You will no doubt have heard many property investors discussing the rate of inflation and how this has impacted their investments and their investment returns. Like so many things in life, a little of inflation is a good thing but not enough or far too much can have a significant impact upon your returns. So, how should you view inflation with regards to your property investments?
You will also hear the term “real returns” very often in the world of investments because this is ultimately your return after inflation. The most basic comparison is interest rates against rental rates. If for example interest rates are 4% and inflation is running at 2% then effectively your real return for the year is 2% (interest rate less inflation rate). If rental rates are running at 7% and inflation is just 2% then your real rate of return is 5% (rental rate less inflation rate). This situation takes into account rental rates as opposed to any potential capital gain because capital gain is much more difficult to forecast than rental rates.
These situations can turn around very quickly if interest rates change although you should always look at the long-term trend as opposed to short-term spikes which can sometimes “correct themselves” very quickly.
Inflation and rental rates
There is a direct coloration between inflation and rental rates because in theory you should be able to increase your rental rates by the rate of inflation at the end of each year. This basically ensures your funds are worth the same in relative terms going forward. This can have a major impact upon your overall investment returns, including capital gains and rental income, as many investors will use their rental income to increase their investment pool. Even just a 1% difference in funds available for investment can have a significant impact upon your long-term performance. You are not just losing 1% per annum but you are also losing the accumulated long-term return on this additional funding.
You will also notice that during periods of relatively low inflation property markets can struggle especially the buy to let arena. In practice this can be offset by increased demand for rental properties, as we have seen across the UK, but in theory relatively low inflation often means a subdued economy. Again, the basic long-term consequences of relatively low inflation can have a significant impact upon your investment returns in the longer term.
While not always straightforward, in theory high inflation means there is relatively high demand for any product, service or underlying economic activity. If inflation is relatively high then it can sometimes be difficult to increase rents in line with inflation. If buy to let investors are unable to pass on a relatively high rate of inflation this will effectively see their income devalued in real terms. Very often high inflation also precedes a challenging economic environment which can lead to a slowdown or possible recession.
It is worth taking into account inflation, interest rates and rental yields (as well as forecast long-term capital gains) when trying to work out your long-term investment potential. Inflation plays a major role in all areas of business and investment and you would be foolish to underestimate its power.