Making Sense of the Real Estate Market with RiverRock MIC CEO Nick Kyprianou

With predictions that interest rates will continue to climb and the housing market will fall 30%, what is an investor in the mortgage market to think? RiverRock MIC’s Nick Kyprianou offers his insight into the numbers and explains why he’s staying the course.

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

Michael Hainsworth:

There was a time when we thought the housing market price graph would always go up and to the right. But with the Bank of Canada wrestling with inflation at 40 year highs, the cost of borrowing has gone through the roof. What does this mean for investors in Mortgage Investment Companies? Nick Kyprianou is the president and CEO of RiverRock MIC. And to ensure continued returns for investors, he’s leaning on more than 30 years of experience in the mortgage lending industry to guide his funds. So where do interest rates to go from here? Nick tells me he’s using the BOC’s own words to help inform his opinions.

Nick Kyprianou:

They said they think they're near the end, which I'm hoping that is true. Reading what all the economists are saying, they think there's another 50 basis points to go. They're all thinking it's going to end around four and a quarter. I hope and think that would be about right.

I think that if they do that by the end of this year, beginning of next year, level off at four and a quarter, and they give the messaging that in case is the fact, I think that we'll see a little bit of a spring market, not that you'll see the multiple offers happening again, or not that you'll see value starting to accelerate. I think next year will be relatively flat. However, on the flip side of that, if they feel that 50 basis points isn't enough to tamper down the inflation and they need to still keep increasing rates, I do believe that will hit the market, and values will soften a little bit more. Obviously, areas will suffer more than others, but there will be more of a softening.

Michael Hainsworth:

Do you think the central banks have inflation under control?

Nick Kyprianou:

Well, I think they do. When you're at 20,000 feet, you're looking at things differently. They're always looking in the rear-view mirror. I'm at the ground level. To me, it seems like people have really cut back. Less spending. I really think that we're in a recession right now, and people are making adjustments to their lifestyle. But it doesn't matter what I think. It matters what the Bank of Canada thinks. I don't think they're tuning in on me and getting my insight. They haven't called me anyways. I think even if they did, I don't think they'd care what I think. I'm hoping that's what they see. They don't want to tank the market. The government has a lot of debt. People have debt. Everybody suffers by increasing rates.

Michael Hainsworth:

Let's expand on your point about what this means for residential sales in 2023. If we are done with the tightening cycle with another 50-basis point increase because we have inflation under control, it's your suggestion that we won't see the on fire markets that we had seen in the springs of the past few years, but more of a flattening. What does that mean to you?

Nick Kyprianou:

Yeah. I think that what I saw this year, for example, we saw this at the beginning of 2017 when the federal government announced they were going to introduce cooling housing measures mid-year, and OSFI, who regulate the financial institutions, said they were going to tweak the stress testing formula midyear. Anytime the Bank of Canada says they're going to increase rates or anytime government says they're going to make some changes that are going to make it tougher to get a mortgage, people race into the market. What happened this year is people went in even harder, I guess because the market was so frothy for two years during the pandemic, and then people panicked. This fear of missing out and this irrational exuberance kicked in, and people, for the first five months of this year, were just overpaying for properties, some areas more than others. The two areas that we felt experienced the worst case of irrational exuberance were the Brampton area and the Durham area, which is Oshawa, Pickering, Ajax.

Michael Hainsworth:

Right outside the city of Toronto. The idea that you're driving until you can afford to buy.

Nick Kyprianou:

Correct. It's interesting. Prior to the pandemic, the Durham region probably had the best value for the dollar in detached townhouses and semis. During the pandemic at some point, people realized that was the best values, and there was a tsunami of buyers that went out that way, and then they overshot it. That's the two areas. Now, different pockets. It's not a blanket they all went up, but those two areas seem to see the biggest drop in values. I would guess anywhere from 10% to 15% in those two areas. Different in different pockets in those areas. The core of the city has held up very well. Maybe a five percent drop. Condominiums in the city have also fared pretty well during this.

Michael Hainsworth:

Now, some big banks are predicting a 30% correction in the housing market still to come. What do you make of that?

Nick Kyprianou:

I think 30% is a bit aggressive. I think you may see the odd example of that, but that's the example where somebody overpaid to begin with. The market was X. They paid X-plus. Then all of a sudden, they use that as the example. It distorts the numbers. A lot of times people have difficulty understanding the numbers. When they say, "Prices have gone down. The average sale price is now X. It used to be Y." The problem is, as rates go up, people's buying power goes down. Therefore, they buy cheaper homes. Maybe the person was looking at a million dollar house, but then with the rates going up, now they're looking at an $850,000 house. That's where the market shifts to. It's not so much that the values drop that $150,000, where that number would reflect that. It's that the market has shifted to cheaper houses because that's affordable based on the rate increases.

Michael Hainsworth:

You said that there is potential for softening in some areas more than others. Where does RiverRock invest?

Nick Kyprianou:

Well, at the beginning of the year, we identified those two regions I mentioned, Brampton and Durham, of being this irrational exuberance. We started backing away from those two areas. When we did lend on those two areas, it was at a reduced loan to value because we were concerned. Back in 2017, when, to a lesser degree, the same type of thing happened, we identified Vaughan as the overheated market, and that one backed off the most at the second half of 2017. You see different pockets, different markets. It's always changing. Different places have different calibrations.

We're just very careful and constantly tracking the markets and looking at where the values that seem to get irrational exuberance. Then what you can monitor now is days on market. I think we're always watching days on market. What you're starting to see now is, right now, there's not a lot of sales activity, but it does seem to be more rational. Homes are on the market for 30-45 days. There's not multiple offers. There's a conditional offer. It's more logical right now. That's based on people that want to buy, that think, "Rates might go up another 50. We can manage it."

The other problem you still have in this country, especially in Southern Ontario, is an undersupply of housing. That's also proven by the fact that rental rates went up 17% this year. What happened was people that were going to go into the market all of a sudden got concerned with the rate increases. So they said, "You know what? We'll back off. We'll rent for a bit before we purchase, before we pull that trigger." That's what put more focus onto the rental market. You also had some people sell their homes and say, "You know what? I'm going to rent for a bit before I buy," because they thought, "Values are going to come down a bit more." Their dollars will be more powerful. That kind of thing.

I think that people don't like to buy during uncertainty. Right now, there's uncertainty to a certain degree. Once there's more certainty, certainty being the Bank of Canada said, "We're done," that creates certainty, and then people jump in. If you've got your income, you have your job, you know what you're making, and you're confident in your job and your security in your job, and you do the math and you can afford to purchase, you're going to purchase. People want to own a home. With this hybrid working environments, some people get to work full-time at home now where they didn't in the past, owning a home is actually more attractive than ever before.

I think this changed the dynamic somewhat, but home ownership is an important factor for people. For the vast majority of Canadians, I think it's their retirement. It's tax free when you sell. There's no other vehicle, other than a tax-free savings account, because an RSP, all you're doing is postponing the tax or deferring the tax. You're not eliminating it. A house, you've got to live somewhere, so paying rent, paying a mortgage, and then you've got a tax-free item at the end of the time when you go to sell.

Michael Hainsworth:

You mentioned the 2017 mortgage rule changes. I wanted to ask you if you had ever experienced conditions similar to what the mortgage industry is dealing with today. Is 2017 really the only comparable example? Or has there been something a little more significant than that, that you can draw on to help guide RiverRock through this?

Nick Kyprianou:

Yeah. There's two more significant times that I've seen. One was the early '90s, which was April '89 to 1995. You had unemployment in Ontario over 12%. You had manufacturers leaving Ontario to the southern states of Mexico because of high provincial taxes.

Michael Hainsworth:

Two things you don't have today.

Nick Kyprianou:

Right. Then you had unemployment. I mean, you had rates go from 9% to 15%. You also had mass speculation in the real estate market. The big difference then was if you want to build a condominium tower today, you have to have 70% pre-sold before you can get construction financing. Purchasers today have to put up much more money, 10% to 20% when they sign the offer. Back in the early '90s, you could get construction financing with no pre-sales. People only had to put $500 down, and they wouldn't have to put up the balance until closing. So somebody said, "Why buy one when I can buy three, and I'll sell to and have no mortgage on the one left." But it didn't work out that way. That's a lot different.

Then you also had an NDP government that won a majority during all this in the early '90s, that created more uncertainty and chaos in the province. During that period of time, on average, residential values dropped about 25%. Commercial values dropped around 50%. Some areas more than 25, some areas less than 25. But it was a long, drawn out, painful, softening. Then, in the early '80s, when rates went up to 21%, that was a one-year ... Everything came to a screeching halt. Banks worked with everybody during that period of time.

The positives that you have going on now, if you want to try to find the silver lining in all of this, one is immigration is strong into this country. You got 400,000 immigrants coming a year. Now they're saying they're bumping that number up to 500,000 for the next three years. Most of those people show up in Ontario. The immigrants that come to Canada today are much different than came in the '50s and '60s. These people come with education. They come with money. They get into the housing market very quickly.

The other thing is material costs have gone up. Labor's gone up. There's still an undersupply of housing. There is a softening that's happened over so far this year. I understand that. But there's still some solid things in the background that'll stop a complete free fall on value. You always look at real estate values over 10-15 years. They're up and down all the time. But I'm highly confident to say that if you bought a property today in 10 years, 15 years out, it's going to be worth a lot more than it is today.

Michael Hainsworth:

With that experience and the backdrop of the 1980s, as well as what happened in the late '80s and into the '90s as well, how has the fund been navigating the conditions that we're seeing today?

Nick Kyprianou:

Yeah. We've always managed the portfolio, I always say waiting for that other shoe to drop. When things are really good, I'm always thinking, "Okay. The only thing that comes after good is bad." I tend to be a glass half empty type of person on this type of stuff. I always say, "Bad things happen to good people all the time." They get sick, they die, they lose their jobs, they get divorced, what have you. I'm always waiting for that to happen. If you looked at our portfolio at the end of August 2021, last year, our average loan to value was 69.8%. If you looked at our portfolio at the end of August this year, we were 67.4%. Our whole portfolio average shifted down two and a half percent over a 12-month period. To do that is not easy.

We really started mid last year getting much more conservative on our lending because we felt that things were getting a little heated. We knew when things got opened up fully that things get a little crazy. Then, as it was getting closer to the end of the year, the Bank of Canada was letting people know they were getting very concerned about inflation. The Bank of Canada only has one tool to curb inflation. Increase rates. So you knew what was going to happen.

Michael Hainsworth:

Since a MIC can use debt to partially fund assets, what's the impact of a rising interest rate environment on its ability to build new funds?

Nick Kyprianou:

Yeah. We have a line of credit. The challenge is when the Bank of Canada increases the rate, our line of credit goes up the next day along with it. Borrowed funds are generally cheaper than investor funds, but that's been going up steadily. That's a bit frustrating because bank debt's a cheap form of capital. With these rising rates so quickly, it's turned out to be not as cheap as it used to be for obvious reasons.

We still have debt, but that keeps us in the market all the time because the advantage when you're in the market all the time, it just keeps a steady flow of business. Then you can pick the loans that fit your criteria. You don't have to stretch when you're in money and then back off when you're not. It allows you to be more strategic in your lending and always keep your quality of business steady. When you're in and out, it's harder to get the better quality business. The line of credit allows us to be in the business all the time in the market, but choose what we want to lend on because I always say that sometimes the best loan you did is the one you don't do.

Michael Hainsworth:

With that in mind, for an investor in a MIC, is the risk to that investment tied to delinquencies within any given housing market? Is that the key indicator we need to keep an eye on when we as an investor choose to make this part of a portfolio?

Nick Kyprianou:

Well, it's not necessarily delinquent, per se. It's losses. Just because you have somebody delinquent and you start a legal action, it doesn't mean there's a loss. It just means you got to deal with it, and then you get paid out in full, and you're made whole. But there's no loss. It's just part of the business. You'd never have a portfolio that has zero delinquencies. That would be highly unusual. It goes back to what I said earlier. Bad things happen to good people. There's things bad happening to people all the time. You've got to have somebody in your book that something bad's happened to. Delinquencies aren't the concern. The concern is if there's a loss. It's all on how you manage your underwriting.

With us, we use third-party appraisers. We also have a triple-check methodology that does a deep dive in every appraisal we get because we always say, "Appraisers can have bad days, too." We live and die by the value. We always say, "That's the constant in a transaction." Things change with people's lives and their income, but the house is constant. Before we approve a loan, we say, "Pretend this deal cracks tomorrow. Can we get out?" What we do is we know what all the friction costs are. We're watching market trends. We reverse engineer all the numbers. If we see a clear path to getting out, we move forward. If not, we either reduce it, or we turn it down. That's held us well. For almost nine years now, we've never had a loss.

Michael Hainsworth:

With that in mind, the Income Tax Act that governs the world in which you operate requires at least 50% of the assets be comprised of residential mortgages or cash deposits. What roles do the Canada Mortgage and Housing Corporation and the CDIC play in protecting investors in a MIC, in an environment like we're in today?

Nick Kyprianou:

Right. Well, those don't protect MICs at all. They only protect federally regulated companies that are regulated by OSFI, and they have CDIC insurance, which protects the deposits. But you're getting 4%, three and a half percent deposit that's guaranteed by the federal government. With MICs, we just increased our target yield this month to seven and a quarter. March 1st, we're increasing it to seven and a half on the F class share. If you do participate in the dividend reinvestment program, you end up with a 25% increase in that return. That's what we're doing. Then we keep modeling it out because we're always modeling. As rates go up, we'll look at increasing our rates to our investors. The other thing that we do is we pay out our target yield first, and we take out our management fee second. For whatever reason, interest rate drag, HST costs, or what have you, if there's not enough to cover, we eat that out of our management fee. We don't pass that on to our investors.

Michael Hainsworth:

Knowing you can't legally provide advice to a listener for whom you don't know their specific financial situation, generally speaking, for whom is a mortgage investment corporation an appropriate investment?

Nick Kyprianou:

Well, they say that 40% of your portfolio should be in alternatives. A MIC would be a good alternative. If you had your money in the stock market the last year or so, not so good. Even if you were invested in good companies, everybody's taken a pounding. We're a nice, steady revenue. We've never missed a dividend payment. We've never gated the fund. We're just steady Eddie paying out that yield, that return every single month, paying out that dividend. From that, it's a nice balance to your book. You've got something always producing a revenue for your portfolio. It's tax-free savings account eligible or RSP eligible, so it's registered account eligible. It's always good to have an investment that's always paying out a steady return because the stock market's so volatile.

Michael Hainsworth:

Nick, thank you so much for your time and insight today.

Nick Kyprianou:

Thank you.

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