In the press release dated March 21, 2024, the Bank of Canada heralded a return to “normalcy,” indicating they are nearing the completion of their balance sheet normalization efforts.

Going back to normal: The Bank of Canada’s balance sheet after quantitative tightening – Bank of Canada

Since April 2022, there’s been a concerted effort to reduce their balance sheet size. Delving into the Bank of Canada’s holdings of Government of Canada Savings Bonds, a stark reduction is evident. From a peak in December 2021 of nearly $435 billion, holdings dropped to about $260 billion by early March 2024.

What implications does this have for interest rates, and why does it matter?
To some, this might seem negligible against the backdrop of Canada’s total outstanding mortgage debt market, valued at approximately $1.8 trillion.

Yet, this shift is profoundly significant. The 40% decrease in savings bonds holdings by the Bank of Canada necessitated the sale of an additional $175 billion in savings bonds to entities other than the Bank of Canada.
This new cohort of buyers—private, retail, or institutional—demanded attractive yields, thus keeping interest rates elevated.

In discussions with property owners and investors in the multifamily brokerage realm, many anticipate a decline in interest rates later in the year.
This expectation leads sellers to postpone selling their properties, foreseeing higher values as interest rates drop, cap rates decrease This action of course makes available properties for purchase diminish, complicating acquisitions.

However, from our perspective at Baron Realty as of March 26, 2024, even a potential rate decrease is unlikely to be substantial.
Reviewing the 5-year Government of Canada Savings Bond rates since 2001, today’s 3.44% rate—though high compared to the 0.35% rate of 2020, an atypical year due to the COVID-19 pandemic—remains
lower than the early 2000s rates, which hovered around 5.57%.

For property owners and real estate investors, the focus should be on controlling revenue and expenses.
Enhancing revenue by upgrading units to align with market rents and minimizing expenses will inherently boost property value.

Relying on Central Bank policies or bond market fluctuations to lower rates isn’t a proactive strategy. Improving a property’s net operating income naturally enhances its value, irrespective of interest rate movements.

A notable pattern I’ve frequently observed within our real estate market is the constant vigilance of a select group of individuals and investors, all poised for new acquisition opportunities. However, some prospective clients, taking cues from renowned investors such as Warren Buffett and the advice of their bankers or accountants, harbour reservations about further committing to the real estate sector. In fact, Warren Buffett has even called real estate a lousy investment.

Link : Warren Buffett Says Real Estate Is a Lousy Investment: Why He’s Wrong | The Motley Fool

Nevertheless, when we step back to examine the bigger picture, the narrative shifts dramatically. In 1963, the average house price in Canada was $15,229 (source: untitled (publications.gc.ca).

Canada’s inflation rates have fluctuated in the years since, with the average annual inflation rate being 3.87%, and the median rate, 2.71%.

Source: Inflation rates in Canada (worlddata.info)

What should a home bought in the 1960s be worth today in Canada?

A pertinent question for real estate investors arises: If a house was bought at the average Canadian price in 1963, what would its value be in 2022? The calculations, based on the aforementioned inflation rates from 1963 to 2022, lead to a surprising answer. The projected average house price for 2022 stands at $135,968, a stark contrast to the current real average home price in Canada of $664,936 (source: CREA | National Price Map ).

So, what can we infer from this significant disparity? Why has the average home price increased 44-fold in Canada since 1963, while the inflation data suggests it should have risen by around 9 times? Explanations often involve theories of supply and demand, declining interest rates, urbanization, foreign investment, and economic growth. However, these interpretations don’t entirely account for the observed reality. The key to understanding this discrepancy lies in analyzing our money supply.

The money supply analysis and explanation

The money supply – which comprises the new currency introduced into the economy – has experienced a dramatic surge, as indicated by the M0, M1, and M2 charts (see below). In other words, our currency has been debased, or diluted, due to the influx of new money into the system.

M0 Money Supply

M1 Money Supply

M2 Money Supply

Conclusion

Returning to the initial question: Is investing in real estate worthwhile? The answer depends on whether the investor wishes to keep pace with this economic currency debasement. If so, real estate investing becomes an effective safeguard. Not only does it present a means to build wealth over time for one’s family and future generations, but it also serves as a potent defense mechanism against currency debasement.

This week, I came across a fascinating article on a significant shift in investment trends.

https://www.siliconvalley.com/2023/05/16/real-estates-popularity-as-investment-tumbles-to-5-year-low/

The article discussed the results of a survey which showed a decline in the popularity of real estate investing among 1,013 U.S. adults, falling from 45% in 2022 to 34% in 2023. It’s worth noting that similar figures are likely to be seen in Canada.

Real estate has historically held appeal for many investors, but its popularity can and will plummet when aligned with a cycle of rising interest rates.

Unpacking the Underlying Issue

Post-Covid-19 events that unfolded globally (including government stimulus packages, global lockdowns, and supply chain issues) triggered intense inflationary pressures. Central Banks, like the US Federal Reserve, responded with rapid short-term interest rate hikes to curb inflation.

 

For instance, the US FED Funds rate saw ten consecutive increases from March 2022, skyrocketing from 0.25% to 5.25% – a 2,000% increase over 14 months.

Given the size of the US economy, which represents 24% of the global economy (note 1), other central banks had to follow suit.  The Bank of Canada, fearing capital flight and potential currency devaluation, mirrored the US FED’s strategy, pushing its policy rate from 0.25% to 4.25% – a staggering 1,700% increase in the same period.

These unprecedented short-term interest rate hikes significantly impacted bond markets and, by extension, mortgage interest rates for borrowers, affecting the viability of real estate investing significantly.

Consider an investor owning a building with a net operating income of $100,000. In February 2022, the property could support a refinance mortgage of $1,646,450. (Amortization 35 years, mortgage rate of 3.10%). Now, due to these changes, the property can only sustain a mortgage of $1,334,280 (mortgage rate increased to 4.66%) — a nearly 20% drop.  This drastic decrease in refinancing capabilities significantly dampens the enthusiasm of real estate investors, explaining the dwindling popularity of this investment avenue, particularly in robust asset classes like multifamily properties, the situation is compounded. Sellers in these sectors are typically disinclined to part with their assets unless they are offered a satisfactory selling price.

Unearthing Additional Issues

Undeniably, there are other factors at play contributing to the current real estate climate. Certain real estate sectors, like office properties, have experienced a surge in vacancy rates over the past few years. The rise of remote work culture among many companies has dramatically altered the landscape of office demand, subsequently affecting investors’ borrowing power. Similarly, the retail real estate sector has long been grappling with its own challenges.

The escalating competition from online shopping, amplified by the impact of the recent Covid-19 lockdowns, has forced many smaller retail stores to shutter or drastically cut down their sales volume.

The Path Forward

Despite these hurdles, the solution for real estate investors remains straightforward. Real estate continues to be a powerful tool for wealth creation and inflation hedge.

Its unique appeal: banks can lend against it, providing investors with the leverage needed to grow their portfolios.

 

In our inflationary environment that has started climbng since 2021, it’s more important than ever for property owners to enhance their property’s financial health. Property owners must treat each property as an individual business entity. Just as public companies strive to generate returns for their shareholders, so should real estate owners view their properties. By providing superior services and amenities to tenants, property owners can improve their property’s financials. Each incremental increase in net operating income directly elevates the property’s value.

Thus, regardless of interest rates or wider economic conditions, a proactive property owner can still thrive.

Note 1 source: https://www.visualcapitalist.com/u-s-share-of-global-economy-over-time/

Mikael Kurkdjian, the broker of record (AEO in Quebec) with Baron Realty and licensed real estate broker in the Quebec and Ontario markets in Canada. Mikael is also a multifamily real estate investor himself.