Falling Out Of Love With Real Estate

The heyday of real estate seems past us as rising interest rates have caused a nationwide chill on new home sales and rising prices. We explore another real asset alternative.

Real estate

Many investors have sought to diversify - or invest primarily through real estate over the last twenty years. Why not? After all, banks are more than willing to lend you 4x your principal to buy an investment property and governments are there to support your purchase due to incremental tax dollars driven by property taxes. Let's also not forget that higher house prices mean you can open up a HELOC and use that cash to fuel the economy or buy more properties.

In Canada and the US it has been a no brainer, house prices have continued to rise out of the GFC in 2010 and supportive government policies from immigration to municipal bans on new developments have both increased demand while squeezing supply. This has also been conflated with falling interest rates that meant you could either purchase more with your principal, or improve your cashflows with smaller debt servicing needs (i.e., your interest payments are lower).

However, the tides seem to be turning on the real estate front after a blistering decade of continued appreciation (+8% CAGR from April 2010 to April 2022). Regardless of talking heads in government claiming to enact measures to cool the market - rate hikes have had an immediate chilling effect. CREA reported a -12.6% decline in house sales with house prices falling slightly month-over-month in April, the first time in two years.

Diversifying Away From Real Estate

Real assets are often viewed as attractive investments during periods of inflation. However, highly levered real assets (like real estate), do not benefit from rising interest rates as debt repayment costs increase.

REITs are one area that are feeling the strain. XRE - iShares S&P/TSX Capped REIT Index ETF has fallen over -13% from its March 2022 highs.

REITs stand for Real Estate Investment Trusts and are investment funds that distribute at least 90% of their net earnings to unit holders. They typically focus on certain industries like apartments or commercial properties.

With an average interest coverage ratio of 40%, it comes as no surprise these highly levered vehicles will now be forced to direct more of their revenues to debt repayment from rising interest rates (all else equal), causing investors to unwind their positions.

Other Alternatives

Utilities are another real asset play that benefit from rising inflation without the major headwinds of rising interest rates and recessionary pressures. These businesses typically operate as monopolies / oligopolies with regulatory oversight on how much they can bill customers. Utilities manage water, electrical and energy distribution, making them more resilient to recessionary pressures since these services are always required.

Here's a few ETFs to capitalize on the Utilities space:

  • XUT - iShares S&P/TSX Capped Utilities Index ETF (Canada)
  • HUTL - Harvest Equal Weight Global Utilities Income ETF (Canada)
  • XLU - Utilities Select Sector SPDR Fund ETF (US)
  • GII - SPDR S&P Global Infrastructure ETF (US)

Concluding Thoughts

Real estate has been an attractive investment opportunity for investors following the Great Financial Crisis. However, with rampant inflation and central banks determined to keep it in check, the heyday for real estate may be past us.

Other real asset plays like Utilities make a more compelling investment thesis due to lower debt servicing needs and business models that can stomach a recession better.

Platform Update

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Note: The information contained in this article is not and should not be construed as investment advice, and does not purport to be. The information and opinions provided should not be taken as specific advice on the merits of any investment decision. Investors should make their own investigation and decisions regarding the prospects of any topic covered herein.

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