Inflation – The hidden risk in post covid property investment.
There is a huge hidden risk in the property market right now that so few people are considering. It is one that could upend all assumptions about investing and make Covid 19 look like nothing. To fight the Pandemic the government unleashed a record £400bn stimulus, a peacetime record. Most of this was financed by the Bank of England printing money to buy government bonds and thus increasing the money in circulation. Unlike the last financial crisis, where printed money was created to shore up bank balance sheets, the majority of this money has been given direct to citizens and businesses. Schemes such as the CIBILS and Bounce Back Loans meant just about every UK business was given 50k minimum. Households and business savings rates are now setting new records and there is a wall of money about to be deployed in a market where there is less supply due to the pandemic. More money in circulation means classic demand pull inflation i.e. too many pounds chasing too few goods. This (along with the 0.1% base rate) is arguably why the UK property market boomed unexpectedly in 2020-21 with a 10% inflation of prices being reported. So are property prices the canary in the mine for general (CPI) inflation?
The large price inflation seen in the property market is now starting to be seen everywhere. Andy Haldane the Bank of England’s economist stated “It is hard to find very many goods or assets which aren’t going up in price”. He is not wrong world commodity prices have been rocketing with copper setting a new all-time record as are world food prices. Warren Buffet at Berkshire Hathaway’s annual shareholder meeting “We are seeing very substantial inflation, we are raising prices. People are raising prices to us and it’s being accepted.” Michael Burry, the mathematician who was featured in “The Big Short” Movie has gone as far to compare the current situation to 1920’s Weimer Republic Hyperinflation. “Germany [the US] started by not paying adequately for its war [on COVID and the GFC fallout] out of the sacrifices of its people – taxes – but covered its deficits with war loans [Treasuries] and issues of new paper Reichsmarks [dollars]. ‘ #doomedtorepeat,” Burry tweeted. The Bank of England and other central banks dispute this though, and have maintained that inflation is all under control. Andrew Bailey the governor said: “In the Monetary Policy Report our forecast suggested that inflation… will rise to target and be above 2.5% this year. We then think it’ll come back down.” The trouble with inflation is that it can soon spiral out of control and despite the best intentions of Central Banks increased prices will not just fall back and can soon lead to an inflationary spiral that gets out of control i.e people expect prices to be higher next year so they raise their prices to mitigate it.
So what does this mean for property people? Moderate inflation is actually good for investors as it deflates the value of mortgage debts and with the flexibility of an assured shorthold tenancy, rents can be revised upwards with reasonable ease. Even in a moderate rise, build costs undoubtedly could increase and don’t be surprised if a contractor calls up asking for more that the contract price to complete a job. Building materials are currently rocketing in price and supplies low at many merchants even at the time of writing. When the general public start to wake up to inflation, we should expect to see further property price rises, as property will be increasingly seen as a safe haven asset, there is “nothing as safe as houses” after all… The “safe as houses” mantra does have some truth in it but buying property using finance or at an silly price is a trap that will suck in many unsophisticated investors should inflation run far too hot…
In the runaway inflation scenario that Michael Burry is suggesting, the Bank of England only has one option. To raise interest rates sharply, this would upend all assumptions held about property and it is somewhat disturbing that so few investors are considering that money might suddenly become more expensive. Sharply rising rates would mean that property values fall, in a world that relies on finance, clearly increased mortgage cost affects affordability / value of the future cash-flows. Many developers using bridging finance or development finance are especially at risk, as GDV’s will be unpredictable and interest costs substantially higher overnight. It could be that lending stops, slows or developers have to refinance on very unfavourable terms. Sharply falling values could also mean lenders request revaluations of portfolios to test if the properties meet LTV covenants. This would cause major issues for the no money down brigade who promote maximum leverage with none of your own money. Equity is sanity in a situation where rates have to rise sharply. Rising rates will also have a catastrophic impact on the wider economy, for the last decade companies and households have gorged themselves on cheap credit and arguably are dependent on low rates. Rising interest rates sharply would almost certainly lead to a recession far larger than the short one we saw in 2020, leading to a lot of unemployed tenants, repossessions and have serious ramifications for investors.
So what can you do to mitigate risk? Cash is always seen as the safest asset but it is now clearly very risky to hold as its value could be deflated quickly. Using excessive leverage should be avoided too due to the risk of rates rising and getting caught out by LTV covenants within mortgage contracts. So how would you get cash off the books but without using finance? The only logical conclusion of this is to buy cheaper properties in cash without any mortgages, meaning that there is equity on the balance sheet that is not held in cash. Should values fall, having un-financed units is also a hedge against LTV covenants in existing mortgage contracts. The bank can be offered a charge on the un-financed property to bring the LTV back to the required level or finance quickly raised unit to satisfy the covenant. Another option for smaller sums is investing in listed property companies (REITS) which typically do quite well in inflationary episodes. As with everything do your due diligence and watch out for REITs who are using excessive amounts of debt, or have credit facilities up for refinancing soon. Another risk management strategy would be to ensure that all mortgages are on the longest possible fixed rate term possible.
The next few months are a very risky time in the property market, the range of scenarios is incredible and so few people have considered that interest rates may change sharply, a huge hidden risk that everyone could be sleep walking into. The million-dollar question is, are the Central Banks correct in their assumptions it will be transitory inflation? Or will they be forced to raise rates sharply?