Part 1: An amateur property investor's guide to navigating inflation

by Nick Gentle on Mar 30, 2022
Article appears under: About Property Investment, Investment Strategy, Mortgages, The Numbers

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Preamble: What follows is simply how I think with regards to my own investing and I am not an economist or financial advisor. Please seek your own advice from suitably qualified professionals.

July 2022 update: The NZ Herald interviewed me about my thoughts on inflation. That article can be found here.  

What is inflation?

Inflation is when the purchasing value of a dollar (owned or borrowed) devalues. 

The value of your dollar declining is bad news for consumers, however the corresponding drop in the value of debt can be a significant win for borrowers. It eventually will lead to capital growth for the associated asset, assuming you navigate the risks that lie ahead. 

Buy and hold property investment is all about the long term, so when the news in the market and on the TV is grim, it is important to understand as much as possible what is going on, work out your risks, and plan a course through it.

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The mood has changed

Inflation didn't take long to move from economists politely publishing "is it temporary or real this time" articles in the back of the business section, to "The Great Cost Of Living Crisis of 2022" becoming the political battleground playing out on the front pages.

Seen any headlines like these recently?

A quantitative estimate of inflation is usually reported as the increase of an average price level of a basket of select goods and services in an economy over some period of time.

The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.

While asset owners like to see some inflation, as it raises the value of their assets and erodes debt, high inflation is generally viewed as damaging because it is so disruptive to all areas in society. Businesses can't predict their medium- and long-term costs, consumers can't predict their cost of living, and since central banks usually combat inflation with interest rate rises, life can get tough.

Why are we in an inflationary cycle now?

Several things are happening at the same time:

1. There is more money in the world due to massive amounts of quantitative easing (read: printing money) by governments, including ours, to steer their economies through the global pandemic. The problem this creates is that there is still the same amount of stuff for this money to buy. More money and the same quantity of goods, means rents and commodity prices go up, which means wages go up.
2. Debt has been very cheap, which pushes up asset prices as more people try to buy them.
3. Rent increases usually follow price increases, which is a cost that businesses have to pass on.
4. There is a global production logistics crunch due to a) work shortages and lockdowns from the pandemic impacting "just in time" manufacturing and shipping logistics, and b) purchasing changes from consumers stuck at home. This has created a backlog that will take time to work through and shipping costs have increased dramatically.
5. The war in Ukraine and subsequent sanctions on Russia's oil exports have increased the cost of oil and shipping.

Are the price increases permanent?

Popular opinion among economists in New Zealand has shifted in recent months, from "it will all blow through once shipping sorts itself" to "at least some of these cost increases are here to stay... and we likely aren't done yet".

Increases in wages, benefits, and allowances are virtually never wound back and an increase in the minimum wage, in particular, serves as an anchor for wage increases right "up the chain" of employees. 

As for housing construction costs... this armchair critic feels it will be a cold day in hell before our cosy building material duopoly unwinds what they can charge for materials unless they are forced to.

So yes, some of this will be the new normal. 

Offsetting this are long term trends in technology, productivity, changes in consumer behavior, and the ongoing trend of globalization.

For example, oil prices are increasing and electric vehicle sales are at an all-time high. EVs result in other cost and infrastructure pressures of course, however, they lower the impact of petrol prices on the owner. 

What happens to property when there is inflation?

Inflation is usually a result of an "overheated" economy, to which banks respond by increasing interest rates to "dampen" demand and avoid an inflation spiral.

Side note: Looking at the "why are we in an inflationary cycle" section above, only half of the items listed can be targeted by lifting interest rates. There is a lot of debate on what central banks and governments can do, and should do. Increasing the OCR won't make ships unload any faster, for example.

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When interest rates increase the price people can pay for assets bought with borrowed money usually goes down. This is visible in property and also the share market (companies also face an increase in debt costs).

Ironically, for those borrowing the money a drop in price doesn't make home ownership much cheaper, if at all, due to the higher servicing costs. 

These changes can take a while to play out in the property market because:

1. Not all buyers and sellers have a mortgage (per Tony Alexander, about one-third of households are tenanted, the rest owned, and half of the owned ones have a mortgage)
2. Most borrowers in New Zealand are on fixed mortgages, so the increase in loan rates impacts people at different times. However at least 60% of our home loans are fixed for 1-year rates....
3. Vendors can choose not to sell, creating a slow-moving stand-off
4. Every property is unique and market shifts do not apply uniformly to each property

Not all properties are affected in the same way. I can't repeat this enough... you are not buying a share in the local property market. A single property or area can perform differently from the rest of the market, and you can buy very well or very badly at any time.

Be ready for emotions to kick in (and a hype-driven news cycle)

Everybody, and I mean this literally, every adult person that you know, will focus on house values.

Fear and greed are funny things and we humans tend to have a recency bias when predicting what will happen. If house values go up or down 5% there will invariably be a vocal group who are certain they will go up or down 50%. This is emotional stuff because we remember when houses were 50% the price they were now. News outlets gleefully produce articles about movements in house values on a daily, weekly, monthly, and quarterly basis. 

I encourage you to try and think objectively about this stuff because when we search for evidence of what we want to happen, we tend to ignore or discount any contrary ideas.

Offsetting downwards pressure: Building costs

Pushing against downward pressure, albeit not in a headline-grabbing way, are:

1. The rising replacement cost of property. During inflationary periods the cost of materials goes up and it takes a lot of materials to make a house.
2. Rental increases

During the last 2 years, the cost of construction has skyrocketed. You may have seen headlines like the below...

There is only so much that the cost of building a house can go up before the existing houses start to appear cheap by comparison.

Side note: Replacement cost (including demolition, designs, and council) is what you should have your property insured for by the way, so if you take nothing else away from this article, jump on a calculator and prepare yourself for a surprise.

In Part 2 I write about the long term benefits and immediate risks to property investors from inflation, with some ideas on how to stay safe now and prosper in the long term. 

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