How Interest Rate Hikes Will Affect Real Estate Investment, an Alberta Perspective.

Current Situation

After reducing the overnight interest rate to 0.25% in 2020, the Bank of Canada raised the overnight rate to 1% on April 13, 2022. As the economy ramps up again, the effects of an increased money supply from government handouts have taken centre stage as inflation hits a thirty-year high of 6% and rising. The Bank of Canada has also announced it will end reinvestment in maturing government bonds and begin quantitative tightening. The intent is to decrease the overall money supply and size of its balance sheet over time. The central planners have indicated that interest rates will need to increase as inflation persists above normalized or stabilized levels.

Too many dollars with too little supply, spikes the cost of goods & services and reduces purchasing power. Quantitative tightening and interest rate hikes are intended to increase the cost or availability of money to reduce demand. The previous low lending rate allowed borrowers to obtain larger capital financing amounts, which led to higher demand for capital assets and an increase in property values. This low cost of borrowing, coupled with the prospect of inflating construction costs created strong demand for real estate investments. This sent prices spiking upwards in the residential sector and pulled the commercial sector through difficult market conditions.

So as mentioned, in an attempt to slow the economy and suppress demand, the Bank of Canada has increased the cost of borrowing while simultaneously slowly reducing the amount of dollars in circulation. This will decrease the available money supply and therefore, economic demand, putting downward pressure on prices. How drastic this effect will be will largely depend on overall economic conditions and how well the Bank of Canada balances economic activity and interest rate hikes.

Forecast

The Bank of Canada (BoC) plans to increase the overnight rate over the next three years in response to predicted economic activity. Higher rates mean the cost of borrowing will increase, and the loan amount you can get approved for will decrease. The result is that those looking to invest in real estate will have to look for cheaper product. This will increase demand and therefore, values of lower-end product. Further, supply shortages in this lower-end category will put greater upward pressure on values in this class. If higher & higher interest rates persist and demand for higher-priced product is stifled over an extended period, prices may decrease is some market areas, depending upon how well the BoC balances the economy.

What we will see is decreased activity in overpriced higher-end markets and increased activity in more affordable markets. I would expect that markets such as Vancouver & Toronto will experience stagnation or even price decline in the coming years if interest rates continue to rise. The last time interest rates were hiked, both those markets hit all-time lows in housing sales. Alberta on the other hand is and is likely to continue to see greater investment activity as market participants look for attainable product in more affordable market areas. Further, increasing economic activity from inflated oil prices has brought much attention back to the province. These factors will likely outweigh interest rate hikes, and Alberta’s future outlook looks promising.

Inflationary conditions are likely to persist in the short term, and although borrowing rates will increase, real estate has historically been a good inflationary hedge, and therefore, demand for real estate assets should continue to be strong. Poor bond yields have also pulled investors toward other assets with riskier but superior returns such as real estate which is seen as relatively stable.

Another major factor that could play into Canadian markets in the future is excessive US interest rate hikes which would lead the American housing bubble to pop. Excessive rate hikes by the Federal Reserve would be necessary if the US dollar was no longer used as the global reserve currency. Western sanctions against Russia have spurred various eastern countries to begin trading commodities with other currencies and gold-backed securities. If this persists, the US won’t be able to export its excess cash and will have to raise interest rates to deal with excess money supply and inflationary conditions. This decrease in liquidity could impact trade exports to our southern counterparts. Furthermore, our economies are so closely tied together that increases of US interest rates would likely be mirrored in Canada.

Capitalization Rates

Capitalization rates are related to the overall level of interest rates in the economy. If interest rates rise, with all other things being equal, the risk of an investment will increase, as will yields and cap rates. However, all other economic influences are not equal. Cap rates also depend on the yields of other comparable investments, and as previously mentioned, the weak bond market has put downward pressure on real estate yields/caps and therefore, upward pressure on prices. Cap rates also reflect expected future rents, and due to Alberta’s boom prospects, downward pressure on caps is anticipated. Further, activity in Alberta is expected to increase as investors get priced out of larger markets, continuing the upward pressure on prices, reducing risk, and decreasing cap rates. With these balancing factors in mind, caps will likely remain stable over the year, but the question is, will we see interest rate levels reach a point where caps increase, and prices start to fall?

Who Are Real Estate Consultants?

Real estate consultants are accredited, licensed, knowledgeable, and experienced professionals that understand the market, value principles, and the forces that affect them.  

Some may claim to be consultants but do not have accreditation, licenses, or a designation of any kind, and should be avoided. (Bowen & Associates Ltd. is fully designated, accredited, & licensed.)

What does a real estate consultant do?

A real estate consultant simplifies complex real estate and property issues providing the client with a detailed report, analysis, recommendations, advice, or guidance to make informed property-related decisions.

The consultant first assesses the client’s problem, needs, and objectives. Given these objectives, the consultant will determine what type of analysis is necessary and how comprehensive it needs to be. This may include market, highest & best use, land utilization, feasibility, and investment analysis. These studies will be explained in detail within later discussions. From the analysis, a use-strategy or implementation strategy is developed and communicated to the client.

A consultant is essentially a strategic advisor. Clients could be a user in search of a site, a property owner looking to understand its site’s best potential use, an investor in search of an opportunity, or a developer looking for direction.

If you have any further questions or would like more insight into this process, please contact us.