01/24/2024

Real estate portfolios can reduce unsystematic risk through property type, geographic, and financial diversification

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 ManagementResearch-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 RATE, MONEY DEMAND, & MONEY SUPPLY 

Graph: Interest Rate, 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

INTEREST RATES & MULTI-FAMILY RESIDENTIAL REAL ESTATE

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 

Graph: TSX and Variable Mortgage Interest RatesStock 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

Graph: 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 increase rental demand at all levels, shifting the entire demand curve up and to the right (DR1 to DR2) (Figure 5).   

FIGURE 5 – RENTAL DEMAND 

INTEREST RATES & MULTI-FAMILY RESIDENTIAL REAL ESTATE

The shift is empirically validated. However, unlike the conceptual illustration, in reality, the shift is somewhat laggedComparing Canada’s variable mortgage interest rate with the inflation-adjusted rental price index (a proxy for multifamily 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 

INTEREST RATES & MULTI-FAMILY RESIDENTIAL REAL ESTATE

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 

INTEREST RATES & MULTI-FAMILY RESIDENTIAL REAL ESTATE

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 Investment12(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 Management18(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. Forbeshttps://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 Research4(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? Forbeshttps://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 Managementhttps://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 Managementhttps://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  



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Limitation on Liability

EXCEPT WHERE SUCH EXCLUSIONS ARE PROHIBITED BY LAW, UNDER NO CIRCUMSTANCE WILL THE COMPANY NOR ITS PARENT, SUBSIDIARIES, AFFILIATES OR THEIR RESPECTIVE DIRECTORS, OFFICERS, EMPLOYEES, AGENTS, SERVICE PROVIDERS, CONTRACTORS, LICENSORS, LICENSEES, SUPPLIERS, OR SUCCESSORS BE LIABLE FOR NEGLIGENCE, GROSS NEGLIGENCE, NEGLIGENT MISREPRESENTATION, FUNDAMENTAL BREACH, DAMAGES OF ANY KIND, UNDER ANY LEGAL THEORY, INCLUDING ANY DIRECT, INDIRECT, SPECIAL, INCIDENTAL, CONSEQUENTIAL, OR PUNITIVE DAMAGES, INCLUDING, BUT NOT LIMITED TO, PERSONAL INJURY, PAIN AND SUFFERING, EMOTIONAL DISTRESS, LOSS OF REVENUE, LOSS OF PROFITS, LOSS OF BUSINESS OR ANTICIPATED SAVINGS, LOSS OF USE, LOSS OF GOODWILL, LOSS OF DATA, AND WHETHER CAUSED BY TORT (INCLUDING NEGLIGENCE), BREACH OF CONTRACT, BREACH OF PRIVACY, OR OTHERWISE, EVEN IF THE PARTY WAS ALLEGEDLY ADVISED OR HAD REASON TO KNOW, ARISING OUT OF OR IN CONNECTION WITH YOUR USE, OR INABILITY TO USE, OR RELIANCE ON, THE WEBSITE, ANY LINKED WEBSITES OR SUCH OTHER THIRD-PARTY WEBSITES, NOR ANY WEBSITE CONTENT, MATERIALS, POSTING, OR INFORMATION THEREON EVEN IF THE PARTY WAS ALLEGEDLY ADVISED OR HAD REASON TO KNOW.

Indemnification

To the maximum extent permitted by applicable law, you agree to defend, indemnify, and hold harmless the Company, its parent, subsidiaries, affiliates, and their respective directors, officers, employees, agents, service providers, contractors, licensors, suppliers, successors, and assigns from and against any claims, liabilities, damages, judgments, awards, losses, costs, expenses, or fees (including reasonable attorneys’ fees) arising out of or relating to your breach of these Terms and Conditions or your use of the Website, including, but not limited to, your User Submissions, third-party sites, any use of the Website’s content, services, and products other than as expressly authorized in these Terms and Conditions.

Governing Law and Choice of Forum

The Website and these Terms and Conditions will be governed by and construed in accordance with the laws of the Province of Alberta and the federal laws of Canada applicable therein, without giving effect to any choice or conflict of law provision, principle, or rule (whether of the laws of the Province of Alberta or any other jurisdiction) and notwithstanding your domicile, residence, or physical location.

Any action or proceeding arising out of or relating to this Website and under these Terms and Conditions will be instituted in the courts of the Province of Alberta and/or the Federal Court of Canada, and each party irrevocably submits to the exclusive jurisdiction of such courts in any such action or proceeding. You waive any and all objections to the exercise of jurisdiction over you by such courts and to the venue of such courts.

Waiver

No failure to exercise, or delay in exercising, any right, remedy, power, or privilege arising from these Terms and Conditions operates, or may be construed, as a waiver thereof. No single or partial exercise of any right, remedy, power, or privilege hereunder precludes any other or further exercise thereof or the exercise of any other right, remedy, power, or privilege.

Severability

If any term or provision of these Terms and Conditions is invalid, illegal, or unenforceable in any jurisdiction, such invalidity, illegality, or unenforceability shall not affect any other term or provision of these Terms and Conditions or invalidate or render unenforceable such term or provision in any other jurisdiction.

Entire Agreement

The Terms and Conditions and our Privacy and Cookies Policies constitute the sole and entire agreement between you and Avenue Living Asset Management Ltd. regarding the Website and supersedes all prior and contemporaneous understandings, agreements, representations and warranties, both written and oral, regarding such subject matter.

Reporting and Contact

This website is operated by Avenue Living Asset Management Ltd. located at 600-1201 Glenmore Trail SW Calgary, AB T2V 4Y8.

Should you become aware of misuse of the website including libelous or defamatory conduct, you must report it to the Company at investor-relations@avenueliving.ca.

All feedback, comments, requests for technical support, and other communications relating to the Website should also be directed to investor-relations@avenueliving.ca.