Why Property is a Smart Hedge Against Inflation

What Is Inflation?

Inflation is the rate at which the cost of goods and services increases each year. This is measured using the Consumer Price Index (CPI), which calculates the cost of consumer products.

However, it isn’t just the cost of goods and services you need to consider when thinking about inflation. It is also the value of the currency you measure prices against going down.

This is an essential concept that smart property investors use to their advantage with mortgage finance and something that we will explain later.

Inflation and the Role of the Government?

Most governments have explicit policies targeting a moderate amount of inflation yearly. For example, the UK and US target a 2%-2.5% inflation rate per year.

Why is that? The main reason is that Governments are concerned about the impact of deflation – which means prices fall over time. If prices fall over time, consumers will more than likely hold onto their cash, hoping for a better deal in the future.

This makes sense. Why would consumers purchase something now if they think prices will fall in the future. This would, in turn, harm the economy.

Inflation also devalues the Government’s debt. Of course, it’s not a perfect science, but the UK government had until late 2022 been able to keep inflation in line with its target of 2%.

It can become quite scary if we look at inflation in monetary terms. For example, the equivalent of £100 in the year 2000 would buy you £56 of goods today in 2022.

This is why you should understand inflation – you don’t notice it over a short period. Still, it can enormously affect your wealth over multiple years.

The Difference Between Short and Long-term Inflation

As a property investor, you should analyse inflation in both the short-term and long-term because they impact property investment differently.

Short-term Inflation

Changes in supply and demand cause short-term inflation. If there are issues with supply but demand is high, prices rise – find out why property prices rise.

When prices rise too much, some buyers leave the market, making supply levels more stable and returning the market to normality. Likewise, if demand for a product increases but supply levels stay the same, the result is the same.

For property investors, short-term inflation doesn’t have a massive impact. It will generally increase wages, which can translate to higher rents. Conversely, the cost of materials increases so that refurbishment projects can be more expensive, reducing the margins for profitability.

Long-term Inflation

In reality, when inflation rises over the long term, it can have a significant impact on property investors.

Long-term inflation isn’t periods of short-term inflation repeated. It is decades or more of continued inflation, which isn’t just impacting the cost of goods, but, more importantly, the value of the currency you measure prices against going down.

The first important thing to consider is that wages are intrinsically linked to inflation. If prices go up 2% per year, then so do wages. On the other hand, spending everything you earn each month doesn’t make any difference.

But what if you don’t spend and want to save? Unless you have a rate of interest that at worst matches inflation, it becomes harder to save because the purchasing power of your money is continually declining.

The Effects of Long-term Inflation on Property Investors

But what about property investments? Looking at the performance of different assets over the past ten years, we can see whether they are in line or higher than inflation.

Since 2012, total consumer price inflation has been 31% – averaging 2.7% per year due to compounding.

If assets had increased in line with the cost of consumer goods (Inflation), you would expect them to have gone up by 31%:

• House prices are up by 63%.
• Gilts (government bonds) have increased by 80%.
• Gold has risen by 180%.

You may be asking why? That is because as a property investor, inflation is on your side as:

• Property values tend to keep up with inflation. If you had invested £100,000 in buying a property, it would have retained its value rather than losing money if you kept it in the bank.
• Rents tend to keep up with inflation, so the value of your income stream is maintained.
• The Devaluation Of Debt: The decreasing value of the pound is a natural phenomenon when there’s a long-term rise in inflation. Therefore, making your current debt cheaper as the inflation boosts.

Property Investment Leveraging: A Hedge Against Inflation

Property values in the UK historically outpace inflation. Many investors say property investment is considered a hedge against inflation. That is assuming you purchased the property in cash.

Property separates itself from other asset classes because most investors will use mortgage finance to leverage their gains.

Once you understand that mortgage leverage is a property investor’s most valuable tool, it’s easy to see why many investors use property investment as their primary vehicle to grow wealth.

You Benefit From a Leveraged Inflation

Let’s imagine you invest 25% of the price of a £200,000 house as cash and borrow the remaining £150,000 from the bank as a mortgage. Your equity in the house would be £50,000.

Over the next ten years, even a low inflation rate of just under 2% sees its value increase to £240,000.

If you sold the house, your profit would be £40,000. And your investment of £50,000 has almost doubled, based on the house’s rising value in conjunction with inflation.

Inflation Devalues Your Debt

Another factor to consider is inflation erodes your savings; however, when it comes to mortgage finance, inflation devalues your debt.

If we build on the previous example. Your £150,000 mortgage would be worth £130,000 in 10 years if inflation were at 2% per year.

Even if you took out an interest-only mortgage, inflation decreases the value of debt year on year.

As a result of leveraging the gain and the value of your debt decreasing, you end up owing less on an asset worth more – even without reducing the mortgage.

For property investors, inflation can be taken advantage of and combined through property leverage to maximise the profits in your portfolio.

Even with a couple of percentage points of inflation per year and no additional asset price inflation, you will see the value of your asset keep pace, and your rental income stream grow. A 2% annual gain in house prices can translate into 6-8% growth in the amount you’ve personally invested, thanks to leverage.