Aggressive interest rate hikes by central banks have sent a significant chill across the real estate sector. Greg Bonnell speaks with Colin Lynch, Head of Global Real Estate Investments at TD Asset Management, about the state of housing and commercial real estate.
Originally published on July 26, 2022
Central bank hikes aimed at combating soaring inflation are having an impact on many segments of the economy, but perhaps no sector is more exposed than real estate. Joining us now to discuss whether there's a rough ride ahead for the space is Colin Lynch, head of global real estate investments at TD Asset Management. Colin, great to have you back on the program. This is an interesting time with the central banks getting so aggressive in the face of inflation. How do those two factors work when it comes to real estate-- I guess perhaps even work against real estate?
Well, first off, great to be here again and thanks for having me. Certainly, those two factors are relevant to real estate. Let's start with inflation. When you are building a new building, there are construction costs, and those are labor costs. There's also material costs. Think about steel and cement. All of those are inputs into the cost of building a new building. And so, ultimately, the cost of construction rises. Now, you can look at the other side, so completion of the building. Ultimately, in a high inflationary environment, at least in theory, the value of those buildings should increase partially because the costs of constructing a new building also increases. The other driver is around income. So when you look at the value of anything, if the income increases over time, in theory, the value should increase over time as well. In real estate, what generates income? Well, it's those rents. And so in a highly inflationary environment, if rents are increasing due to inflation, in theory, the income should be increasing as well. And the capital value should be increasing as well. Now, there's a caveat, which is, just like any other business, you have revenue and expenses. So rents are the revenue. What are the expenses? Well, the costs of maintaining and cleaning, and et cetera, the building, capital, repairs, and all of those. So those can increase as well. But in theory, the income should increase and the capital value should increase. So that's all on inflation.
That's interesting, right? Inflation, the way it's got us so worried about so many things as investors. But it doesn't have to be a complete negative for real estate. It can be a positive.
Precisely. And the key there is, what is the state of the economy? If the economy is growing, and we have high inflation, that's generally OK for real estate because, ultimately, those rents will grow faster than the expenses. If the economy is shrinking, and we have high inflation, that's when you get into some trouble because, ultimately, what drives rents is the growth of the economy. So if your expenses are rising due to inflation, but your rents aren't going up as fast as your expenses, then you have some issues. That's all on inflation. Then we've got central banks. And what does a rate hike mean? Ultimately, it means that the costs of doing business in general increases for real estate. That's the cost of borrowing money. And that's borrowing money either to operate the building or to construct new buildings. And so that just increases the expense line, whether you're building or you're operating, depending on whether you have leverage or not. And so that does increase the risk profile for real estate. And it becomes really important to understand, is leverage being used? Is debt being taken out to opt to either build or to operate the building? And if so, what is that form of leverage? So not necessarily negative, but certainly more challenging as interest rates rise.
Now, a year ago, maybe 18 months ago, the conventional wisdom would have been that, yes, at some point, the central banks will begin raising rates. At some point, the year 2023, which we haven't gotten even close to entering yet, was thrown about as lift-off, and then, it'll be very slow, very gradual. The amount of rates we've seen, the magnitude we've seen in this short period of time, we've pulled forward a lot of that. Are there certain real estate projects in this kind of environment with borrowing costs moving that steeply higher in such a short period of time in jeopardy of not getting done?
Yes, so certainly, there are projects that are in jeopardy of not getting done. Have we seen the outcome yet? No, because we're still relatively early into the cycle. And by that, I don't mean the absolute number of hikes have been early. I just mean from a time horizon from where we were when we weren't even thinking about raising rates to today. That's been a very short period of time relative to prior cycles. And it takes time for the implications of rates to make their way through the system. And in the case of developers or real estate, it takes time for numbers to begin readjusting and the like. So today, we're seeing a lot of pause. We're seeing a lot of things that were going to be brought to the market-- so if you think about condominium construction and the like-- that were going to be brought to market, but now folks are saying, maybe not now. Maybe later. We'll see how things progress. That hasn't produced a lot of outright cancellations. But my hunch is there will be some cancellations as the math will have changed for a few folks in the market.
Now, if we were doing this show in front of a live audience and taking the questions of people watching us, you have to know if you're discussing real estate in this environment, the run up we've had, someone's going to bring up the word crash. What are the dangers that we could see a real estate, a property market crash? Are we being a little too concerned on that front? And what are the fundamentals?
Yeah, I'd say we have seen crashes clearly in the past. There were different reasons that drove some of those crashes. Today, I would say the risk of a crash is relatively low. The risk of a decline is relatively substantial. And so what gives me the difference between decline and the crash? In Canada, we still have a few things going for us. One, robust demographic growth. And what drives that? Well, our immigration. And effectively, Canada is viewed as a very attractive place to be. When you have robust demographic growth, the chance that you continue to see good economic growth increases. It's not a certain, but it is more likely. And ultimately, given real estate serves the economy and more broadly serves society, so it serves the economy by being a place for people to work and to distribute goods through and to sell goods, but it also serves society by being a place for people to live. So if there are more people coming to the country, and more people-- that means more people taking on jobs and doing et cetera-- that means, in the longer term, that provides a good foundation for real estate. In the shorter term, that also provides a good foundation because the government, federally, has been driving immigration targets higher. And so that helps. Clearly, you have some headwinds. And the headwinds are higher borrowing costs, concerns about economic growth in the near term. Certainly, out west, we have energy prices that have broadly increased. And that's provided some optimism. You balance that all out, and you say, certainly, risk of a decline in the short term. But an outright crash? Hard to say. And you can look around the world and sort of draw not exactly the same conclusions but similar conclusions. In the US, they went through GFC, Global Financial Crisis, in 2008. Ditto to the UK. And the amount of the leverage in the system is substantially lower today than it was in 2008. And in a moment like now when those borrowing costs are rising, that's a good thing. So you could go market by market, and you could say, yes, there are risks for sure. Outright crash, can't see it yet.