Is property a good inflation hedge?

One of the most keenly debated topics today is how the property market is likely to perform in light of current inflationary pressures. At a time when almost all other asset classes are coming under fire, many investors are asking: is property a good inflation hedge?

2022 has been the worst start to a financial markets year since 1939 with many major indices having already dotted in and out of bear market territory. The reasons have been addressed in previous articles, but the upshot is essentially that we are seeing a complete reversal in monetary policy by most central banks as a result of rapidly rising inflation. The pandemic was characterized by loose monetary conditions and a strong accompanying rally. The re-opening, in contrast, seems to be characterized by the unwinding of all this stimulus. Added to that is the impact of the war in Ukraine, which has amplified inflation and supply chain issues that were problematic to begin with.

It is unlikely that markets stabilize until the very root of the problem has been addressed: we need to see hawkish central bank action successfully subdue inflation. While some measure of inflation will likely prevail for years, it is unlikely that equity markets will rally until there is some certainty of inflation at least moderating.

Property is a good inflation hedge in theory

We are entering a period of guaranteed longer-term inflation (relative to the long period of extremely low inflation we are coming out of). Most other asset classes are likely to continue to struggle at least in the medium term. In theory, property should offer a good alternative. Let’s remind ourselves why property is a good inflation hedge by definition:

• Property is a real asset, derived from underlying components that all increase in an inflationary environment. That is particularly relevant now, when we consider the massive surge we have seen in the cost of building.
• Landlords can raise rents in line with inflation, assuming economic conditions such as growth and employment permit.
• Property has little correlation with equities and bonds, 2 asset classes in particular that are bearing the brunt of inflation.
• Property is generally underpinned by debt, and debt is eroded by inflation (the opposite is true for deflation). In other words, property can be effectively leveraged during times of inflation provided the cost of borrowing is lower than the rate of inflation.

In practice it’s less simple

There is no doubt that over long-term horizons, both in theory and practice, property performs well under inflation. In the UK we have essentially not had deflation since the 1930s, so we have had some form of positive inflation for the past 90 years. During that time average house prices have increased from 300 pounds, to about 300 thousand pounds. But one can argue that virtually all asset classes have appreciated drastically over that period. Individual investors don’t have 100 year investment horizons, what is more relevant is the relative performance of property during periods of inflation over say a 5-10 year period.

And this is where we get to the elephant in the room: Rising interest rates. Rising interest rates are in fact one of very few factors that generally cause property prices to decline. The others are recession (another increasingly possible scenario) and high unemployment (for now that is not an issue, as employment is actually at an all-time high in many developed nations). Rising rates are obviously the most direct impediment to property prices as they create a very clear affordability barrier. Loan-to-values in the UK, Europe and the US are significantly lower than they were during the last major global property market collapse (2008/2009), but they are still high enough to impact affordability. The average loan-to-value in the UK is around 73%. The base rate has barely increased so far this year, but already 5 year mortgage rates have increased by more than 1%. It is quite conceivable that the overall monthly mortgage payments for many buy-to-let investors will more than double by the end of the year. New mortgage approvals will decline as fewer buyers will satisfy lending criteria.

Property markets lag behind more liquid markets

There is another factor to consider when weighing up property as a potential inflation hedge: The property market is always slower to react than more liquid financial markets such as equity and bond markets. This is purely down to the fact that transactions take months, rather than minutes. In the current backdrop a huge amount of pain has already been priced into almost all asset classes, yet the property market is still in a euphoric high. When viewed under the microscope, however, signs of slowdown are already emerging (declining mortgage applications, lower transaction volume and in some cases even price reductions). It is likely that within months headlines of a property market slowdown start making it onto the front pages. Property should always be viewed as a long-term (ideally 10 year +) trade, so one could argue there is little point trying to time the market. But there is another unique characteristic that needs to be considered which makes the property market very different to the aforementioned more liquid markets.

Property markets are binary

One can look at historic periods in rear view and almost always assign a status to the prevailing trend; we are almost always either in a buyer’s, or a seller’s market, but very rarely neutral. This couldn’t be more different to equity markets. Even in a bear market, equities trade within an extremely tight (essentially free) bid/offer. Selling property in a buyer’s market is significantly harder than selling in a seller’s market. In some cases achieving the correct “market price” can take months, or even years. And this is really the crux of the argument: Does one want to buy property in what is likely the final stages of a seller’s market, when the economic backdrop is clearly negative and we have already seen the negative impact on other asset classes? Do we believe property can buck the trend, despite rapidly rising interest rates? Property is a long-term trade, yes, but that makes it all the more vital to get the timing right on the way in. Buying property almost anywhere in the word, is quite possibly going to be easier 6-12 months from now. At this very moment even buyers who are aware of the risk of slowdown are trying to jump the gun on locking in comparatively low financing, as they believe they will be able to afford less 12 months down the line. This phenomenon is likely to push the seller’s market we’re currently seeing out by a few more months. In countries that offer real long-term fixed mortgages, i.e. 20-30 years (like the US and parts of Europe) this can represent a huge amount of cost saving on a home. In the UK where most fixed rates are no longer than 5 years that is a harder argument to make. It makes less sense to rush into a new property purchase in order to beat rate increases, as you will likely be re-financing 5 years from now at a significantly higher rate.

What has a greater impact on prices – inflation or interest rates?

We are clearly in an environment where there is a bit of a tug of war between inflation and rising interest rates (and the 2 are of course completely interdependent). It is up to investors to decide which of the 2 has a greater, and more lasting impact. Here are some arguments to assist with that call:

• A huge proportion of today’s economically active have never seen interest rate hikes, and have created their wealth in a virtually zero-interest rate world. The world has forgotten what real interest liability means. We should not underestimate the impact of rates increasing significantly for the first time in decades, as it is unlikely to happen without creating some unexpected waves.
• Having said that, the global monetary system has gradually morphed into a one that favors, and depends on comparatively low interest rates. It is unlikely that major developed-world central banks can sustain high longer-term rates. It is doubtful whether we can ever return to the level of rates seen in the 80s and 90s. So while it is certain that rates will increase, we are likely to end up with comparatively low interest rates (in a historical context) even at the end of the current hiking cycle.
• From a rates point of view we are currently experiencing a “system shock”, mainly because central banks were extremely slow to react to inflation (having spent the majority of last year believing inflation would be transitory). But this means that we will catch up at some point and the forward curve will start to stabilize. Inflation on the other hand (even after it is brought under control) is likely to be a long-term phenomenon. We are entering a new age defined by a reversal in globalization and an increase in sustained geopolitical tension. The pre-requisites that drove down inflation to nearly zero over the last 2 decades are no longer in place, and it is reasonable to assume that most developed countries will have some measure of inflation for the foreseeable future (be it 3 or 5%, whereas before inflation was essentially zero).

On balance a reasonable assumption to make is that in the short-term interest rates will have a much greater impact on property prices. Interest rates are more cyclical (less consistent than inflation) and so the entering of a new cycle will cause a shift in dynamic. Undeniably significant increases in interest rates create downward pressure on property prices. There are no meaningful historic exceptions. Long-term on the other hand inflation (which generally persists even after a step-up in rates) is likely to have more impact. Perhaps one does well by avoiding the inevitable period of initial adjustment going into a new rate hiking cycle. In the slower moving property market that period is likely to last 1-2 years.

What can we learn from the past?

1989

Perhaps it is worth looking at what the prevailing conditions were during previous UK, and global property market crashes. The first relatively recent major property market crash worth looking at is 1989. In the UK from 1989 to 1992 property prices dropped on average by 20-25% depending on area. It was undoubtedly caused by a large increase in interest rates. It is worth noting that prevailing rates were already significantly higher going into that crash (the UK base rate increased from about 8 to 15% in a matter of months). The reason for the increase in rates was also exactly the same as it is today: spiraling inflation due to oil price shocks and rising wages. It is vital to distinguish between the sheer difference in quantum between then and today. Inflation coming into 1989 was already running at 7%, and it eventually peaked at 9.5%. Bringing inflation down from 10% to what was deemed an acceptable 5% (inflation targeting was only introduced in 1992) required a ~8% increase in rates. In 2022 the monetary system is vastly different, and central banks have an arsenal of additional tools at their disposal. It is likely (in fact we are already seeing the impact) that an increase in rates well below the actual level of peak inflation is likely to bring inflation down. The point is, we probably can’t assume that the same amount of damage is likely to be sustained by rate increases from 0-2.5%, as was inflicted by an increase from 8-15%. UK inflation then averaged about 3-4% for the following 5 years into the 90s (by 1995 it had dropped to 3.5%). What is interesting is that the 90s, despite the crash in 1989, were one of the weakest decades in history for UK house price growth (negative, in real terms). In the 1990s the tight monetary conditions and poor GDP growth (~0% until the mid-90s) were more impactful than inflation. It took an uptick in economic growth (by 1997 GDP was 5%) to spur the property market back into action. This should tell us that the presence of inflation alone is no guarantee for property price appreciation – economic growth and unemployment are potentially more important. If we are entering into a period of prolonged inflation now, the positive impact on property could well be nullified by the impact of negative growth.

2008

The other crash worth looking at is the GFC (2008/2009). Rates both in the UK and the US were gradually increased in the 2000s until they peaked at around 5%. The reason for rate increases was again – as it always is – inflation. The crash of 2008 was very different to 1989, however. Leverage was fairly low in the 80s, but by 2008 it was nothing short of excessive (in particular in the US). The combination of rate increases, and a structurally flawed market resulted in the biggest global property crash most of us can remember. What becomes apparent, is that highly leveraged, interest-rate sensitive markets (prime example Florida) got completely wiped out, while less leveraged markets (prime London is a good example) were relatively unscathed.

Timing is everything

So when assessing whether or not property offers an effective hedge to inflation, we need to accept that property prices, interest rates, and inflation will not move in lock-step in the medium term. If 1989 and 2008 are anything to go by, it is possible that a property purchase today could initially underperform inflation for a couple of years. In 1989 and 2008 property prices were coming off an extremely high base, but that is no different in 2022 (the result of long-term accommodative conditions). Had one picked up a “bargain” in 1990 one would have been in the red for the first few years. Bargain hunters in 2008/2009 were back in the money slightly sooner. Over the long-term, property investments generally turn out to be positive. The message here is: Don’t let inflation panic you into making a move to soon. Make sure you get the timing right. I rarely give specific predictions on whether property prices are likely to go up or down. I have been investing in property in the UK and the US for 20 years and have rarely been bearish. Like most asset classes, if you’re in it long enough, you’ll make money. But if pushed for an answer right now I would say the odds of property prices (in major UK and US cities in particular) increasing over the next 12 months are close to zero. On balance the odds or prices declining appear to be much higher. One needs to weigh up the risk of buying on the crest of the wave of a seller’s market, and the reality is that most major global cities are in seller’s market status. Sometimes it is worth keeping powder dry for a few months if it means achieving a discount on the cost of the asset. The impact of a 10-15% discount on the asset price can be far greater than the drag of a few months worth of inflation. Every individual situation is different but all property buyers should keep the following guidelines in mind right now:

• If you have flexibility and you do not have to buy right now, it is probably worth seeing how the market pans out over the next few months. The bias is likely to shift. Worst case scenario (as a buyer) we are still in a seller’s market, but at least you’ve given yourself the chance of landing in a buyer’s market. Investors have the luxury of waiting things out. In almost all global property markets (that are bound to continue to be impacted by rate rises) the bias is likely to be downward rather than upward.
• Home buyers can take less liberty when it comes to timing than investors. Not only does the property have to tick more boxes than if it were a pure investment, one also needs to consider the cost saving of not renting. Additionally the opportunity cost of existing financing has to be considered, particularly in the US, where many home owners have cheap financing locked in for 30 years.
• Leveraging can be an extremely effective catalyst in creating wealth, but we can no longer consider debt to be “free” as it has been for the last 2 decades. Borrowing certainly still make sense in an inflationary environment, but one needs to be sure that borrowing is affordable. A reasonable stress test to do is assuming that your borrowing cost will be 3 times as high as it is now when you come to refinance. If that scenario is uncomfortable, borrow less.
• Act rationally and without emotion, in particular if the property is an investment. Do your homework on what the right price/yield is, and if you aren’t successful, move on. Property purchases are large by nature, allow yourself to go through the bidding process multiple times if necessary, in order to give yourself the best chance of achieving a discount. In a market where financial conditions are tightening, the chances are higher that you will find a bargain further down the line.
• If you own investment property that you are likely to want to liquidate in the next couple of years, now is probably a good time to sell. If the market shifts to a buyer’s market it might take 5 years or more before you have the opportunity to sell at the right price.
• If you own a portfolio of properties and intend to do so for the long-term (10 years+), there is probably no need to consider drastic selling. It is highly likely (in my opinion) that the market softens from where it is now, but there is no reason to believe that we are on the verge of a full-scale global property market Armageddon. 40-50% declines are almost impossible in my opinion, as the market today couldn’t be structurally more different to 2008, and supply/demand dynamics are far more biased toward appreciation than they were in the 80s. Corrections, however, are almost inevitable and will vary depending on the nature of the mortgage market.
• As we are likely to see “rates stress” rather than “delinquency stress”, i.e. a shock caused by increases in interest rates, rather than severe economic deterioration (particularly high unemployment) the most interest rate sensitive markets will accordingly be hit hardest (the UK for example, where roughly 2 million mortgages are re-financed at prevailing rates every year).
• From a pure investment standpoint, one should be avoiding highly leveraged, interest-rate sensitive markets, as they will certainly not be immune to the coming rate hikes.