Weekly Comment- July 27, 2022

July 27, 2022 | Nick Foglietta


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Canadian Real Estate and

Some other Stuff

 

“Interest is the price of time. Time is valuable, or as Ben Franklin would say, time is money. And if you don’t place a proper price on time, the world will turn upside down”.

Edward Chancellor – Financial Historian and Author

 

This week’s topic for the summer series of editorials was driven by your responses to last week’s comment.

The analogy of the island and the rising water really hit home with readers and your replies were thoughtful and deserve a more specific response. I’ll do my best…

The crux of your replies pondered the correlations between:

  1. Real Estate
  2. Interest Rates
  3. Inflation

Intuitively, we can all sense there is a relationship present between these variables. But can we easily quantify it?

The short answer is “no, there is not a concise formula to be applied when correlating real estate prices with interest and inflation rates. Directional correlations are definitely present but not correlations with rate of change accuracy.”

Human emotion plays a large role in the outcome of correlating rate of change between our variables.

Political agendas influence how the similar raw data is acted upon. For example, at one moment in time the politics of the day state 2% inflation is desirable and to be targeted. Later in time, 2% inflation might be too low and the political climate states a higher rate is “right.”

The attitudes of consumers feed into the range of outcomes possible. Consider the next two charts as examples of differing consumer appetites.  

 

 

 

 

Confident consumers were pushing both real estate and retail inventories lower for an extended period of time. Their aggressive behavior forced companies to build (or buy) all the inventory they could; and then demand/confidence shifted. Sudden change is difficult for companies to work into their models and that is why inventories rise quickly.

The next chart shows consumer confidence expressed in both the US and Canada relative to real estate.

 

 

Notice how two countries with similar inflation and interest rates had completely different outcomes in their real estate valuations relative to income during the past 20 years. Why would that happen?

To start, let’s go back to the section of the earlier comment that stirred the replies from you:

Below are some numbers Markus and I cobbled together considering how significant of impact the higher interest rates are having on real estate affordability. (All figures assuming an $800,000 mortgage).

Variable Rate Mortgage at Lowest Level: 1.35%       Monthly Payment: $3143.00

Variable Rate Mortgage today: 4.00%                         Monthly Payment: $4223.00

5 year fixed Rate Mortgage today: 5.35%                   Monthly Payment: $4814.00

To view this data as most potential homebuyers would view it you would say that, with a monthly budget of $3143 to spend on a mortgage payment, the potential buyer can now only borrow $525,000 at a fixed interest rate of 5.35% as compared to $800,000 with a 1.35% floating interest rate in 2021.

This brings us back to the opening quote below the title for the editorial. Interest is the price of time.

Lower prevailing interest rates create higher boundaries a set amount of income can borrow. Higher borrowing boundaries encourage higher real estate prices and speculation.

Shifting gears, let’s use a 3 year time line and see might have been different and probably would have made more sense to have done as central bank policy makers: (The Red Entries are what actually happened in terms of interest rate increases and the Blue Entries represent what might have been wiser. Remember, COVID lockdowns started in March 2020).

 

January                March                      June                September       December (2020)                 

No changes to central bank policies employed in 2020. Do it all the same again

January               March                      June                 September       December (2021)

                                                               0.5%                                                0.5%

January              March                       June                September        December (2022)

                               0.75%                      1.0%

                               0.5%                         0.5%

 

So nothing changes in 2020 for the central banks. They did the right things in that year and history supports their actions when the world shut down with the unknowns surrounding the Corona virus COVID-19 at the time.

By 2021 it was becoming clear that the stock market was overheating and real estate was getting frothy. The mistake by the central banks was leaving their foot on the interest rate accelerator in 2021.

If the Bank of Canada or the US Federal Reserve had taken the “blue path” in the graphic above to raising interest rates, they would have started to quell the speculation in both stocks and real estate a year earlier. The irony is that, in Canada, interest rates are only 0.25% lower today than they would have been if they had taken a more measured approach to raising rates. (Blue = 2% of increases and Red = 1.75% of increases).

The blue path would have set a narrative in place a YEAR EARLIER that central banks were ready to normalize the financial world after the “COVID liquidity dump. That absolutely would have impacted behavior in terms of quelling reckless speculation.

So back to our 3 correlating factors: Real Estate, Interest Rates, and Inflation.

The key to successful monetary policy is managing expectations. Look at the following graphic summarizing retail sales in the UK.

 

 

Rising cumulative value of sales with falling unit volume is one of the worst economic conditions consumers can find themselves in. It ravages the consumer budget at all socioeconomic demographic levels.

The inflation problem the world is battling today was evident in 2021. The battle needed to have started a year earlier. The chart below considers the percentage of countries with inflation BELOW 2%. That number is ZERO today. But look how soon after the COVID money printing the percentage started to plunge.

 

It was clear in mid 2021 the inflation momentum had completely turned around when central banks were using the term “transitory.”

In conclusion, this editorial supports the following themes:

  1. Inflation is unlikely to be an easy challenge to solve.
  2. Central banks were late to the party when it came to fighting inflation.
  3. Real estate valuations are precariously high in Canada relative to what is likely needed to be done to fight inflation.

Therefore, the idea that the Bank of Canada needs the valuations for Canadian real estate to decline makes sense in terms of their longer term fight against inflation. The high valuations problem is not new but the COVID supply chain shortages and the Ukraine war have awoke the broader inflation giant from its slumber and makes is much tougher to fight today.

The US real estate market is less likely to see another severe correction (like 2008/2009) but is definitely going to cool with more rounds of interest rate increases and inventory builds.

Buckle up and maintain a conservative balance sheet for your household. These economic issues are going to take a while to rein in.