This commentary is part of our September Special Report on Real Estate in Canada and around the world. To see all the articles so far, click here.
For those who spend time within the Canadian family office community, it is impossible to underestimate the powerful wealth generation potential of real estate. Despite volatility during memorable geo-economic crises like the 1997 Asian financial crisis, the 2000 Tech Wreck, the 2008 Global Financial Crisis and the COVID-19 pandemic, Canada has experienced relatively smooth and steady wealth creation across all real estate categories over the past 30 years.
However, a deeper look into demographic, geopolitical and macroeconomic warning flags may portend longer-term challenges for real estate investing in Canada.
As many investors realize, prolonged periods of strong investment returns are normally precipitated by a crisis, so let’s look at history for some clues to where the risks may lie.
The last big real estate crisis in Canada dates all the way back to the early 1990s, a period of plummeting valuations and economic hardship punctuated by the failures of developer Olympia & York and insurance giant Confederation Life. The 1992 bankruptcy of the Reichman family’s property development company was the largest bankruptcy in Canadian history at the time. The impact of a global downturn in commercial real estate was exacerbated by significant cost overruns at Olympia & York’s flagship project, Canary Wharf, in London.
Even more significant for Canadians was the 1994 failure and forced liquidation of Confederation Life Insurance Co. The company was engaged in aggressive real estate investments, particularly in commercial properties, office buildings and retail spaces, especially in major urban centres like Toronto. Due to the lack of diversification and illiquidity of its portfolio, falling rental income and property values led to a liquidity crisis.
The failures of Olympia & York and Confederation Life were the highest-profile casualties of a broader real estate collapse experienced in the early 1990s, when a severe and prolonged economic recession racked Canada for several years. Beyond the collapse in commercial real estate, Canada was also severely affected by a sharp decline in oil prices in 1990. Average Canadians also felt the pain, as home prices fell significantly. According to the Toronto Regional Real Estate Board (TRREB), average home prices fell for seven straight years from 1989 to 1996, declining by 28 per cent from a peak of $274,000 to $198,000. The 1989 price peak was not surpassed again until 2002.
Interest rates were also problematic for real estate investing in the early 1990s. Having experienced stubborn inflation from 1974 to 1982, developed economies finally began to tame rising prices and saw lower levels of inflation through much of the 1980s. However, a sticky rebound in inflation between 1989 and 1991 led the bank of Canada to aggressively increase short-term interest rates, to more than 13 per cent in 1990. Higher rates, weak oil prices and soft economic growth helped drive the unemployment rate to 11 per cent. With weaker consumer confidence, housing sales and prices weakened significantly.
When things are as bad as they were back then, prices reflect the lack of confidence, and value-oriented investors begin to respond. Driven by supportive interest rates, accommodative banks and strong demographic trends, value-oriented real estate investors of the 1990s generated exceptional returns for almost 30 years. From the mid-1990s onward, the Canadian economy diversified and grew significantly, the population—especially the working-age population in urban centres—expanded, and interest rates fell meaningfully. Together, these factors led to strong returns across real estate categories, especially in Canada’s cities. As one indicator of these strong returns, TRREB MLS data showed a fivefold increase in the average home price in Toronto, from $200,000 in 1995 to $1.12 million in 2005.
With such strong and consistent returns over such a long period, it comes as no surprise that many wealthy families continue to have a disproportionate level of their wealth exposed to real estate. Although it remains an important asset class to which most families should have some exposure, the risks we will discuss below—similar in some respects to those in the early 1990s, and some signalling a reversal of the tailwinds that have driven markets for the past three decades—underscore why a balanced approach or even underweight exposure to real estate might be worth considering.
Demographic risk
In his book The End of the World is Just Beginning, Peter Zeihan highlights how demographic shifts and their associated risks require a nuanced understanding of local and global trends to accurately navigate the future of real estate valuations. A couple of the key demographic risks he highlights:
- Aging population and declining birth rates: As populations age and the working-age cohort declines, there is a decrease in the demand from first-time homebuyers. Also, older populations may prefer smaller housing units or retirement communities, which can lead to an oversupply of larger family homes in suburban areas.
- Technology and migration: Remote work has allowed people to live in less expensive regions farther from city centres. To date, urban property values have been adversely impacted, to the benefit of secondary urban centres. However, as artificial intelligence and communications technology continue to improve, migration patterns of skilled international workers may also adjust accordingly.
Regulatory risk and taxation
As explained by Ray Dalio in a recent interview with David Rubenstein, the increasing focus on wealth taxes by many left-leaning politicians is an important emerging risk for real estate investors. Real estate is an illiquid, fixed asset that is one of the easiest to tax. When authorities impose real estate taxes, they have a direct and meaningful impact on both cash flow and valuation.
A differentiated regulatory risk is the growing imposition of foreign buyer regulations. Legislation like the Prohibition on the Purchase of Residential Property by Non-Canadians Act can restrict foreign investment and affect market dynamics. These rules are expressly directed at lowering market prices and controlling rent inflation, decreasing the pool of potential buyers and investors. Decades of accommodative central bank rates and neoliberal economic policies have led to rising wealth and income inequality. This has led to growing support for populist fiscal policy approaches like rent controls that are meant to address widening socioeconomic dispersion.
Inflation, interest rates and economic growth
Higher inflation and corresponding increases in interest rates contributed to the real estate collapse in the early 1990s. Then, interest rates falling from more than 13 per cent in the mid-1990s to lows of around 1 per cent in the late 2010s drove significant gains in real estate values. Rising interest rates can significantly increase real estate funding costs, negatively impacting affordability and leading to a decrease in property values.
Even the modest rate increases of the past couple of years have had meaningful impacts on the real estate market, but we may be only in the early stages of a longer-term inflationary challenge. Heightened geopolitical risks, including tariffs and trade wars, can have a dual impact on real estate values, as they lead to inflationary pressures and economic weakness.
Overbuilding and/or oversupply
Whether a market is overbuilt, which we may be experiencing in the condominium markets of larger Canadian urban centres, or is oversupplied due to a change in economic activity, impacts on valuations can be significant. Two examples of oversupply due to changes in economic patterns are suburban malls, which have been displaced by online shopping, and commercial real estate, which continues to be affected by the work-from-home trend.
As we can see from the 1990s real estate collapse and the strong returns generated over the subsequent 30 years, real estate is sensitive to inflation, interest rates, demographics, economic growth and the direction of governmental intervention. Although the current environment is not a perfect comparison to the last significant period of crisis, there are enough macroeconomic, geopolitical and market similarities to warrant some caution.
When considering an appropriate portfolio exposure for real estate, investors must consider the medium- and longer-term potential for each of these key drivers. Given the directional risk of these indicators, real estate investors might consider taking a more balanced and diversified approach to portfolio construction and err toward asset classes that provide inflation protection but offer other advantages, like liquidity and some level of tax-risk mitigation.
Keith McLean, CFA, MBA is a CFA Charterholder and holds an MBA from Dalhousie University. Keith is the President of Cabrasuke Inc. and a Partner with Chamberlain Family Office Advisors. With over 30 years of experience in risk management, equity investment analysis and portfolio management, he has experienced numerous market cycles that have allowed him to develop and expand his expertise while staying consistent to his long-standing investing principles. He has held senior investment and executive positions with several leading Canadian investment management businesses. His broad experience covers public and private asset classes as well as fundamental and quantitative investment strategies. Most recently, Keith helped a family office develop and grow an investment management platform. Beyond his work with Chamberlain, Keith has been building a private credit business focused on personal-injury medical receivables in partnership with Proof Capital. Keith is also an active board member and volunteer for education and veterans’ causes, including Northmount School for Boys and SADCAN Foundation.
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