Inflation and How it Relates to the Property Market

Inflation is very topical right now and everyone is starting to feel the pinch. Just look at the cost of your most recent grocery bill, or what it cost you to fill the fuel tank in your car.

The economies of most developed countries around the globe are seeing higher inflation levels than they (and we) have seen in many years. This is driven by many factors, not the least of which is the vast amount of money that has been printed and pumped into these economies (called Quantitative Easing) to get through the impacts of the Covid 19 pandemic.

In this blog, we will not be focusing on the myriad factors, but rather starting with the basics of what inflation is, as to avoid or remove any assumptions, and how it relates to the property market, including what impact it has on property values.

What is Inflation?

Inflation is generally considered to be the measure of the increasing cost of living. Investopedia offers this definition: “Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in prices, which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.” They also note that “inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.”

In Australia, our inflation levels are recorded and reported as the Consumer Price Index (usually abbreviated to CPI) and are reported quarterly by the Australian Bureau of Statistics (ABS). You can visit their site if you want to review current and historic CPI data. The CPI is reported by the ABS for each of the eight (8) capital cities around the country, as well as the weighted average of these cities, the latter being what is normally used/referenced as the general rate of inflation in this country.

The CPI figures are reported by the ABS for individual groups of general expenditure within the economy, such as food and non-alcoholic beverages, alcohol and tobacco, transport, clothing and footwear, various others, but perhaps most importantly, housing. These are collated and referred to by the ABS as ‘All Groups’ to report on the overall level of inflation.

How is Housing Affordability Captured in Inflation?

It is important to note that housing is the most heavily weighted category/group in the CPI. It accounts for around 25% of the overall measure of inflation. When you consider what proportion of your income you might spend on rent, you can understand why it is given such a heavy weighting.

The ABS advises that the housing group includes “new dwellings purchased by owner occupiers (houses, townhouses and apartments), rents and major renovations. Including new dwelling prices captures the cost of adding to the housing stock.”  They tell us that “the two largest components of housing are new dwelling purchases by owner occupiers (8.5 per cent of all household spending) and rents (7 per cent of all household spending).”

The ABS also provides further definitions on how they review the data and what they include in their reporting, helping to avoid assumptions about how housing inflation is measured. They note:

  • For detached houses, the ABS collects information from builders in each capital city, which includes prices of project houses and details of any promotions or bonus offers. A ‘matched model’ approach is used, where prices are collected each quarter for the most common type of project houses being built in each city. These houses are ‘matched’ over time so that price changes are calculated on movements between ‘like’ houses based on attributes such as number of bedrooms, size of the house etc. Where necessary an adjustment may be made to ensure that the quality of the houses priced over time remains the same.
  • The rents series includes rents paid by new and existing tenants on privately owned and government-owned properties. For privately owned dwellings, the ABS collects data from real estate agents for a sample of rental properties in each capital city.

While this compromises the primary components of the housing sector, the remaining components include the maintenance and repair of dwellings, property rates and charges, as well as utilities, with utilities consisting of electricity, gas and other household fuels, as well as water and sewerage.

For a more detailed explanation of how ABS measure the housing component of inflation, you can read their Consumer Price Index and Selected Living Cost Index FAQ’s here.

Pressure on Interest Rates

It is important to understand that one of the key roles of the Reserve Bank of Australia (RBA) is to help maintain a stable currency. To achieve this, they conduct monetary policy to meet an agreed medium-term inflation target. Their primary tool to achieve this is to lower or increase the official interest rate (or cash rate), as may be necessary to meet the inflation target.

At present, with inflation rates starting to soar, we have an environment where the RBA will need to lift interest rates to curb the growing inflation and prevent it from growing out of control. We have already seen the RBA lift the official interest rate by 0.5% (the highest single rate rise in over 20 years) and we are told to expect several more rate hikes before the year is out.

Experts are tipping the official cash rate, which is at 0.85% as of this writing, to rise to at least 2.5% by the end of 2022. When you consider the RBA’s target range for inflation is generally between 2% and 3%, it’s not hard to see why most experts are predicting continued rate rises.

Impact on Property Prices

When considering the above factors, it is not illogical to think that as inflation rises and interest rates rise to curb that growing inflation, that property prices may fall. Afterall, if you have a $500,000 mortgage and your interest rate increases by 2%, your repayments will increase by $10,000 per annum. This reduces the affordability, which may in turn lower demand, which in turn can force property prices to reduce to ‘meet the market’.

While this principle may be reasonable, it is not something that will play out evenly across all market segments, especially in any market where the demand continues to outweigh the supply. As an example, the industrial property market seems to be well insulated against this at present. While there has been a decent amount of industrial development (in our market on the Central Coast) in recent years, that supply has been met with ample demand from buyers. This can easily be seen by the very small number of industrial properties that are ‘built and ready to occupy’ currently on the market for sale.

Given we have continuing strong demand from buyers, and few properties available, it is likely that the predicted moderate interest rate rises will not have a material impact on reducing prices. For that to occur, many more impactful economic factors would need to coincide with the increasing interest rates.

Inflation Pushing Up Commercial Rents

It is common practice in commercial real estate to link rental increases to inflation. This will sometimes be a direct link where the rent is increase each year (most commonly on the anniversary of the lease commencement date) in line with the movement in the CPI. It is also commonly structured where the rent will be increased by the greater of a fixed percentage and inflation, such as the greater of 3% or CPI.

This can be a double edged sword, as if the change to the rent is linked only to CPI, then the rent may actually decrease in the instance of deflation. This has occurred in very recent times during the pandemic. Most commonly, however, and certainly over the expanse of time, increases by CPI see commercial rents continue to grow, which can tie strongly to the underlying value of the property growing as well (as the rental value will impact the property value).

Inflation Impacting Commercial Property Yields

One potential threat to commercial property values is the threat that inflation poses to investment yields. As inflation increases and the RBA responds by increasing interest rates, the cost of borrowing increases in line. As the cost of borrowing increases, investors need to achieve better returns from the properties they buy to meet their loan payments and achieve a return on their investment.

Right now, we ‘re commonly seeing investment properties sell at net yields between 4% and 6%. If we see official interest rates increase to 2.5% in the near future, which is an increase of 165 basis points over the current official cash rate, we will likely see yields soften in line, which resultantly reduces the value of investment properties.

As we’ve mentioned earlier in this blog, the impact on values for vacant properties being acquired by owner-occupiers is not likely to be impacted in the same way. This impact is more relevant to buyers who need the rental income from the property to repay their loans, so as their repayments are higher, they need better returns.

If you’re interested to know more about our thoughts on inflation and what impact it will have on the local and broader commercial property market, feel free to reach out to one of our team members and we’d be happy to chat.