Understanding Key Challenges Impacting Real Estate in 2024

Published On: January 31, 2024Categories: Viewpoint articles

In the year ahead, many of the key challenges that defined Canadian real estate in 2023 can be expected to continue to drive headwinds for the industry at large. Interest rates, entrenched inflation costs, a construction labour shortage, and wavering housing-market sentiment have consequently led to softening growth and returns among many property types.  

Office, commercial, and retail property values and profits are strongly correlated with the Canadian economy, which entered the new year exhibiting virtually flat growth. Interest-rate sensitive single-family resale home prices, which can be equally driven by mass psychology and speculation, saw a moderate but clear correction with the national Home Price Index softening for a third consecutive month in November 2023.  

Understandably, a focus on these stalling real estate assets can lead to cooling investor sentiment around Canadian real estate at large. However, it is important that investors rightly observant of these economic trends fully understand their impacts, as they do not affect every facet of the real estate market equally. Indeed, it is in this economic environment that multi-family apartment assets are viewed by some as a strong opportunity for investors seeking alternative exposure in 2024. 

Interest Rates 

After raising interest rates 10 times since March 2022, the Bank of Canada’s (BoC) aggressive campaign against inflation finally moderated into a dovish hold at its current 5% benchmark rate. Rates are widely expected not to climb any further in 2024, but the question of potential cuts – when and how much – has divided rate watchers.  

As the effects of the Bank’s hiking cycle continue to work their way through real estate markets, raising investment capital for acquisition and development can prove more challenging for firms. Retail investors dealing with the personal impacts of a slowing economy have less liquidity to invest. Along with fewer investor funds, a higher cost of capital can slow firms’ ability to obtain leverage for construction. Meanwhile, REITs holding mortgages maturing within a high-interest period face the possibility of significant interest-cost increases. As a result, investors will see slower, more conservative markets and downward pressure on the value of some property types.  

A study of multi-residential apartment assets’ relative strengths will find them well-positioned to mitigate the effects of high interest rates. Investors will note that cap rates, a measure of potential profitability partially driven by interest rates, have been unfavourably rising across most major Canadian property types. From Q4 2021 to Q3 2023, and through the BoC’s rate-hiking cycle, softer-than-expected real estate activity saw national average cap rates increase for major property types; however, multi-family cap rates remained at the low end of all major property types, buoyed by expectations of rent growth and investor demand. Canadian institutional investors, which have been net sellers of real estate since the pandemic, have continued to make multi-billion-dollar investments in multi-family properties.  

Investors interested in the multi-residential space should continue to look to private REITs displaying strong fiscal governance through interest-risk mitigation strategies, such as staggered mortgages. With less-prepared buyers sidelined or struggling in the current economic environment, financially healthy firms can take advantage of the weakness in the market to purchase assets at discounted or distressed pricing levels and grow their portfolios efficiently. 

Entrenched Inflation Costs 

According to the BoC’s 2023 Monetary Policy Report, core inflation has dropped from 2022 highs to just below 4%. Excluding shelter costs — the sole component of the BoC’s inflation measure that has not experienced a decrease — inflation currently rests just shy of 2%. Although inflation growth remains muted in the wake of the BoC’s rate-hiking cycle, like shelter costs, many of the attendant increases remain entrenched. For example, residential building construction costs across 11 major Canadian metros rose 6% year over year in Q3 2023, driven by increases in material costs and construction wages. Property owners are faced with higher operating, utility, tax, and maintenance costs.  

Stable rental income from multi-residential apartments provides a welcome buffer against possible property-value fluctuations, offering firms another way to reward patient investors. Rental income is considered an effective hedge against inflation in the current environment with asking rents hitting new highs across Canada. However, like owners of other property types, multi-residential apartment owners face increased expenses in categories ranging from insurance to payroll.  

For this reason, REITs best positioned to weather inflationary cost increases include those with an active approach to property management. Firms who manage properties directly versus outsourcing their management to third parties are better able to tap into economies of scale through vendor partnerships, create operational efficiencies, and act on opportunities to create cost savings. Likewise, portfolios with a substantial gap-to-market benefit from a greater ability to absorb or mitigate costs. 

Construction Labour Shortage 

A severe construction worker shortage continues to fuel Canada’s chronic inability to meet skilled employment demand on job sites across all major property types. This serious imbalance results in longer construction timelines and stalled projects and poses greater risk for investors.  

By mid-2023, the industry had erased a surge in post-pandemic hiring from September 2022 to January 2023. A partial rebound in October and November 2023 did little to advance the situation for housing and infrastructure labour demand, resulting in a net loss of 15,000 jobs since year-start.  

Worker loss due to retirement is the primary contributor. According to forecasts, Canada will see more than 245,000 construction workers retire by 2032, roughly 20% of the 2022 labour force. Meanwhile, demand growth is expected to reach almost 300,000 workers. The widening gap has already sent labour costs soaring with construction wages increasing nearly double the pace of other industries in 2022. Economic conditions have slowed the pace of construction as firms trim headcount, resulting in 67% of home builders and developers reporting plans to build fewer units.  

Though November 2023 posted a decline in rental housing starts, they remain at multi-decade highs in both absolute and per-capita terms, underscoring expectations that starts in the category will remain elevated through 2024. This strength can be attributed partly to past and newly implemented government programs which reduce the impacts of construction-related challenges. The complete removal of harmonized sales tax on purpose-built rental projects in many provinces provides an immediate reprieve from mounting construction costs, while initiatives like the federal government’s recently announced express entry status for immigrants skilled in the trades suggests sustained political will on the issue. Organizations, such as the Canadian Chamber of Commerce’s Housing and Development Strategy Council*, help to ensure federal housing and development policies around labour reflect industry realities.  

*Equiton is a member of the Housing and Development Strategy Council 

Housing-Market Sentiment and Policy Risk 

Despite the country’s diverse real estate offerings, a wide-ranging media focus on Canada’s housing supply crisis has in many ways soured investor sentiment and spurred some governments to enact policy in this area. While not expected to have a significant impact on housing supply or pricing, foreign purchase bans, vacant-home taxes, and the application of taxes to newly constructed and substantially renovated residential housing instead create new sources of apprehension for investors hoping to enter the single-family home market. Less directly, interest-rate increases have taken hold in the form of softening residential resale prices and stymied growth.  

In this complex environment of fluctuating home values and heightened policy risk, investors are reminded that single-family homes, although a major component of Canadian real estate, do not represent the sector at large and that the demographic shifts informing Canada’s housing policy response may represent opportunities for other property types.  

The federal government expects to welcome 500,000 new immigrants annually by 2025, creating further demand for housing which is widely expected to be unmet. Low housing supply and affordability has pushed more Canadians into the rental market and limited existing renters’ ability to transition to homeownership. That said, more Canadians within the younger and senior tranches of the population are actively choosing to rent, seeking a more affordable, urban-oriented lifestyle free of property upkeep. Rentership growth is more than double the rate of homeownership and highest among the financially stable baby boomer generation, which numbered more than 9 million in 2021 

REITs that focus their development and acquisition strategy on high-growth regions in Southern and Western Ontario, as well as growing metros in Alberta, British Columbia, and Quebec, will have an advantage as immigrants settle into populous but underserved markets. Additionally, property owners catering to Canadians’ advancing preference for rental living through condo-like amenities and community-building will be rewarded with high-quality residents and the ability to right-price rents to the market’s currently higher levels. 

Mitigating Risk with Multi-Residential Apartments 

Sophisticated investors who understand these challenges and how different categories of real estate are impacted can more clearly see and take advantage of investment opportunities in Canadian real estate while other investors shy away. With the moderation of cost increases attributed to inflation and the resolution of rapid shifts in monetary policy, Canadian housing and multi-residential apartments should continue to yield rewards for investors over the coming years. 

IMPORTANT INFORMATION: This communication is for information purposes only and is not, and under no circumstances is to be construed as, an invitation to make an investment in Equiton Residential Income Fund Trust (the “Fund”) or with Equiton Capital Inc. Recipients of this document who are considering investing in the Fund are reminded that any such purchase must not be made on the basis of the information contained in this document but are referred to the Confidential Offering Memorandum which may be obtained upon request.