Monetary easing, characterized by interest rate cuts, aims to stimulate economic activity by lowering borrowing costs and encouraging investment. However, during these periods, the dynamics of real estate liquidity can be significantly influenced by financial frictions. Recently, the Bank of Canada has implemented its fourth interest rate cut, bringing the rate down to 3.75%. While these cuts are meant to ease borrowing conditions, they can have a nuanced effect on real estate liquidity, especially when financial frictions—barriers that impede the efficient allocation of capital—are present in the market.

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Understanding Financial Frictions

Financial frictions refer to obstacles such as transaction costs, imperfect information, and borrowing constraints that prevent market participants from responding optimally to monetary policies. In the context of real estate, these frictions can take the form of stringent lending standards, high transaction costs, or reduced willingness of financial institutions to extend credit, even during periods of monetary easing. These frictions can severely limit the positive impact of lower interest rates, particularly on real estate transactions.

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Current Monetary Easing and Real Estate Liquidity

The latest rate cuts by the Bank of Canada aim to reduce borrowing costs, thereby boosting demand for real estate and other capital-intensive investments. However, despite these cuts, real estate liquidity—the ease with which properties can be bought or sold without significant price changes—remains a complex issue influenced by financial frictions.

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In Q3 2024, following previous rate cuts, residential property sales saw a modest 1.3% month-over-month increase . This uptick, however, was unevenly distributed, with suburban areas experiencing more activity than major downtown areas. Real estate liquidity in high-demand markets like Toronto and Vancouver has shown signs of strain, particularly in older properties and lower-tier assets. This uneven liquidity is in part due to financial frictions that persist, even as borrowing costs decline.

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How Financial Frictions Affect Liquidity in Real Estate

1. Borrowing Constraints

‍While interest rates have dropped to 3.75%, potential homebuyers still face stringent lending criteria. Mortgage qualification remains tied to stringent stress tests introduced after the 2008 financial crisis. Many financial institutions continue to assess borrowers' ability to repay loans at much higher benchmark rates than the prevailing market rate. This makes it harder for buyers to qualify for loans, reducing liquidity in the real estate market despite monetary easing.

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For instance, in 2023, the Bank of Canada estimated that about 20% of prospective homebuyers failed to qualify for mortgages despite interest rate cuts, due to financial institutions maintaining conservative lending practices during uncertain economic times. Even in 2024, as rates dropped, financial institutions have continued to assess loans conservatively, thus limiting real estate liquidity.

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2. Transaction Costs

‍Transaction costs, including brokerage fees, legal fees, and property transfer taxes, remain significant frictions that reduce real estate liquidity. In British Columbia, for example, the Property Transfer Tax (PTT) contributes to higher transaction costs, discouraging frequent buying and selling. Although monetary easing reduces borrowing costs, these persistent frictions limit the actual liquidity improvements in real estate markets.

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According to a recent BCREA report, the PTT alone can add an additional 1% to 2% of the property price in fees. Combined with legal and realtor fees, the overall transaction costs can reach 3% to 5%, dissuading both buyers and sellers from participating in the market during periods of rate cuts.

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3. Imperfect Information

‍Information asymmetry also contributes to financial frictions. During periods of monetary easing, not all buyers and sellers have full access to information about future market trends, making them hesitant to transact. This reluctance is particularly evident in the commercial real estate market, where uncertainties about post-pandemic office space demand and future interest rate hikes make liquidity more constrained.

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In 2024, this issue has been particularly noticeable in major markets like Vancouver and Montreal, where commercial property owners are holding off on selling due to uncertainty, even as borrowing costs have fallen. The volume of commercial property transactions has remained stagnant, even with rate cuts encouraging more investment in other sectors.

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Liquidity and the Divide Between Real Estate Segments

While financial frictions limit liquidity across the real estate market, the impact is not uniform. Trophy assets—high-end commercial properties and newly built residential units—continue to attract significant investment due to their perceived stability and long-term value. Conversely, older and lower-quality properties face liquidity constraints as investors shy away from these riskier assets, particularly in a market where financial frictions limit financing options.

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The CBRE report for Q3 2024 noted a vacancy rate decrease for top-tier office properties, while older buildings continued to experience rising vacancies. This bifurcation highlights how financial frictions disproportionately impact lower-tier assets, reducing liquidity and leaving older properties stranded in the market despite rate cuts.

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The Role of Monetary Easing in Easing Financial Frictions

While the recent interest rate cut to 3.75% is designed to stimulate real estate demand, the broader context of financial frictions must be addressed to improve real estate liquidity effectively. Policy measures targeting these frictions—such as easing stress test requirements, reducing transaction costs, and increasing transparency in the real estate market—could amplify the positive effects of monetary easing on real estate liquidity.

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The latest projections from the Bank of Canada indicate that the rate cuts may continue into 2025. However, unless financial institutions adapt their lending practices and policymakers address transaction costs and information asymmetries, real estate liquidity is unlikely to recover fully in the short term. Even with monetary easing, financial frictions remain a critical obstacle to improving the fluidity of the real estate market.

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Conclusion

Monetary easing, including the recent rate cut to 3.75%, has made borrowing cheaper and theoretically more accessible, but financial frictions continue to dampen the expected liquidity in the real estate market. Borrowing constraints, high transaction costs, and information asymmetries all contribute to a lag in liquidity recovery, particularly in older and lower-tier properties. Policymakers must address these financial frictions to ensure that the benefits of monetary easing fully translate into improved real estate liquidity.