This week, the Bank of Canada concluded an important monetary policy meeting, at which it decided to cut interest rates by 25 basis points (bps), or 0.25%. The interest rate cut was the first since the bank initiated a pause in rate cuts this past March. Prior to the pause, the Bank had cut interest rates several months in a row, following an unprecedented sequence of rate hikes in 2022 and 2023.
With interest rates trending downward, Canadians are eager to find investment opportunities that capitalize on the newly lower cost of money. Real estate seems logical, with mortgage rates likely to come down. Indeed, lower interest rates do in fact reduce the real cost of housing (assuming you get in before prices adjust of course). So right now is probably a somewhat better time to buy a home than others in recent memory.
That doesn’t mean that a house is the best investment you can make, though. Far from it. In purely financial terms, private real estate investments are mired with problems, including maintenance costs, time costs, manual labour, and sometimes onerous regulations such as rent control. It’s not always easy being a landlord. Stocks, on the other hand, are purely passive and tend to deliver good returns over time. In this article, I’ll explain why stocks still beat real estate after the Bank of Canada’s recent interest rate cut.
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How stocks benefit from interest rate cuts
Stocks, like all other assets, benefit when interest rates go down. The reasons for this are twofold:
- Lower interest rates reduce companies’ borrowing costs.
- Lower interest rates reduce the “opportunity cost” of stock market investments, which cause “fair values” to go up in discounted cash flow (DCF) models.
So, stocks have two ways to gain from lower interest rates. Granted, the above facts apply to real estate investments as well as stocks. Houses can be valued by DCF models, though it’s rare for them to be valued that way in reality. However, stocks are more responsive to interest rate cuts than homes are, because many stocks enjoy fast-growing cash flows. Tech stocks, in particular, often grow at a breakneck pace. The faster the growth rates in cash flows, the more the asset value increases in a DCF model with reduced interest rates. So, stocks should perform even better than real estate in times of falling interest rates.
What to buy
If you want to ride the wave of lower interest rates on the stock market, you have many options. One of the best options is index funds. Index funds are pooled investment portfolios that trade on the stock market. Offering built-in diversification and low fees, they reduce your risk without costing you too much return.
Take the iShares S&P/TSX 60 Index Fund (TSX:XIU), for example. It’s an index fund consisting of the 60 largest Canadian stocks by market cap. Its 60 holdings give it an adequate amount of diversification. Its management fee (0.15%) is sufficiently low so as not to eat into your returns much. Finally, the fund is among the most popular and high volume in Canada, meaning you can trade it without giving too much money to market makers. Overall, it’s a compelling value.
