Authors
Grant Alexander Wilson, Ph.D., Assistant Professor, Faculty of Business Administration, University of Regina
Jason Jogia, MBA, M.Fin., Chief Investment Officer, Avenue Living
Author Bios
Dr. Wilson is an Assistant Professor at the Hill and Levene School of Business, University of Regina. His research focuses on marketing, strategy, and innovation. He has published over 20 peer-reviewed articles in top management journals including Journal of Small Business Management, Research-Technology Management, and Journal of Business Strategy. His research has been featured in the National Post and by the World Economic Forum. Dr. Wilson is also a research consultant and contributor to Avenue Living Asset Management.
Mr. Jogia is the Chief Investment Officer at Avenue Living and has over 15 years of experience in real estate capital markets, originating over $10 billion in real estate loans and $1 billion in equity. He has extensive experience in real estate investment analysis and capital structure across various real estate classes. In addition to holding 2 Masters’ degrees in Finance, Mr. Jogia is pursuing his Doctorate of Business Administration and currently serves as an instructor at the University of Calgary, specializing in real estate finance.
INTRODUCTION
The global pandemic caused the Government of Canada to have an “all hands on deck” approach to its intervention in the free market economy. Specifically, the Government of Canada enacted both expansionary fiscal and monetary policies. Fiscal policy “consists of changing government expenditure and/or taxes” (Lumsden, 2011). In contrast, monetary policy “consists of changing the money supply or interest rates” (Lumsden, 2011). The pandemic stimulus package (government expenditure) was the largest on record (Wilson, 2021), equating to 11.2% of Canada’s gross domestic product (GDP), 420% larger than the 2008 recession (McKinsey, 2020). Other fiscal policies to expand the economy included a number of new tax exemptions and deferrals for both individuals and businesses (Government of Canada, 2021). In the early weeks of the pandemic, interest rates were reduced (expansionary monetary policy) to record-breaking lows (e.g., 0.25%) (Bank of Canada, 2022a; Foran, 2020). According to the Bank of Canada (2022a), “lowering interest rates [was] the Bank’s best-known tool to encourage borrowing to stimulate the economy.” Simply, in times of low interest rates such as the pandemic, economic actors are more likely to borrow money and make large purchases, increasing the overall demand for money (Investopedia, 2021).
Figure 1 illustrates how the lowering of interest rate (I1 to I2) results in a movement along the money demand curve (MD). In order to establish equilibrium between the money demanded (MD) and supplied (MS), the money supply needs to increase (MS1 to MS2).
FIGURE 1 – INTEREST RA TE, MONEY DEMAND, & MONEY SUPPLY
An effect of increasing the money supply too quickly is inflation (Ross, 2021; Lumsden, 2011). While “the natural tendency of the state is inflation” (Rothbard, 1962), Canada is currently experiencing above-average inflation (> 2%) (Trading Economics, 2022; Wilson, 2021; Wilson, 2022). Specifically, in June of 2022, Canada’s annual inflation rate was 8.1%, the highest since 1983 and well above forecasted figures (CNBC, 2022; Trading Economics, 2022) (Figure 2).
FIGURE 2 – INFLATION IN CANADA
Trading Economics (2022)
In response, the Government of Canada has committed to a series of interest rate increases (contractionary monetary policy) to “forcefully” curb inflation (Bank of Canada, 2022b). This paper explores the macroeconomic implications of interest rate increases. Specifically, the relationships between interest rates and the stock market, home values, and residential rents are examined.
INTEREST RATES & THE STOCK MARKET
According to Hall (2022), changes to the interest rate “impacts both the economy and stock markets because borrowing becomes either more or less expensive for individuals and businesses.” Interest rate increases, such as those occurring now and in the foreseeable future, “negatively affect earnings and stock prices” (Hall, 2022). An examination of the TSX Composite Index (benchmark measure of the Canadian stock market) and historical variable mortgage interest rates (a measure of real-time consumer interest rate changes) exemplifies this inverse relationship (Figure 3).
FIGURE 3 – TSX & VARIABLE MORTGAGE INTEREST RATES
Stock Performance (2022) & Super Brokers (2022)
Given the inverse relationship between the stock market and interest rates, recent and committed rate hikes have investors concerned, anticipating a recession, and seeking alternative investments. Real estate positions have been characterized as alternative investments that possess inflation-hedging benefits (Hartzell et al., 1987; Hoesli, 1994; Lee & Lee, 2014; Nickerson, 2021; Rubens et al., 1989; Wilson, 2021; Wilson, 2022). However, not all real estate investments react similarly – as they do with inflation – to interest rate increases.
INTEREST RATES & HOME VALUES
Interest rates and home values are central to homeownership affordability. According to Nielsen (2022), “interest rates are important to the housing market for several reasons. They determine how much we will have to pay to borrow money to buy a property, and they influence the value of [homes].” Low interest rates increase the demand for homes and increase prices, whereas high interest rates decrease the demand for homes and lower prices. A comparison of Canada’s historical overnight rate and new house price index (a proxy for home values) from 1990 to 2022 illustrates this relationship. As interest rates decrease, the new home price index increases (Figure 4).
FIGURE 4 – INTEREST RATES & HOME VALUES
Bank of Canada (2022) & Statistics Canada (2022)
A regression analysis, using interest rate as the independent variable and the new house price index as the dependent variable, confirms that the two are negatively correlated (β =-.713, p < 0.001). This demonstrates that as Canadian interest rates decreased, home values increased. In contrast, as interest rates increase, home values are expected to decrease. Given their “strong” negative correlation (r > ±0.40) (Hair et al., 2000), future interest rate increases are likely to create lower demand for homeownership in Canada, resulting in a “flight to affordability” or renting.
INTEREST RATES & RESIDENTIAL RENTS
A demand curve is a graph that depicts the relationship between the price and quantity of a good or service (Lumsden, 2011). Moves along the demand curve show how the quantity demanded changes at every level of price (Lumsden, 2011). A shift of the demand curve occurs when a variable, not on the axes, changes (Lumsden, 2011). In real estate, increasing interest rates and lower demand for homeownership increases rental demand at all levels, shifting the entire demand curve up and to the right (DR1 to DR2) (Figure 5).
FIGURE 5 – RENTAL DEMAND
The shift is empirically validated. However, unlike the conceptual illustration, in reality, the shift is somewhat lagged. Comparing Canada’s variable mortgage interest rate with the inflation-adjusted rental price index (a proxy for multi–family residential rents) shows that as mortgage interest rates increase or decrease, residential rents experience lagged corresponding increases or decreases (Figure 6). Given that the rental price index is inflation-adjusted, it can be concluded that these changes are direct responses to rental demand fluctuations.
FIGURE 6 – RENTAL PRICES & VARIABLE MORTGAGE INTEREST RATES
Bank of Canada (2022c) & Statista (2022)
It is evident that multi-family residential properties have distinct advantages in an increasing interest rate environment. As interest rates increase, more individuals are contemplating renting. At the same time, new multi-family construction slows down due to the cost of borrowing. The increased demand, but stagnant supply, puts upward pressure on residential rents. For savvy investors seeking to preserve and grow wealth, it may be strategic to include or expand multi-family residential real estate positions. Currently, wealth preservation is top of mind, as big banks and economists are forecasting an impending recession (Tepper, 2022; Ray, 2022).
GROSS DOMESTIC PRODUCT (GDP) & RESIDENTIAL RENTS
Gross domestic product (GDP) is a comprehensive assessment of a country’s economic health, as it measures its total domestic production. Increasing GDP, over two periods, is known as economic growth or a boom. In contrast, declining GDP over two consecutive quarters is defined as a recession. Comparing the annual changes of Canada’s GDP (booms and recessions) with changes to inflation-adjusted residential rents shows an inverse relationship (Figure 7).
FIGURE 7 – RENTAL PRICES & GDP
Statista (2022) & World Bank (2022)
A regression analysis, using GDP as the independent variable and rental prices as the dependent variable, shows that the relationship is negative (β = -0.756) and statistically significant (p = 0.007). This suggests that in times of GDP decline, inflation-adjusted residential rents (real increases to rent) experience the largest growth, supporting multi-family residential real estate as a recession-proof investment.
WHERE TO NEXT?
The last two years have been anything but stable and predictable. As a result, individual and institutional investors have had – to say the least – a “bumpy ride.” Understanding that the Bank of Canada is increasing interest rates and will continue to engage in contractionary monetary policies to curb inflation, it is a precarious time for investors. Examining historical data that compares rising interest rates with the stock market and home values emphasizes the importance of alternative investments that perform well in times of rising interest rates, namely multi-family residential real estate. As the world economies face increasing interest rates and impending recessions, this real estate asset class offers significant advantages.
REFERENCES
Bank of Canada. (2022a). Our COVID-19 response: Policy actions. https://www.bankofcanada.ca/2020/05/our-policy-actions-in-the-time-of-covid-19/
Bank of Canada. (2022b). Economic progress report: Navigating a high inflation environment. https://www.bankofcanada.ca/2022/06/economic-progress-report-navigating-a-high-inflation-environment/
Bank of Canada. (2022c). Canadian interest rates and monetary policy variables: 10-year lookup. https://www.bankofcanada.ca/rates/interest-rates/canadian-interest-rates/
CNBC. (2022). Canada inflation rate gallops to near 40-year high, calls for supersized rate hike mount. https://www.cnbc.com/2022/06/22/canada-inflation-rises-to-near-40-year-high.html
Foran, P. (2020). COVID-19 pandemic pushes Canadian interest rates to near historic lows. https://toronto.ctvnews.ca/covid-19-pandemic-pushes-canadian-interest-rates-to-near-historic-lows-1.4982314
Government of Canada. (2021). Changes to taxes and benefits. https://www.canada.ca/en/revenue-agency/campaigns/covid-19-update.html
Hair, J. F., Bush, R. P., & Ortinau, D. J. (2000). Marketing research: A practical approach for the new millennium. Irwin Professional Publishing.
Hall, M. (2022). How do interest rates affect the stock market? https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/
Hartzell, D., Hekman, J. S., & Miles, M. E. (1987). Real estate returns and inflation. Real Estate Economics, 15(1), 617-637.
Hoesli, M. (1994). Real estate as a hedge against inflation: Learning from the Swiss case. Journal of Property Valuation and Investment, 12(3), 51-59.
Investopedia. (2021). Monetary policy. https://www.investopedia.com/terms/m/monetarypolicy.asp
Lee, C. L., & Lee, M. L. (2014). Do European real estate stocks hedge inflation? Evidence from developed and emerging markets. International Journal of Strategic Property Management, 18(2), 178-197.
Lumsden, K. G. (2011). Economics. Edinburgh Business School Heriot-Watt University.
McKinsey & Company. (2020). Total stimulus for the COVID-19 crisis already triple that for the entire 2008–09 recession. https://www.mckinsey.com/featured-insights/coronavirus-leading-through-the-crisis/charting-the-path-to-the-next-normal/total-stimulus-for-the-covid-19-crisis-already-triple-that-for-the-entire-2008-09-recession#
Nickerson, C. (2021). Multifamily withstands pandemic better than most property types. https://renx.ca/multifamily-withstands-pandemic-better-most-property-types/
Ray, S. (2022). Another major international bank forecasts recession in the U.S. Forbes. https://www.forbes.com/sites/siladityaray/2022/06/20/another-major-international-bank-forecasts-recession-in-the-us/?sh=686292ff2f44
Ross, S. (2021). How does money supply affect inflation? https://www.investopedia.com/ask/answers/042015/how-does-money-supply-affect-inflation.asp
Rothbard, M. N. (1962). The Case for a 100 Percent Gold Dollar. Libertarian Review Press. 94-136.
Rubens, J., Bond, M., & Webb, J. (1989). The inflation-hedging effectiveness of real estate. Journal of Real Estate Research, 4(2), 45-55.
Statista. (2022). Rental price index in Canada from 1st quarter 2001 to 3rd quarter 2021. https://www.statista.com/statistics/198862/consumer-price-index-of-rented-accommodation-in-canada-since-2001/
Statistics Canada. (2022). New house price index. https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=1810020501
Stock Performance. (2022). S&P/TSX composite index (Canada) early returns. https://www.1stock1.com/1stock1_766.htm
Super Brokers. (2022). Mortgage rate history: History of average variable vs 5 year mortgage rates. https://www.superbrokers.ca/tools/mortgage-rate-history
Tepper, T. (2022). Is the U.S. headed for another recession? Forbes. https://www.forbes.com/advisor/investing/is-a-recession-coming/
Trading Economics. (2022). Canada inflation rate. https://tradingeconomics.com/canada/inflation-cpi
Wilson, G. A., Jogia, J (2021). Canadian real estate & farmland: A hedge against inflation. Avenue Living Asset Management. https://www.avenuelivingam.com/canadian-real-estate-farmland-a-hedge-against-inflation/
Wilson, G. A., Jogia, J (2022). Re-examining a hedge against inflation: Multi-family residential real estate. Avenue Living Asset Management. https://www.avenuelivingam.com/white-paper-re-examining-a-hedge-against-inflation-multi-family-residential-real-estate/
World Bank. (2022). GDP growth – Canada. https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?locations=CA
