Negative Real Interest Rates Are Here to Stay: Implications for Real Estate Performance

Because of unprecedented debt levels accumulated by developed governments, a negative real interest rate environment is likely to persist for the long-term. This environment will allow real estate performance to thrive.

But what is a “Real” Interest rate?

An interest rate is the percentage of principal charged by the lender to a borrower for the use of its money.

If it is expected that the price of goods and services in an economy will be 2% higher in a year from the inception of a $100 loan, the lender will want to at least preserve its purchasing power to ensure that the $100 can buy the same quantity of goods and services a year later when the loan is due to be repaid. This means that the interest rate should at least be above the 2% inflation rate. This same basic concept applies to savers who deposit their money at a bank. If the interest rate is lower than the inflation rate, a negative real interest rate exists – the savers lose the real value of their dollars, and the borrowers gain that real value through advance use of the dollars.

There is a clear correlation between higher government debt to GDP readings and periods of negative real interest rates. Why is that? A highly indebted public sector cannot sustain positive real rates for long before running into a balance of payments problem.

In plain English, debt is more burdensome on a borrower when it costs above the rate of inflation.

Many developed nation governments have breached debt levels of over 100% of GDP since the Global Financial Crisis of 2008-09 (“GFC”) – Canada included at 116%.

This is not just a government problem; this has been a private sector problem as well, even before the COVID-19 pandemic. The pandemic, however, has accelerated debt levels to new highs. Total global debt, which includes households, corporations, and governments, is currently over $303 trillion – representing 351% of global GDP. This means quite simply that with no new debt added, world GDP will have to grow 3.5 times the cost of interest on this debt just to service the interest expense and keep the 350% debt to GDP constant. The world also faces another growth headwind – aging demographics.

Evidence from the GFC and the more recent COVID-19 pandemic is clearly hinting that most nations have already chosen an inflationary scenario based on the coordinated policy responses of the advanced nation governments and central banks to expand the money supply in the real economy. The expansion of money supply in the real economy, or monetary inflation, can have substantial impacts on future inflation rates. Furthermore, the action of the central bank purchasing government bonds also helps to keep a lid on long-term interest rates in the case government deficits eclipse investor demand, leading to a rise in rates.

[IMPLICATIONS OF NEGATIVE REAL INTEREST RATES FOR REAL ESTATE]

History has proven when inflation rises to higher levels that real estate exhibits a higher correlation to preserve purchasing power, primarily due to rents that grow with inflation and the intrinsic value in land, which tends to appreciate due to its scarcity.

Real estate is well-known by the institutional investor network as a real asset and, as such, should capture increased capital allocations during periods of higher inflation. The recent inflation acceleration of 2021 is coinciding with a Canadian real estate performance acceleration. The asset class provides an opportunity to outperform as economies recover from COVID-19 lockdowns over the next few years.

During an inflationary environment, one would expect to see a gradual rise in interest rates, but based on the thesis of this report, one would expect a general benign response from interest rates to create a favourable negative real interest rate regime. Rental growth benefits are likely to more than offset interest rate effects. This directly translates to a reduced response in mortgage rates and discount rates used to arrive at value conclusions. Finally, given the competitiveness of the Canadian commercial real estate market and the secular shift toward more pension plan allocation to real estate, it is highly likely that capitalization rates will not expand to fully discount inflation. Remember the first example – negative real interest rates cause savers to look elsewhere when banks or fixed-income investments pay interest rates well below the rate of inflation. This shifts fixed income capital out the risk curve into asset classes that can preserve purchasing power. Real estate is time-tested at preserving purchasing power.