Simple logic says that when rates go down, the economy gets a boost and so does real estate. The reverse is also true. However, reality is rarely that simple.
We are in a housing crisis and all eyes are on how to fix it. Should the Bank of Canada lower interest rates now, or hold steady until achieving a two per cent inflation target? It all seems so complicated and confusing.
Yet, all complicated problems are made of simpler components. Let’s look at the pieces we do understand to find answers.
What is the relationship between real estate and the economy?
Did you know that residential housing makes up about two-thirds of the entire real estate market while commercial real estate (CRE) accounts for the remaining one-third?
The relationship between the residential real estate market and the economy is straightforward: when the economy is strong, the housing market tends to thrive, and vice versa. This is because housing is a direct consumption good and plays a significant role in consumer spending.
As a result, media coverage on the residential market outweighs that of commercial real estate. Yet, the impact of CRE on the economy seems less straightforward. Why is that?
CRE is both a factor of production and an investment asset class
CRE is a factor of production – it includes trade and distribution. Picture an industrial warehouse where people and machines make, package and ship goods. Or think of an office where people work.
These are places where businesses turn vision into reality to create and sell new products. In this way, CRE is a factor of production. As such, plans to expand operations or build a new factory are set in motion well before shifts in the economy.
Consequently, the impact of CRE on the economy is not immediate. There is a time-lag.
Moreover, as inflation takes hold, businesses will charge more for their products and pay higher rents. In this way, the impact of CRE on the economy is indirect rather than immediate.
CRE also operates as an investment asset class. It is a significant component of the balance sheets of financial institutions. Fluctuations in CRE values have a direct impact on lending practices: a decrease in CRE values reduces the availability of debt and raises the cost of capital, while an increase allows financial institutions to issue more loans.
These impacts on lending go far beyond the real estate sector and influence every industry. Once again, the link to the economy seems to have a time-lag.
In a broader sense, rate hikes contribute to slowing down the economy, in a cyclical way:
- Financial institutions and banks reduce lending when CRE values decline. This makes debt more expensive and harder to secure.
- Reduced liquidity leads to decreased spending by businesses and people tend to save more for a “rainy day”. Some can’t make ends meet and go out of business.
- Enough market “pain” can lead to a reversal in GDP growth, often resulting in a recession.
- To stimulate the economy, the Central Bank will lower rates and reverse this cycle.
- Real estate is subject to cycles: construction, asset pricing and space markets.
- Both the economy and real estate are cyclical, but not always in the same way.
Construction cycles
The construction industry, responsible for building all types of properties like CRE and housing, is a key link between real estate and the economy. It’s a labour-intensive sector that boosts economic growth.
Here are two key points about the construction cycle: first, residential construction is sensitive to buyer sentiment and quickly adjusts to economic changes; second, non-residential construction in CRE is less cyclical. This is because businesses plan long-term and expand or contract slower than the shifts in residential markets.
Asset market pricing cycles: This represents the most direct connection between the economy and real estate. Central banks closely monitor these cycles due to their significant influence on borrowing costs and the availability of credit / lending. The valuation of CRE on financial institutions’ balance sheets dictates it.
Space Market Cycles: These cycles revolve around the supply and demand of physical space in the market. Ultimately, they are influenced by various factors including the economy, demographics and even government policies.
In short, there are times we witness an oversupply of physical real estate. Calgary’s office sector is a prime example with very high vacancy.
Putting it all together . . .
Direct impacts of the economy on real estate:
- residential housing;
- asset market pricing cycles;
- indirect impact of the economy on real estate.
CRE is a factor of production with values fluctuating at a different pace and exhibiting a time-lag.
The construction cycle also experiences a lag.
The space market cycle is direct, unless external factors such as government policies limit or increase supply.
The factors mentioned above act like waves that overlap at different time intervals. That’s what makes it so difficult for economists to predict the impact of one on another.
It also underscores the indirect yet tangible link between real estate and the general economy. And why, by the time the impact of a slowing economy reverberates through the entire real estate sector, the Central Bank’s policy changes course.
Conclusion
When predicting the future, it’s wise to remember the words of the great philosopher, Homer Simpson: “Trying is the first step towards failure.”
But let’s try anyway. Here is one way: choose a likely direction, but also prepare to be wrong.
Consider these scenarios: is it more likely that the Bank of Canada will lower interest rates or increase them in the next nine months? Lower rates would stimulate the economy and the real estate industry. Given the ongoing housing crisis, which is unlikely to be resolved soon, a rate reduction would seem positive for the real estate industry, wouldn’t it?
However, due to the indirect and delayed impact of the relationship between real estate and the economy, it’s wise to protect your investment by accounting for a longer time horizon.
And finally, don’t let the first casualty of rate hikes be our sense of humour. Remember, in both good times and bad, this too shall pass.