With inflation rising and an interest rate rise expected for the first time in over 3 years, we look at why investors use property as a hedge against inflation.
On 15 September 2021, the Office for National Statistics (ONS) published data showing that the twelve-month inflation of the Consumer Prices Index (CPI) was 3.25% in August, the highest it had been since February 2012 when it reached 3.4%.
Figures released today by the ONS (20th October), show that inflation in September fell back slightly by 0.1% to 3.1%.
The reason for the fall is because prices in restaurants in August rose less this year than last, when the Government’s Eat Out to Help Out scheme ended.
Despite the slight fall in prices in September, further price increases are to be expected over the coming months, with increases in the energy price cap, continued disruption to supply chains and a partial reversal of the VAT reductions for hospitality and tourism.
The Bank of England expects Consumer Price Index (CPI) inflation to rise to slightly above 4% in Q4, 2021 and remain above 4% into 2022. Well above the governments, target for inflation of 2% p.a.
Andrew Bailey, Governor of the Bank of England, signalled that UK interest rates might have to rise to combat rising inflation. Bailey stated the BoE would “have to act” on the risk of medium-term inflation.
Why should you be concerned about inflation? More importantly, why is property investment such a good idea in times of high inflation?
What is inflation?
Inflation is the rate of change in the price of goods and services over time. Both demand-pull and cost-push factors cause inflation, and monetary policy is used to combat inflation if prices rise too quickly. What are the different types of inflation, and how do they occur?
Cost-Push Inflation
Cost-push inflation occurs when the cost of producing goods or services increases. Typically this is due to increases in the cost of raw materials or increases in wages, or both. Low unemployment rates and shortages in labour also contribute to wage increases and cost-push inflation. The UK is currently suffering from significant supply chain issues slowing the delivery of goods and raw materials for production. In addition, the knock-on effects of Brexit and Covid have significantly reduced the UK’s available labour pool.
Demand-Pull Inflation
Demand-pull inflation is caused by long-term imbalances between the supply and demand for goods and services. Demand for goods and services increases as economic confidence increases and unemployment rates are low. When sustained demand reduces supply, companies can increase prices as buyers pay more for increasingly scarce goods and services. Demand-pull inflation has been an issue for many parts of the world as economies recover from Covid 19 shutdowns. Supply chains have struggled to keep pace with rapid increases in demand as economies come back online and demand increases.
How is Inflation Measured?
Consumer Prices Index (CPI) measures inflation; it tracks the cost of a basket of 700 different goods and services, including transport, food and entertainment and medical care. It monitors prices and measures the change in the price of these goods and services over time.
Why is inflation currently high?
The Monetary Policy Committee (MPC) of the BoE had anticipated rises in inflation in the near term. However, increases have been sharper and more rapid than many had expected. What has caused rapid inflation in the UK? There are several reasons for recent inflation:
- Consumer demand – for goods and services has increased rapidly as the economy has come back online. Demand increases have been caused by pent-up demand that was not fulfilled as people put off purchasing decisions at the pandemic’s height. As well as increased consumption due to new economic optimism as unemployment rates have reduced and wages have grown.
- Supply chains – UK supply chains have struggled to cope with rapid increases in demand which have rebounded rapidly. Shortages in the supply of specific goods have affected many consumer goods. A noteworthy example being shortages in semi-conductors which have disrupted car manufacturing. This has increased demand for secondhand cars and used car price inflation rose to 18.36% in the 12 months to August.
- Staff Shortages – changes to who can live and work in the UK post the Brexit referendum as well a number of people returning home during Covid lockdowns, have caused significant shortages in everything from HGV drivers to butchers. The staff shortages means companies have to pay more for staff and ultimately pass these costs on to consumers.
- Energy prices – have risen since April: and these increased prices have been passed on to consumers. The natural gas market has seen considerable spikes in demand as economies come back to life with the wholesale price of natural gas increasing by 250% since January.
Why is inflation such a concern?
The UK’s target rate of inflation is 2%, and it’s currently 3.2% – the highest figure in nearly 10 years. The consequences of high or rising inflation mean that your money will not buy you as much each month. Similarly, if you’re saving and have money in a savings account when interest rates are low, and inflation is high, the money will not have the same buying power.
The problem with spikes in inflation is that except for items such as road fuel, prices do not tend to drop once they have been increased. So even when inflation is back to its target 2%, the price of consumer goods and services won’t fall because retailers and service providers don’t reduce prices once increased.
Interest Rate Rises and long-term inflation
The MPC uses interest rates to try achieve the inflation target of 2%. Increased interest rates help to reduce the demand and consumer spending because:
- the cost of borrowing is increased, discouraging consumers from borrowing and spending
- it’s more attractive to save money rather than spend
- disposable incomes are reduced for those with mortgages
The BoE looks set to be the first major central bank to raise interest rates since the beginning of the pandemic. Traders are betting on an interest rate rise to 0.25% by December, with a further interest rate rise to 0.5% by March next year.
Some investors anticipate that UK inflation will increase to around 6% next spring, caused by the rise in costs of energy prices. Analysists are also anticipating longer term pressures, with some expecting that inflation will average around 3% over the next 10 years.
Real Estate as a hedge against inflation
Real estate investment is considered by many to be a good hedge against inflation over the long term. An inflation hedge means investing in an asset that is expected to appreciate in value by more than inflation. Real estate is considered a good hedge against inflation for serval reasons:
- Real estate prices tend to increase with inflation
- As the price of property increases, the loan to value ratio falls, meaning the equity in the property increases. Assuming a fixed rate mortgage, the monthly mortgage repayments remain static
- During periods of inflation, rents also increase, meaning gross rental income will increase
- For those buying property with debt, inflation helps to counteract the interest payments over time: If inflation is on average 2% per year over 30 years, and you have a fixed rate mortgage of 3%, you are effectively only paying 1% per year in borrowing costs
Inflation, construction cost escalation and supply and demand imbalances are just three of the reasons why property prices are set to increase, particularly in London (you can learn more here: Why London property prices are set to soar) Average rents in London are also increasing, they have shot up by 25% – 30%. You can find more on this in our article here.
So as the Bank of England prepares to increase interest rates to curb increasing inflation, smart investors will not be missing the opportunity to explore real estate opportunities as a hedge against inflation.
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