The Bank of Canada’s aggressive rate hikes are aimed at inflation but have been felt particularly hard in real estate. Greg Bonnell speaks with Colin Lynch, Global Head of Real Estate Investments at TD Asset Management, who says the downturn may be painful but necessary for the sector.
- Rising interest rates have been the main tool central banks have used to try to tackle red-hot inflation. Of course, one of the big consequences of that is the impact on the housing markets. With rates set to rise even further, there could be more pain to come.
But my next guest says for housing markets like ours here in Canada and the United States, it may be a necessary medicine to get those markets back to fundamentals. Colin Lynch, head of global real estate investments at TD Asset Management, joins us now.
Colin, always great to have you on the program. Obviously, this is a pretty tough time for a lot of asset classes, including housing, and some tough medicine. Walk me through it.
- Well, first off, thanks for having me. It's great to be here. If you step back and look at the rate hikes, and we look at the reason why we're having rate hikes, we ultimately have the reason being high inflation. And a lot of that inflation has two elements to it.
One is supply. And we have had constrained supply across a variety of sectors, including those that impact real estate. Whether it's labor or whether it's materials, there's been constraints.
We've had significant demand. Some of that demand has indeed been brought to you in some respect by low interest rates. And that has spurred greater consumption, greater household expenditures. And that filters through the economy and contributes to some of that high inflation.
So that's been the dynamic. And I would say that dynamic, the world of, call it, 0% or close to 0% interest rates over the long term isn't really a healthy dynamic to be in. And so hence, the necessary medicine.
It's important that we return to a more normalized environment where central banks have tools like interest rates that they can use to respond to inflationary environments. So what does this mean for housing, for participants in the residential sector, whether it's apartments or condominiums or else?
Over the last few years, we've seen a significant appreciation in housing prices. And some of that appreciation has been based on the view that we will be in a very long-term 0% interest rate environment. And as interest rates adjust back to normal, some of that pricing has to adjust to reflect. Whether it's hiring and borrowing costs or higher construction costs, et cetera, some of that pricing has to adjust to reflect the more normalized environment.
So as a result, we're seeing this across asset classes, whether it's public equities or fixed income. Similarly, in aspects of the real estate world, there has to be a bit of an adjustment to reflect that we're going back to a normalized-- more normalized environment over the long term, where we see higher interest rates.
- I know here at TD, whether it's TD Securities or TD Economics, the call is, obviously, we have seen the pullback in real estate. We've seen prices come down. If we're talking about tough medicine to get us back to some sort of fundamentals, what does that look like going forward?
What are, I guess-- the cheap money, as you said, is no longer a reality. But I guess there's other driving forces. I think of immigration, too-- some of the demographics and how that could play out for real estate in this country.
- Yeah, absolutely. And so there's, let's call it, two sides of the coin. We have in Canada-- and if you compare Canada to other countries, we have robust immigration. And that provides a bulwark for the entire housing market because ultimately, housing, real estate, serves the economy, serves society. And if society is growing, requires housing, that creates a lot of demand. So that provides a bit of, call it a floor, to the housing market.
If you look at Canada, though, as a country, we have a much bigger real estate sector as a proportion of GDP relative to other countries, i.e. the USA. And so that would be the other side of the coin. When you look from an overall economy perspective, one has to be cognizant of that.
And so what does that mean? I would say the potential for interest rates in Canada to have a greater impact than the US say is there because we have a real estate as a broad sector, including construction as a bigger component of our economy here in Canada. The other side says, well, over the very long term, we will continue to see robust growth in our population, particularly in centers like Toronto and Vancouver, which are magnets for global immigration.
And if you factor in all the universities, the international students that come and are able to stay, you see the potential for significant growth in these cities. And ultimately, that will get reflected in, whether it's apartment condominiums or other housing that serves these new immigrants and current populations in these cities.
So, yes, two sides of a coin here-- in the short term, some volatility, some adjustment required. I think it's necessary because if the adjustment doesn't happen today, it will happen at some point in the future. And if it's some point in the future, it's more likely that adjustment will be harder than it is today. So better to take the medicine today and have the adjustment, recognizing we still have very strong long-term fundamentals for this country as it relates to the immigration and the demand for housing.
- What does that do to the real estate investor's mindset? Because as you're saying, well, we can't shake the money tree anymore and expect it to fall off at a low cost and just go off and make our investments. But you would think any investor, serious investor in real estate, would take that longer-term focus. OK, the money's not free anymore. But I've got to look forward five, 10, 15, 20 years.
- Absolutely. And so perspective on investing is always important. And one can take a short-term perspective, or one can take a long-term perspective. We've always chosen to look at the long-term perspective and look at those fundamental drivers-- long-term economic growth, long-term demographic growth.
The other thing that's critically important in real estate is leverage. Participants in the space use, some of them, quite a lot of leverage. And it's important to look at what type of leverage.
So who is the lender? Is it a fixed or variable rate, and for what term? All of those decisions become incredibly important in an environment like today.
And so those questions are really critical to look at. If you had fixed leverage at a conservative LTV, and you got that leverage two years ago, that is really quite accretive relative to going out today, trying to get very high loan to value and perhaps trying to do a fixed rate today. That's going to be an incredibly different picture.
So that leverage question is very, very important. And so when one is looking at participants of the space and their opportunity to create value, that leverage question-- what is the philosophy to leverage?
How much leverage? What type of leverage? Who are the lenders? What is the quality of, whether it's the developer or the owner or the participant in the apartment space-- what is the quality of that company doing that participation in terms of credit? It becomes incredibly important and a driver of value today.
- In the short term, do we worry about that leverage component for the people who perhaps didn't decide to lock in to a certain borrowing cost over a fixed amount of time and just let it float because a while-- only six or seven months ago, that was pretty seductive.
- Well, and that's where the math becomes very important, right? And when one invests for the long term, it is really critical to do that, to build the mathematical quantitative analysis, and to do the scenario testing for different types of interest rate environments.
And so, yes, if you haven't done that, or if you've made an assumption that rates were going to look like they were seven months ago in perpetuity, you might have some troubles. For other participants in the industry who have done the work, who have done the scenario analysis, that have looked at their leverage, have been a bit more conservative, that might present an opportunity, right?
There might be an opportunity to acquire incredibly well-located fantastic assets that otherwise wouldn't be available for sale that one knows will make sense in the very long term. There might be an incredible opportunity to acquire these assets today because you might have some participants that are caught out, for lack of a better term, as a result of the changing interest rate environment.