[+] Not Time to Lose Sleep Over Inflation, Yet

There are mixed views about the outlook for inflation and how it may impact property prices.

Inflation is rising sharply in some markets, including Australia and the US but conditions in the financial market are still largely artificial.

While the impact of Covid, such as shutdowns and border closures, are putting a handbrake on economies, massive government stimulus packages and unconventional monetary policy have been introduced to help prop-up economies, which is putting a lid on inflation.

It won’t be until the pandemic has washed through the global financial system that inflation will start to normalise.

In its simplest form, inflation is when the price of goods and assets rise. Inflation has been incredibly low in most markets since interest rates have been at all-time lows during the past decade.

But between the March 2021 and June 2021 quarters, inflation rose from 1.1 per cent to 3.1 per cent in Australia.

In the US, inflation jumped from 2.6 per cent in March this year to 5.4 per cent in July.

While this rapid rise may appear alarming, experts say it’s important to take into account the unusual economic conditions before starting to worry too much about inflation.

▲ The rapid rise in inflation is not something to be alarmed about, say economists.
▲ The rapid rise in inflation is not something to be alarmed about, say economists.

Chief investment officer, multi-asset strategies, at American Century Investments Rich Weiss said the rapid increase in inflation is transitory.

“It’s a product of the dramatic rebound in demand for materials, goods and services at a time when supply chains simply aren’t fully up and running,” he says.

“We see the comparatively high US unemployment rate, and the continuation of long-term trends like an ageing population, automation and digitisation, combining to limit inflation over time.”

In fact, rising inflation may be positive for property markets in the short-term.

“Don’t fear inflation. Inflation can be your friend when investing in real estate,” Quay Global Investors principal Justin Blaess says.

“Higher inflation will protect your investment from supply issues and will reduce competition for tenants. It will also drive up replacement costs for property and the residual value of any improvements you make to your property.”

What if inflation beats forecasts?

One of the biggest risks to financial markets is if inflation rises more sharply and substantially faster than expected—hyper inflation.

This could happen under two main scenarios: if government stimulus artificially inflates demand in the economy and, subsequently, prices rise sharply; or labour shortages leading to wages growth could also prompt an inflation spike.

▲ The goldilock's inflation rate is between 2 per cent and 3 per cent.
▲ The goldilock's inflation rate is between 2 per cent and 3 per cent.

Founding director at EG Advisory Shane Geha says rising inflation will affect all asset classes.

“Once inflation sets in, wages have to be artificially adjusted, which brings on more inflation, which is not a good formula for property at any time,” he says.

The goldilocks inflation rate is between 2 per cent and 3 per cent which is the Reserve Bank of Australia’s target for setting the cash rate.

The central bank will adjust the cash rate when inflation moves above or below this band. Inflation has been persistently below 2 per cent for the past few years, which is a reason interest rates have been so low.

Moderate inflation, however, may be good for property values. But it’s not such good news for returns.

“Real estate investment trusts generally aim to generate returns of at least 5 per cent above the inflation rate,” Geha says.

“The main impact for REITs in inflationary environments is their assets become inflated in capital terms compared with their signed-lease incomes. This means that the rate of return on the investment lowers.”

One way to hedge away inflation’s negative impact is to invest in diversified REITs exposed to a variety of different assets across retail, commercial and office assets in a number of geographies.

“REITs that diversify into shopping centres with fresh food retail assets, or funds that get exposure to data centres, will likely generate positive returns both during and after the pandemic, no matter if inflation rises,” Geha says.

“There are other steps REITs could take to mitigate the risk of inflation impacting their fund. An example is to buy assets that are future looking, such as electric car recharging stations.”

▲ Rising interest rates can mean improving economic conditions.
▲ Rising interest rates can mean improving economic conditions.

An interesting dynamic is the impact inflation has on REITs’ divestment strategies.

Rising inflation will generally inflate property asset prices, but, says Geha, divestment of certain properties should be considered when capital values become so high as to prompt returns to fall to between 1 per cent and 2 per cent a year.

“It’s likely at this point, the asset price has reached its maximum potential.”

Systemic effects of inflation

Rising inflation tends to be symptomatic of a range of other, typically negative, variables that have the potential to impact financial markets. For instance, when inflation rises, so too do interest rates.

This tends to mean higher costs for properties underpinned by mortgages because loan repayments rise, which lowers an asset’s returns.

Conversely, rising interest rates means economic conditions are improving. Rising interest rates also tend to be balanced by rising rents, which landlords lift to account for the higher cost of borrowing.

In this environment, another salient factor is debt levels among real estate investment trusts.

Most REITs boast comparatively modest gearing levels, having learned their lesson during the highly-leveraged, pre-GFC years.

They should therefore be able to accommodate any medium-term interest rate rises.

Overall, it’s too early to tell how inflation will play out across property markets now and after the coronavirus pandemic.

The consequences of central bank actions such as extensive bond buying programs to prop-up markets have kept inflation artificially low.

What’s unknown is what could happen if they run out of unconventional monetary policy ideas to control inflation.

We’re a long way from there, however, given western banks have plenty of firepower left to help pave a smooth way out of the pandemic and back into more normal market conditions, when inflation should also stabilise.

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Article originally posted at: https://www.theurbandeveloper.com/articles/inflation-property-real-estate-australia