Canada’s housing market has been in a 30-year-long bull market. Most families that bought real estate in the 1990s are now sitting on an asset worth multiple six figures. Much of that appreciation has been driven by one key factor: declining interest rates. This factor is now reversing.
Last week, the Bank of Canada announced an end to its quantitative easing program. The central bank was printing money to purchase bonds and mortgages, which kept interest rates low. Now, as the program ends and the central bank starts hiking interest rates, the housing market could stagnate.
Here’s a closer look at what’s going on and how investors can navigate this new economic phase.
Why are mortgage rates rising?
A typical five-year fixed mortgage is now available at 2.2%. Earlier this year, the rate was as low as 1.9%. In 2022 and 2023, the rates are expected to be significantly higher.
To understand why rates are rising, you need to first understand why they were so low for so long. The Bank of Canada kept its key benchmark rate at 0.25% — a historic low — for the duration of the pandemic. It also printed money to buy bonds, corporate debt and mortgages in an effort to support the economy.
However, now the pandemic is receding while the money printing is causing inflation. The inflation rate is already at an 18-year high. To control this, the central bank is expected to raise rates eight times over the next two years. In other words, mortgage rates could roughly double by 2023.
How does this impact the housing market?
The housing market is already severely overvalued. Families can manage these stretched valuations, because mortgages are cheap, and their monthly costs are minimal. But if mortgage rates rise, fewer families can afford new homes, and current homeowners could struggle to refinance.
A decline in house prices cannot be ruled out.
What should investors do?
Investors may want to consider lowering their exposure to residential real estate. If the housing market cools, real estate investment trusts like Minto Apartment REIT (TSX: MI.UN) could see a squeeze on income and book value.
Higher mortgage rates could raise Minto’s operating costs. Meanwhile, lower borrowing capacity could stagnate or reduce the value of the company’s properties. The REIT currently offers a dividend yield of 2%, but that could quickly be offset by a decline in share price or rise in inflation.
Investors might also want to consider investing in stocks that benefit from rising rates and inflation. Payment processor Nuvei is an excellent example. Rising costs could push merchants on Nuvei’s network to raise prices, which boosts transaction volumes. Nuvei stock could see further upside if this trend continues.
Bottom line
Higher inflation is compelling the Bank of Canada to raise rates. Mortgage rates could skyrocket, which could cool the housing market. Investors should consider pivoting from REITs to inflation hedges in 2022.
