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Interest rates – Looking forward and back You might recall that interest rates in Canada stayed unchanged for about seven years. The recent interest rate hikes in 2017 – and the ones projected for 2018 – have some people in the rental housing industry quite nervous. They might not remember what happened in previous decades (such as the 1980s) when interest rates were much higher than today, and the Bank of Canada increased interest rates further.

RHB Magazine interviewed Ron Schuss and A. Britton Smith, two owners with a combined 100 years of experience, on their recollection of how interest rates affected their business and the rental housing industry. We also spoke to Benjamin Tal, Deputy Chief Economist of the CIBC, to get his views on where interest rates are going, and how an increase could affect the market. Looking ahead to 2018 In 2017, the Bank of Canada increased interest rates twice – in July (from 0.5 to 0.75 per cent) and in September (to 1.0 per cent). Some experts predicted a third interest rate hike in October, which did not occur. Following recent statements from Stephen Poloz, governor of the Bank of Canada, on the direction of the economy, some experts expect more increases to come for next year. “I see the Bank of Canada raising rates by 25 basis points twice or three times during the course of 2018,” said Benjamin Tal, Deputy Chief Economist, CIBC World Markets. “That would be a total interest rate increase of 50 to 75 basis points, which is a total of one half or three quarters of one per cent over the year. The Bank of Canada will go slowly because of the elevated Canadian dollar, slowing growth and increased sensitivity to higher interest rates.” Inflation appears to be the key factor behind the interest rate hikes. The Bank of Canada stated that inflation will emerge at some point in 2018, which is one key reason to raise the interest rate. However, some experts (including Tal) believe

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that the inflation rate will be relatively muted in the coming year. Canada’s GDP was stronger than expected in 2017, and a stronger economy can also push interest rates higher. Other factors, such as tensions with North Korea and the NAFTA negotiations, could also affect interest rates in 2018. “The North Korean situation is a risk that can lead to higher long-term interest rates,” said Tal. “Any serious problems with the NAFTA negotiations – or especially an outright cancellation of NAFTA – would tend to lead to lower interest rates, as the market will discount a slower economy.” Impact on rental housing Rising interest rates, as well as tighter housing rules, should slow down Canada’s housing market. However, as we have already seen, the impact won’t be evenly felt across the country; some markets will remain hot while others will stagnate. Housing prices in Toronto, Vancouver and other cities will continue to increase, as slightly higher interest rates will not deter homebuyers from getting in on the action. Some cities (such as Montreal and Halifax) could see declining housing prices, with the increasing interest rate an influencing factor. “Interest rates in the past have gone through a number of dramatic changes, all of which our industry has absorbed, although around 1990 new construction came to a dead stop as it was impossible to arrange financing,” said A. Britton Smith, Executive Chairman, Homestead Land

“We are prepared to adjust to changes in the market rates for at least the next five years,”

Holdings Limited. “Today an upward change in interest rates would bring about an increase in cap rates and lower values. There might be a few sales and some reduction in new construction.” The impact on rental housing will depend on the rate at which interest rates rise. Slower, smaller interest rate increases should have a relatively modest impact on housing prices and mortgage rates. However, the overall impact of higher interest rates and higher qualification rates for prospective homebuyers will increase demand for rental units. “Even though more people turn to renting, there are still many vacancies, as people and families try to stay together as much as possible,” said Ron Schuss, President and Founder, Dorset Realty Group. The past is a good indicator of what will happen to these markets when interest rates rise. Interest rates were quite high in the 1980s, and when they rose, there was an increase in foreclosures and “fire sales” of buildings. The rental housing industry took a few years to recover after the downturn. “The long-term consequences have been a period of great profit and high real estate values,” said Smith. “The profit margin in the industry is at an all-time high and there is plenty of room to pay higher interest without increasing rents. Higher interest rates will reduce profit but we have had the butter on both sides recently.” However, the amount of debt is much higher than it was in the past, due in part to higher housing prices and rents compared to income levels. This means that people would be more sensitive to an interest rate increase than they would have been in the past. Increasing the interest rate by one point is more significant than it would have been previously. As a result, the Bank of Canada does not have to raise interest rates as much today to have a substantial effect, although some people

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(and companies) are more prepared than others to deal with the increase. “We are prepared to adjust to changes in the market rates for at least the next five years,” said Schuss. “Due to our debt-service ratio, we have room to increase financing or increase interest rates, depending on what we need. We can say that, for the foreseeable future, we will be comfortable even with a significant increase in interest rates.” Real estate investment trusts (REITs) and other institutions also have to deal with projected interest rate hikes for 2018. Given that they already experienced two interest rate hikes in 2017, how they react to future hikes will depend on several factors. However, given today’s environment, high quality residential REITS should fare better than lower quality REITs in any real estate sector, as the former have a lower sensitivity to changes in interest rates than the latter. “To the extent that interest rates do not rise as quickly as the market currently anticipates, high quality residential REITs might perform well compared to many other investments,” added Tal. Conclusion While higher interest rates will affect some homeowners with open mortgages and mortgages coming due, it’s not all doom and gloom for members of the rental housing industry. Barring significant increases in interest rates, building owners will continue to proceed as they have over the past year, and construction of new properties should continue unabated. No one knows for sure what to expect in 2018, but being prepared for an increase in interest rates is a good strategy for anyone involved in the industry. By David Gargaro, in collaboration with Benjamin Tal, A. Britton Smith and Ron Schuss

RHB Nov 2017 Interest Rates  
RHB Nov 2017 Interest Rates  

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