Interest rate hike creates tougher market for developers

Key Takeaways:

• The rate hike creates challenges for developers in the short term, but is necessary for the health of the overall economy, says BakerWest CEO Jacky Chan.
• Chan believes the challenges could impact housing numbers years down the line.
• He advised developers to act wisely and efficiently with the projects they choose.

The Whole Story:

In September the Bank of Canada increased its target for the overnight rate to 3.25 per cent.

It was the fifth consecutive rate hike this year and the bank noted that it planned to continue its policy of quantitative tightening.

“The global and Canadian economies are evolving broadly in line with the Bank’s July projection,” stated bank officials. “The effects of COVID-19 outbreaks, ongoing supply disruptions, and the war in Ukraine continue to dampen growth and boost prices.”

Bank officials explained that global inflation remains high and measures of core inflation are moving up in most countries. In response, central banks around the world continue to tighten monetary policy.
“The Canadian economy continues to operate in excess demand and labour markets remain tight,” said officials.

Officials added that given the outlook for inflation, the bank anticipates the policy interest rate will need to rise further.

“Quantitative tightening is complementing increases in the policy rate,” stated bank officials. “As the effects of tighter monetary policy work through the economy, we will be assessing how much higher interest rates need to go to return inflation to target. The Governing Council remains resolute in its commitment to price stability and will continue to take action as required to achieve the 2 per cent inflation target.”

Jacky Chan, founder and CEO of real estate firm BakerWest, explained that while the hike will make things more challenging for developers in the short term, it is necessary in the long term for the health of the economy.

“The immediate impact of a rate hike, specifically for developers and developments is that it poses a change to the financial model of every single development.”

“When projects are being contemplated or planned, or the valuations or appraisals of land are being done, obviously the financial costs are a big component of whether something could move forward or not,” said Chan. “You see headlines saying the Canadian market is going to see a big crash, real estate will drop more than 25 per cent this year. To be honest I think those comments are far fetched. I don’t know where those speculations came from in terms of supporting factors. What a lot don’t realize the fundamental reason why the interest is being increased so dramatically. That is a forgotten truth. People only see the immediate negative financial effects.”

Chan explained that when times are tough the government wants to lower the rate to encourage more borrowing, hiring, purchasing and development, and more activity in general so it can sustain a downturn. He added that the government doesn’t make these decisions blindly.

“The government also knows all of the economic metrics ahead of time,” said Chan. “They have the most accurate forecast of real time economic data and also future economic data.”

According to Chan, such a drastic rate change suggests that the bank has evidence that the economy will get out of control if nothing is done. While this is good in the long term, it presents some short term challenges.

“A lot of the numbers have to be redone now,” said Chan. “It impacts the immediate borrowing capacity of developers and buyers. Furthermore it impacts developers in a much bigger way because most of real estate development is a business of financial leverage. You’re using heavy financial leverage to actually make a profit for developments. That basically takes away the majority or all the profit or the safety buffer for these major financial decisions.”

This can create a domino effect that ends up in less housing supply, something sorely needed throughout Canada. Chan said that when developers can’t build projects quickly, it will negatively impact housing supply, even at pre-construction and presale stages.

“Let’s say we have a lot of these developments getting slowed down or reworked,” said Chan. “It will effect a huge portion of the supply three, four, five, six years down the road. What will that mean for the demand that is also increasing?”

On the consumer side, those with mortgages could see a higher percentage of their payments going towards interest.

“With desperate times come desperate measures and each measure comes with a cost,” said Chan. “While it creates a positive impact for the long-term health of the economy, we need to learn to adapt during these difficult times.”

Chan said developers must be more discerning and that the rate hikes could weed out developers who act more impulsively.

“We need to be more effective, more careful and more efficient with everything we do,” said Chan. “It creates a situation where it will be a more healthily competitive market where everyone needs to be better, faster, more accurate and more careful with their work and calculations in order to succeed.”