The Canadian real estate market has faced challenges recently. Direct property investors felt the pinch in 2022 and 2023 when interest rates climbed to 5%, leading to higher monthly mortgage payments.
But it wasn’t just those buying property who were affected. Canadians who invested in real estate investment trusts (REITs) also saw their investments drop in value. Here’s why that happened.
What are interest rates, anyway?
In Canada, the central bank, known as the Bank of Canada, plays a significant role in setting a key interest rate called the “overnight rate.” This rate influences other interest rates throughout the economy, from the rate banks offer on savings accounts to the rate at which you might get a mortgage for a home.
Now, the Bank of Canada can use the overnight rate as a tool, or “lever,” to influence economic activity in various ways, the two main ones being
- Tackling inflation: If inflation is too high, the Bank of Canada might increase the interest rate. When borrowing is more expensive (because of higher interest rates), people and businesses tend to spend and borrow less. This reduced spending can slow down the economy and help bring inflation under control; and
- Boosting the economy: If the economy is sluggish and needs a push, the Bank of Canada might lower the interest rate. With lower rates, borrowing becomes cheaper. People might buy homes or cars, and businesses might expand or hire, giving the economy a boost.
How REITs are affected by interest rates
REITs often borrow money to buy more properties or improve the ones they have. This is called “leverage.” When interest rates rise, the cost to borrow money (think of it as the “rent” they pay on borrowed funds) also goes up. This can reduce the profits REITs make from their properties.
REITs also distribute a significant portion of their profits as dividends to shareholders. When interest rates rise, other investments, like cash, can become more attractive, because they might offer similar yields with lower risks. This can lead to investors selling their REIT shares, causing the price of REITs to drop.
Finally, higher interest rates can also impact the broader real estate market. They can make mortgages more expensive, which can lead to a decrease in property purchases. When fewer people are buying properties, real estate values might drop. This can affect the value of the properties that REITs own.
Taking the guesswork out of REIT investing
Each REIT has its own unique quirks that can lead to disparities in interest rate sensitivity. As a result, I like to bet on the broad REIT sector instead of trying to find the best pick.
My investment of choice here is BMO Equal Weight REITs Index ETF (TSX:ZRE), which, as its name suggests, holds an equally weighted portfolio of 22 Canadian REITs, ensuring decent diversification.
Currently, ZRE is sporting a 5.53% annualized distribution yield, with the bonus of a monthly payment schedule. If you’re looking for consistent income from real estate, this exchange-traded fund is a great way to get that going.
