In conversation with... Tom Duncan
Insight | 10 minute read
Inflation is a key component of any economy. A change in the inflation rate is often seen as an early sign of impending change and the end of an economic cycle. A sudden spike in inflation can have a significant impact on investment portfolios particularly if investors fail to navigate it successfully.
A dangerous mix of closed businesses, higher unemployment rates and large injections of monetary stimulus from governments around the world, all as a result of COVID-19, has led to many experts predicting higher-than-normal rates of inflation are on the medium-term horizon.
In the US and across European economies, future inflation is forecast to be far higher than it was over the previous decade. In Australia, inflation is also expected to be relatively high, rising by 1.9% per year on average. High inflation would see interest rates rising, impact exchange rates and push highly indebted individuals, investors, businesses and governments closer to default.
The dominant concern of central banks at the moment, however, is still to try to raise inflation and inflation expectations hoping that this will be enough to raise interest rates above zero. This would provide room to manoeuvre in response to future negative economic shocks.
Rising inflation can be both good and bad for real estate, and offer potential opportunities for investors. Real estate is often seen as a highly effective hedge against rising prices with assets that benefit from leases with fixed annual rental escalations effectively offsetting increases in inflation.
The downside for investors is that the typical response to inflation is to make money and the cost of borrowing more expensive. The fact inflation also devalues currencies forces most lenders to raise rates further, making the cost of debt even more expensive still for those that need it.
Positively for investors, inflation can lead to an increase in property values. For example, rising inflation will result in an increase in the cost of building materials for developments. Between the higher cost to borrow and the additional cost to build, new construction can become increasingly less attractive, especially as these higher costs tend to be passed onto occupiers. This can lead to a rise in the price of existing properties, particularly if the supply of new construction is reduced.
Inflation also typically leads to an increase in rental values with higher mortgage costs generally resulting in more people preferring to rent rather than to buy their own property. This increase in demand for rental properties and the influx of tenants usually prompts landlords to raise their rents.
The longer-term economic effects of COVID-19 will take time to fully emerge. While interest rates are extremely low, making it a good time to borrow, the huge and ongoing economic stimulus funded by governments around the world could drive an increase in inflation.
The benefits of the stimulus currently outweigh the potential future issues – but with debt levels at an all-time high, the balance between the two will be an increasingly fine one. Irrespective of the outcome the real estate sector's ability to offset inflation through rental value growth makes it an attractive asset class relative to bonds or equities.