One worry at the top of many investors’ minds in the aftermath of the great recession is whether inflation will rear its head again. In short, this article will show how over recent years, buy to let property investments would have provided investors with a good deal of protection against inflation. In Britain this is a particular worry as the pound has been falling against other major currencies such as the euro and also because of worries that the Bank of England may struggle to mop up all of the money it has printed through quantitative easing.
In fact internationally worries about inflation have helped push up the price of gold to record highs and have been leading some investors to advise against buying bonds, which fall in value if inflation rises.
Property and inflation
The interesting thing about property investing is that over time it offers some protection against inflation. Normally investors look at commercial property, because there are deep and active markets in which one can buy chunks of big office buildings or shopping centers. Because these have to be renewed or replaced every 20 years or so, their prices must ultimately rise in line with the costs of replacing them, and it is safe to assume that replacement costs also rise over time with inflation.
The same isn’t quite true in the case of residential property. Often in big cities the price of a house will be many times higher than the cost of building it. In London, for instance, the insurance replacement costs of many houses is generally a third or a quarter of the market value. This is because residential house prices also reflect all sorts of factors beyond building costs such as the cost of land, proximity to good schools, whether the neighborhood is a good one, and so on.
Residential house prices
So the question then remains whether buy to let property investments offer any protection against inflation. Over the long run house prices would usually be expected to rise in relation to average wages, which usually rise slightly faster than inflation. In recent years that relationship has broken down and in the run up to the peak of the property market in 2007, house prices accelerated far faster than wages. That the grew so quickly was one of the signs of a bubble becoming overheated. This means that over the very long run, the prices of real assets such as houses should keep pace with inflation. Over shorter runs, however, property prices can be extremely volatile. Thus over periods of up to 5 years, there is no certainty that prices will rise in line with inflation. If one take the recent drop in prices, house prices in some areas are down by 25%, even though inflation has steadily ticked upward.
The magic power of borrowing
Buy to let property investors do, however, have another trick up their sleeves when it comes to beating inflation. That is that many of them are buying houses using borrowed money. Inflation, simply defined, is the erosion of the buying power of money. If you have borrowed money to invest in a real asset you are letting the bank’s money erode in value while you, in exchange, have a real asset (an investment property) that should retain its value over time.
That idea is supported by figures produced by the Association of Residential Letting Agents (Alra), a trade body in the UK, that has calculated the impact of inflation on the returns earned by typical buy to let property investors over five years. The following chart shows some of those numbers.
The impact of different rates of property inflation on returns from buy to let property investments. Source: Arla
The blue bars show the projected annual rate of return on an investment in a typical buy to let residential property that is bought for cash. The bar in the middle is based on house price inflation continuing at its average rate. The different graphs to the left or right show the impact of inflation being higher or lower on average over the next five years than it was over the past five.The orange bars show the expected return based on a geared purchase where the investor puts down 25% of the purchase price and borrows the rest. As you can see the geared return is not only higher but is considerably more sensitive to house price inflation. Lower inflation will cut returns considerably (though in these cases they remain positive) and higher inflation leads to a huge jump in the return that is earned.
What does this mean for buy to let
For buy to let property investors the conclusion would be that when borrowing money from the bank, inflation is actually your friend as it can boost returns considerably. There are however two warnings that should be given. The first is that sharp falls in house prices can really hurt geared investors and put them into negative equity very quickly. They just have a thinner cushion of safety. The other is that when inflation goes up, so does the Bank of England’s rate and so too do mortgage interest rates. Higher mortgage rates can also be a killer if your rental yield is not high enough . If you are expecting a jump in inflation and want to profit from it be sure to fix your mortgage rate.
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