving Ontario to go to the southern states of Mexico because of high provincial taxes. You had mass speculation in the real estate market, predominantly in the high rise condo market, because back then the rules were quite different. As soon as you said you were going to build the building, the banks would provide financing immediately with no pre-sales. And the builders allowed you to put a deposit down of $500, and you wouldn't have to come up with the balance of the funds until the deal closed. So people didn't really have any skin in the game, so people said, "Well, why buy one when I can buy three and make more money?" Right? And then all of a sudden they couldn't close, and then combination of all these other triggers I mentioned, caused the values to draw pretty dramatically in the condo market especially.

Builders were doing the same. They were building streets out without pre-sales. Where now, you look at new home construction, whether it be townhouses, semis, or detached, they're not starting to dig holes until they've got at least 70% pre-sold. And detach homes, they're not building until they are pre-sold. They'll build a couple of models here and there, but they won't go build streets out. High rise condos, you have to have 70% pre-sold before you can obtain bank financing, and builders are requiring anywhere from 10 to 20% down payment within the first six months of the offer.

Michael Hainsworth:
I can't imagine you're suggesting that we are returning to 21% interest rate levels, but-

Nick Kyprianou:
No.

Michael Hainsworth:
Are you suggesting that if the Bank of Canada did raise the overnight lending rate by a full percentage point in such a quick span, that it would have a similar sort of dampening effect on the housing market?

Nick Kyprianou:
I think it would have a cooling of the market, right? Because every time you raise the rate a quarter, less people can afford to buy, right? Because it's all based on qualifications, right?

Michael Hainsworth:
Right, you got the B20 Regulations, they revised.

Nick Kyprianou:
And then with this ... Yeah, which is the stress testing. So they go ... They're already, you got to qualify ... What's the rate today? I think you can get a rate for 3%, but you got to qualify at 5.20.

Michael Hainsworth:
Right.

Nick Kyprianou:
Right? So every time the rate goes up that 5.20 goes to 5.45, or what have you. So that creates less people able to purchase, right? Then the people that are owning a home looking to move up, that might say, "You know what? Maybe we'll hold off." Right? So it does slow the market down. Employment is very strong. We've got very low unemployment numbers, so I'm not seeing anything like the early '90s happening at all. Even if rates go up 100 basis points, that's still very, very cheap money.

Michael Hainsworth:
So what's this mean for the non-bank lenders? The folks like you?

Nick Kyprianou:
Like me, yeah. Well, it's a real opportunity for people like us. When they increased the stress testing the last time, about two years ago, it was a big influx of business for us. It really boosted our business. So deals that we wouldn't get in the past because the bank would do them, all of a sudden we were getting bank quality type product, but we were getting a premium. So it was a real big win for us on that side of the business. So I think that rates going up always creates more business for us, right? Because of the stress testing and various other things, right? The market, I still think that some areas did accelerate too fast in the values. I personally think the [Derum 00:06:59] region ran a little too hard. Prior to the pandemic, probably the Derum region was undervalued, right? And then when people realized the value, there was a tsunami of purchases.

Michael Hainsworth:
The value of having a big backyard.

Nick Kyprianou:
Yeah, and then they all of a sudden overshot the values. You know what I mean? It's typical human behavior, right? Then everybody just piled on and it overshot a bit. So I wouldn't be surprised with these rate increases and everything else if values didn't kind of flow back about 10% in that area. I saw the same thing at the end of 2016, there was this irrational exuberance where valued, multiple offers, people were overbidding for homes. And in the beginning of 2017, the provincial government said they were going to introduce cooling housing measures, and then the regulators said they were going to increase the stress testing rate, mid-'17. And I saw that the area that had the biggest kind of irrational exuberance increase in values was that [region. So we really kind of backed off on that region in late '16, early '17. And the second half of 2017 values in Vaan area dropped back about 10 points.

Michael Hainsworth:
What of the projected influx of new immigrants over the next several years? What does that mean for a mortgage investment corporation?

Nick Kyprianou:
Well, it's very positive for us because the immigrants that come today, they're targeting a 400, 425, 1,000 people coming in for 2022 and 2023. The immigrants are much different than the immigrants that came to Canada in the '50s and '60s. My family came here in the '60s, and the people that came then were hard working, but they didn't have any money and they didn't have any education. They just had hard ... They were just hard working, right? The people that come today come with lots of education and money, right? So they get good paying jobs very quickly. A lot of them in the IT sector and the other types of sectors where the pay is very good. And then they also come with a lot of cash. So they hit the housing market very quickly. So that puts more pressure on value.

So the rate increases have a dampening effect, but the new immigrants have a kind of a counter effect. So that's why I not anticipating a crash in the market, and I don't think there's a bubble. I think there's a lot of moving parts. And then you have to look at, since the pandemic started a little over two years ago, values have gone up close to 50% over that two years, right? So even if people, even if values back off 10%, people still are good, right? And I always say people, when the newspapers reporting values are dropping, people always believe their neighbor's house is dropping, they don't believe their own house is dropping.

Michael Hainsworth:
Right.

Nick Kyprianou:
Right? That's just human nature.

Michael Hainsworth:
So back to the tighter regulations and the five and a quarter minimum sort of thing. I suppose that cushion for this increased exposure in a rising interest rate environment is an improving loan to value ratio. Sure, the loan side of the ratio is going up, but you're also anticipating an acceleration in property values to come along with it.

Nick Kyprianou:
Right, right. So everybody's book is looking very good right now, because deals that you did a year ago, the loan to value is substantially lower. So even if there's a softening in the market, your portfolio ... Provided you did your due diligence when you did the loan originally, and you were watching values in and making sure you had a good appraisal and triple checking it, that's what we do. We put a tremendous amount of emphasis in real estate appraisals and the values of the properties and the marketability. So we have a triple check methodology that we'll check. And I always say appraisers have bad days too, just because they're on your approved list doesn't mean they don't make mistakes. And we've caught several where we just felt that they were being irrationally exuberant on a value, and we would just cut the loan back or decline the loan.

Michael Hainsworth:
Let's follow on with my past question here with more of a dinner party conversation question, now that we, of course ... Apparently COVID is over and we can all start seeing each other again, what kind increases in property values are you predicting?

Nick Kyprianou:
Well, I think the second half of the year is going to be a bit of a flat line. I don't think we'll see much of an increase this year.

Michael Hainsworth:
Why is that?

Nick Kyprianou:
I just think because the rates, I think if they go up 50 basis points next month, it's going to throw some cold water on people and they're going to get a little concerned. And then it'll also stop the move up buyer. Like they'll say, "Oh, rates have gone up half. I've got a good rate right now locked in. Do I want to really go and move up? And then I got to have to open my mortgage up and then experience a higher rate." So it has a double effect. It has one effect on, you got one group that can't ... All of a sudden they're pushed out of the market because of affordability, because of the rates, the stress testing.

And then you have the move up buyer saying, "Oh, you know what? I've lived in this house for three years. I've done really well. I've got a great rate. Do I really want to break that rate at this point in time? You know what? Maybe I'll finish the basement, or maybe I'll put an addition on the back instead of moving up." That kind of thing happens. Because there's a lot of friction costs to move, right? Real estate commission. Then you got land transfer tax and legal costs. And then you never move from house A to house B, stick your furniture in, put your TV on the wall, and sit down. Somebody's always saying, "Oh, we got to paint it. We got to do this." There's always a lot of friction costs in a move.

Michael Hainsworth:
All right. So I just got a note from my bank telling me that they've raised my adjusted mortgage to 1.7%. I've got a variable rate. Was that a smart move, or back to the dinner party question, was I an idiot to not lock in earlier?

Nick Kyprianou:
No, I think like 1.7, when you factor in inflation, you got free money.

Michael Hainsworth:
That's what I was thinking.

Nick Kyprianou:
You look at, you can invest in RiverRock and we'll pay you seven. And if you do the drip, you get 7.24 or something. You're doing way better.

Michael Hainsworth:
The one fly in the ointment here, the one asterisk to this entire conversation, does this not all depend in part on a post-COVID economic recovery? And if so, what are the implications of the Russian invasion of Ukraine?

Nick Kyprianou:
Yeah, I think that there's ... Like I always say, there's lots of moving parts to this thing, but there's been a tremendous amount of savings over the last couple years. Canadian savings rates are record levels, number one. Number two, if you are a homeowner, you have generated a tremendous amount of wealth over the last few years in your property. A tremendous amount of equity, right? So there's lots you can do with that. You can refinance your mortgage, get a second mortgage, take equity out, do things with that money. Whether it's investing, putting additions on, buying another property, or what have you. So I think ... I'm not overly concerned. I think there's a lot of savings, and I think there's a lot of equity in people's homes.

Nick Kyprianou:
And I think when people have a lot of equity, they have options, right? Even if they hit a speed bump in life, like I always say, bad things happen to good people all the time. They get sick, they get laid off, they lose their job, they get divorced, somebody dies. Stuff happens in people's lives all the time, right? And if you have equity, there's solutions to get over that speed bump, right? You can increase your mortgage or get a second mortgage to get you over that period of time until you're back on track, right? So that's the solve it. In the early '90s, when people ... You had a house worth five and all of a sudden your mortgage was 475, you have no options. So if one of these bad things happen to you, you're just losing your house, right? If you can't make the payments anymore. Where if the house was 750, you've got options. You can refinance, get a second, sell the house. There's many things you can do. But when you don't ... So that's the positive in all of this.

Michael Hainsworth:
RiverRock is issued more than a half billion in mortgages, and you claim you've had zero loan losses. How do you manage that?

Nick Kyprianou:
Yeah, it's really based on our proprietary underwriting model, that puts a tremendous amount of emphasis on the real estate, right? So we use our approved appraisers that we've had long term record with, but like I mentioned earlier, people make mistakes, people have bad days. So we have this triple check methodology where we go through the report, look at their comparables, triple check comparables. We're also getting a tremendous amount of data on areas and markets. I don't just say Ontario. Oh, Ontario's gone up X percent. I look at each individual little pockets. You got pockets in the city of Toronto, you're west of one street, the values change compared to the east of that street, right? So you really got to know your markets, and we really put a lot of time and effort it into it.

Nick Kyprianou:
So then what we also do is we say, because our philosophy is bad things happen to good people. We say, if this deal cracks tomorrow and we have to start proceeding with a legal action on this, can we get out? So we basically reverse engineer the underwriting on that loan before we approve it, and do we see a clear path to getting out? And that's a critical component, and that's what's basically prevented us from having any losses. Also the fact that we move very quickly, we're very efficient in our collection and the way we administer that, the way we communicate with our clients. If they're not communicative, how we deal with those, that way. I've been doing this for 36 years, there's nothing I haven't seen or nothing I haven't done. So basically I can tell very quickly which course of action to take on any single file.

Michael Hainsworth:
What's your strategy? What's behind your strategy of holding only loans of a year or less?

Nick Kyprianou:
Right. So the strategy there is, one is when you're in an increasing rate environment, that's important, right? You want to be able ... If you give somebody a three year term and rates are constantly going up, you've got to pay investors. If your investor rates start going up, all of a sudden a profitable loan can turn into an unprofitable loan, right? Even though they're making their payments every month and it's a good loan, if you're paying the investor seven and all of a sudden you're getting less than seven from the investor, that's bad, right? So that's one of the reasons. The other reason is if somebody's a real problem account, you can reassess them very quickly. And that's not to say we're going to call it and say, "Oh, we want you to pay us out. We're no longer renewing." We might renew, however we're going to reassess the risk profile and charge more accordingly to the risk and the workload.

Michael Hainsworth:
So how do you achieve your target of an annual yield of north of 7%? Is this back to the B20 regulations, the minimum five and a quarter percent plus the bank rate?

Nick Kyprianou:
Yeah. So our rates currently are starting at 5.99. So you say, well, how can you pay seven when some clients are getting 5.99? Well, what we do have is a line of credit. So we've introduced some leverage into the portfolio, and our cost to capital from the bank is extremely low, so that's how we're able to do that. So that brings our cost, our overall cost down. That's how we can comfortably pay out a seven. The other thing that we do that I'm not aware of any other MIC doing is that we pay out our target yield first, and then we take our dividend next, our management fees second. So if there's not enough funds to cover our full management fee, we'll eat it.

Nick Kyprianou:
So for example, there has been cases, not in the last couple of years, but there has been some cases in the past where we may have been sitting on a bit of cash, and we still got to pay the target yield out to investors, but the money's not making money because it's just sitting in the bank. So in those cases, it creates an interest rate drag. So in those cases we would eat it, because I look at it that's a management issue. If we weren't able to deploy the cash, that's not the investor's issue, that's a management issue. So we should eat the cost of that.

Michael Hainsworth:
So for an investor listening to this conversation, what's the one thing you want them to walk away knowing?

Nick Kyprianou:
The vast majority are residential MICs in Ontario are run by mortgage brokers, right? So when people say to me, what do you lie awake, sleep ... Can't sleep at night, what do you worry about? I said, "I always worry about the same thing. Headline risk." One of these MICs that are mismanaged by one of these people that have no experience running a lending operation, blows up and it's on the front page of The Globe.

And then all of a sudden RiverRock's investors are rattled, they're nervous and saying, "Oh, what do you guys doing?" And so then all of a sudden it becomes a challenge, right? Because you got to deal to calm people down. That's what I worry about. Everybody that works at RiverRock has worked at a regulated institution before, most of these people have worked with me at Home Trust or Equity, where I worked before. All understand the intricacies of underwriting risk, credit risk, operations. They know what they're doing. They come from that background. And it is a different background.

Michael Hainsworth:
It's been a fascinating conversation, Nick, thank you for your time.

Nick Kyprianou:
Oh, no trouble. Anytime.

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.