Interest Rate Repercussions: Investors await real

RATE

RAMIFICATIONS

Real Estate Investors Awaiting Price Adjustments

By Barbara Carss

DEPUTY PRIME MINISTER Chrystia Freeland is not an outlier in asserting that Canada is well positioned to curb inflation and recover from a downturn. Nick Axford, Chief Economist with Avison Young, concurs — predicting that a likely “technical recession” will be less severe than the prospects in Europe and that inflation will be on a downward trajectory by the spring of 2023.

“I think we’ll see inflation easier to tame in Canada,” he hypothesized during an online presentation earlier this fall. “Canada will probably be seeing declining GDP toward the end of this year and into the early part of next year, but we are not, in North America, expecting to see a really, really hard decline coming through. We are not expecting to see mass unemployment and business failures, but we will see some stress coming through in the economy.”

Real estate is in line for a share of the fallout, which has already taken form in a drop-off in investment transactions over the past couple of months. That’s in contrast to the first two quarters of 2022 and much of 2021, during which deal volume surpassed pre-pandemic levels. However, the steepest and most rapid rise in interest rates thus far this century has undermined that momentum.

“What we’re seeing at the moment is many investors stepping back and just waiting for the adjustment in pricing that they see coming to materialize in the market,” Axford said.

Looking at current economic dynamics — inflation, rising interest rates and the spectre of recession — he reiterated that inflation is the underlying ailment, while interest rates are the medicine with discomforting side effects.

Central bankers are attempting to reintroduce some slack into the system to avoid scenarios like the wage-price spiral of the 1970s. In doing so, they’re closing out an unparalleled era of low government bond rates and upending some comfortable assumptions. Axford characterized the years since the financial crisis as a “gravy train” in which real estate and other asset classes were benchmarked against rates of return that even fell into the negative zone in some countries.

“We need to start thinking about the fact that we are entering a different era in which interest rates are certainly going to be higher than the ultra-low, freemoney level of rates that we got used to over much of the last 10 years,” he

“We are entering a different era in which interest rates are certainly going to be higher than the ultra-low, free-money level of rates that we got used to over much of the last 10 years.”

submitted. “What we’re heading back into is not an unusual blip that is likely to be quickly corrected. Interest rates as low as they have been over the last 10 years is actually the thing that is unusual.”

UNEVEN IMPACTS FORESEEN In the months ahead, he expects a recession could diminish tenant demand, particularly for Class B office and assets in secondary and tertiary markets, while inflation could improve real estate’s profile for some types of investors planning to hold it for the long term. He also foresees rising cap rates across all property types as lower demand, higher financing costs and changing perspectives on risk and returns relative to other asset classes filter through to values.

“We are absolutely going to see cap rates coming under upward pressure,” Axford maintained. “The implication is that we’ll see, on average, 100 basis points minimum likely to be added to the benchmark cap rates that we’re thinking about for real estate, which a) will take some time to come through and, b) will come through unevenly. Some sectors will be more affected than others.”

Among those potentially harder hit, he cites a trifecta of challenges shaping investors’ outlook on Class B and aging Class A office buildings including climbing vacancy rates, more difficulty obtaining financing and higher costs (due to inflation) for required capital upgrades. On the flipside, he credits the trophy assets for bolstering market-wide average occupancy rates.

Avison Young’s proprietary Vitality Index — which tracks visits to locations via mobile phone data — shows a steadily growing influx into urban cores and downtown office buildings. Axford suggests the balance will continue to shift in favour of formal offices as each new wave of returnees exerts more pull on colleagues working from home. The shadow of job uncertainty in an economic downtown could also boost employees’ desire to be seen in the workplace.

“Broadly speaking, our cities are coming back to life and they’re coming back to life to the same level, if not more, than the period before the pandemic,” he observed. “The high-quality assets with great sustainability credentials and attractive, amenity-rich, accessible locations, I think they’re going to thrive. I think they are going to outperform. If I was buying anything, they would be very high on my list.”

GLOBAL FRONTRUNNER Nevertheless, buyers are expected to be hesitant at least until the spring. A further 50 or 75 basis point boost in interest rates is also anticipated.

Axford noted that the Bank of Canada was the global frontrunner in raising interest rates — perhaps swaying both the Bank of England and the U.S. Federal Reserve to follow suit — and is a good bet to take the lead on cutting them again. However, given that the impacts of interest rate adjustments typically take 12 to 24 months to work through the economy, he advises that central bankers are also in watch-and-wait mode.

“We expect to see that inflation is less endemic in Canada. They’ll be able to start cutting probably by the end of 2023, which isn’t something that we’re likely to see in many other parts of the world,” Axford said. “That said, don’t expect them to drop rates back to 1% or below. The cuts are going be a quarter point and they are going to be largely symbolic to start with. It’s going to take some time to get back to what they reckon is a neutral rate, which is somewhere around 2 to 3%.” zz

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