Property and Economic Downturn 2022
At a time such as now, when all sorts of economic indicators seem to be pointing in the wrong direction, it’s natural to consider which might be the safest forms of investment. In this post, we’ll give some thought to that question and try to assess how prospects might change as we look ahead.
Economic Challenges
First, it’s perhaps worth listing some of the key economic challenges that the country faces, and some of the forces that are driving them. (We could of course devote many pages to each of these topics, so what follows is no more than a short summary. Nevertheless, it provides useful context for the UK’s present situation.)
Inflation and the cost-of-living
Perhaps most obvious challenge of all is the huge surge in living costs that ordinary Britons are facing. It’s true that inflation has risen rapidly right across the world but, in the UK, the problem has been compounded by some unique circumstances.
Before we get into those, however, it might be useful to review why inflation matters to investors. One key reason is because it erodes the value of savings and spending power; when inflation is running at around 10%, people very quickly start to feel materially poorer. They see their outgoings mounting every week and unless their earnings are rising at same fast pace, they find themselves with less to spend. That renders them less able to pay rising rental costs or to compete with other potential buyers to acquire new homes. In time, this can have a slowing effect on growth in property prices and rental values.
In that sense, high inflation is unhealthy for investors. Not only can it lead to slower growth in capital and rental returns, but the real value (i.e. the buying power) of those returns is itself eroded.
At the start of July, the ONS put the Consumer Price Index measure of inflation at +9.1% and the Retail Price Index (an alternative measure) at +11.7%. This is important because, if an investor’s total returns are growing at less than that rate, he or she is seeing a real-terms fall in value. Happily, for UK residential property, the combined average returns from capital and rental growth have tended to stay well ahead of inflation, as we’ll examine later on. However, with the ONS forecasting even higher rates of inflation – rising to around +11% later this year – it’s something that all investors will be watching carefully.
Drivers of inflation
There are many drivers of inflation and they often interact with one another, which makes it hard to unpick their respective influences. However, some of the most notable are relatively easy to identify.
First, the lull in industrial activity during the Covid pandemic prompted a worldwide fall in demand for materials, fuel and energy resources and, consequently, a drop in production and stockpiling. But then, when the pandemic receded and global industries sought to resume normal operations, demand for these vital commodities quickly returned. The combination of high demand and short supply drove international market values higher and, since virtually all industries need energy and other key materials to function, the knock-on effects were widespread.
Perhaps unexpectedly, climate change has also had an effect on energy prices. Droughts in India, China and elsewhere reduced the potential for hydroelectric power generation, so these and other countries needed more fossil fuels as their economies gathered pace. That coincided with an unusually cold winter in parts of Europe, which only added to demand-pressures on limited supplies. Both factors tended to inflate global prices.
Brexit has been another driver of inflation in the UK. First, the value of the pound fell sharply on the news of the decision to leave the EU, and it has remained low ever since. As a result of Sterling’s reduced buying power, imported goods (including food and fuel) have been proportionally more expensive. An independent report featured in the International Economic Review (September 2021) estimated that this has added +2.9 percentage points to the UK’s rate of inflation; said to be equivalent to an extra £870 in average household costs per year.
Brexit has also added to the costs of trading with overseas suppliers and customers, and it prompted a decline in the supply of labour from other EU nations. The resulting shortages – particularly in vital sectors such as agriculture, haulage and construction – compelled some UK employers to pay higher wages in order to attract enough staff to function. Rising labour costs in key strategic industries therefore became another contributing factor.
The war in Ukraine has been a further driver of rising prices, and indeed one of the most powerful. Import restrictions on Russian oil and gas have pushed wholesale prices even higher, and the same is true of certain food commodities, especially grains and food oils. Whether deliberate or accidental, the timing could hardly have been worse.
There are numerous other factors, of course. High levels of government spending during successive lockdowns were widely welcomed as steps necessary for protecting jobs and businesses, but this injection of extra money into the economy may also have had an inflationary effect. The same may also be true of quantitative easing measures, the low base rate and even the stamp duty holiday, which was one of many reasons why house prices rose so quickly. (Since mortgage costs are included in some of the ‘baskets’ used to calculate RPI, house price growth has, itself, been a contributor to this higher inflationary figure.)
Inflation and the Base Rate
One significant feature of these inflationary pressures is that there is very little that the Bank of England can do to change most of them. It has a remit to keep inflation down to a target figure of +2% per annum. However, aside from the ability to set the base rate, it has very few tools available – and none at all that can change the reality of the war in Ukraine, Britain’s trading relationship with Europe, or global demand in the wake of the Covid pandemic.
Nevertheless, in an effort to prevent inflation from accelerating even faster than it has, the Bank has raised the base rate in steady increments over recent months. There is much speculation as to how high it might ultimately go; most estimates vary from around 1.75% to 3.0%. For investors, a rising base rate will obviously add to the costs of a new mortgage, although it’s important to note that, in a historical context, these rates are still comparatively low. Moreover, the Bank of England expects inflation to drop back much closer to its 2% target at some time in 2024, so pressure to raise interest rates may soon abate.
Earnings and Living Standards
Faced with today’s rocketing inflation and the highest tax burden in 70 years, working Britons are understandably anxious that their earnings should keep pace with living costs. However, the UK government is equally anxious not to stoke a wage-driven inflationary spiral, so it is attempting to discourage claims for higher pay.
For investors, neither outcome is looking ideal. If people see their real incomes fall then, as noted earlier, they will have less to spend and so average values (i.e. house prices and rents) could begin to stagnate. On the other hand, if inflation continues to rise, that could still constrain consumer spending power, in real terms at least, while also reducing the real value of investors’ returns.
Market Variation
If that all seems to paint a gloomy picture, it’s important to consider that the UK residential property market is not homogeneous. Conditions vary enormously according to location, property type and size, as well as by target market and a host of other variables.
Take the question of energy efficiency, for example. Landlords are currently prohibited from letting a property that has an EPC rating of F or G and, under government proposals published in September 2020, the minimum standard for new lets will be raised to EPC band C by 2025. It will apply to all tenancies by 2028.
That requirement coincides with fast-rising awareness of energy costs. They have already risen faster than at any time in living memory and, in October, they are likely to do so again, reaching £2,800 per year by some estimates. It’s no surprise, then, that many recent reports have indicated that tenants and buyers would be willing to pay more for energy-efficient homes.
This suggests that buy-to-let investors may be reaching a fork in the road. Those who stick with cheaper, harder-to-heat properties may well face rising improvement costs, together with falling demand and a greater risk of voids and arrears. Clearly, these are not the ingredients for a profitable investment.
On the other hand, those who invest in modern, higher quality properties should see greater demand and – since new-build and newly converted apartments tend to be built to much higher standards – they should incur few if any costs for raising them to a lettable standard. What’s more, those properties may well appeal to more demanding, higher-earning tenants who should be better able to cope with cost-of-living pressures. Consequently, returns from this segment of the market are likely to be stronger and more reliable. In short, the current economic conditions, and the energy price crisis in particular, might soon give rise to a “two-speed market” and deliver much greater rewards for landlords with more energy efficient properties.
Inflation and Leverage
While there isn’t much in the current economic picture that’s unequivocally rosy, present circumstances do undoubtedly favour borrowing and leveraged investment. This is simply because the rate of inflation is so much higher than the current cost of borrowing. As a result, the real value of the repayment costs is constantly being eroded by inflation – making the debt much more affordable in real terms.
Here's an example featuring an 80% LTV mortgage and an assumed +10% rate of annual house price growth (which is close to the current mean):
• Property price: £250,000
• Investor's deposit: £50,000 (20%)
• BTL mortgage: £200,000 (80%)
• Annual capital appreciation: +£25,000 (+10%)
• New value after one year: £275,000
Here, the investor sees +£25,000 of capital appreciation, despite only contributing £50,000 as a deposit. (The rest of the purchase price is borrowed.) That equates to a gross return of +50%. If the investor had bought the property outright, then the gross return would have been only +10% - i.e. the standard rate of house price growth. To put that another way, borrowing will have delivered a five-fold improvement on gross capital returns.
That illustrates the principle of leverage in a very simplified way. What we can also show, however, is that in a high-inflation environment, leverage works even more efficiently. That’s because, during the 12 months in which the absolute property value has been increasing, the real value of the debt has simultaneously been falling.
If we take a rough average of the current CPI and RPI measures, we get an inflation rate of around 10%. So although an investor may be paying between 3.5% and 4% interest on an 80% mortgage, the real value of the debt is being eroded much more quickly – i.e. by that estimated 10%. Here’s how it affects the real-terms repayment costs:
· 4% repayment on £200,000 = £8,000 pa
· Real value of £8,000 after 12 months at 10% inflation: £7,200
· Real terms debt-reduction: £800 in year 1*
(* Note that inflation will continue to erode the real value of repayments in all successive years, too.)
In this still-simplified example, the rate of inflation and capital gains are both assumed to be +10% so there is no real-terms change in the property value. In reality, of course, house price growth and inflation will both fluctuate over time. Over the last 12 months, for example, house price growth has averaged well above the prevailing rate of inflation. And, as we’ll see in the next section, investors have also benefited from fast-rising rental returns over the same period.
Combined Returns
Different sources – lenders, estate agents and others – use their own data sources, so they calculate different rates of house price growth. In June 2022, for example, Rightmove quoted an average year-on-year gain of +9.72%, while Nationwide quoted +10.7%. Data from Halifax showed a rate of +10.5%, while Zoopla’s most recent estimate was +8.4%. The ONS figure (for April) was +12.4%.
There’s a fair degree of spread there, but it’s clear that the mean figure is probably somewhere close to +10%. That’s about the same as the current rate of inflation but that has only been the case in the last few months. Up until recently, inflation was considerably lower; according to ONS, it was 5.5% in January 2022, and just 2.0% in July last year. So over the last 12 months, average house values have clearly risen much more quickly than prices more generally.
That situation could change in the next few months, of course, but with inflation expected to drop back to around 2% in 2024, any such reversal would only be short-lived. By contrast, 5-year house price forecasts suggest inflation-beating returns: growth of between +2.5% and +3% per annum. (In June 2022, Savills predicted average gains of +12.9% by 2026, while Knight Frank has predicted +16.9%.)
But even if house prices only ever managed to keep pace with inflation, investors would also gain from monthly rental income, so the investment would still see a net gain in value. It’s therefore useful to note that rental returns have been very strong recently. According to the June Lettings Index from Homelet, UK residential rents rose by an average of +10.6% year-on-year. Taken together, capital growth and rental returns have undoubtedly been producing returns that far exceed the rate of inflation.
Summary
The present economic conditions are difficult, both in the UK and overseas. But that still leaves the important question of what to do with any savings; in other words, what can be done to preserve their value at a time of such high inflation and uncertainty?
There is certainly no bond or high street savings account that is capable of beating inflation at its current rate, so investors must inevitably look for other options. Commodity prices are fluctuating wildly, many businesses are tightening their belts, and international stock markets are volatile, particularly in the wake of the war in Ukraine. There are few obvious choices.
Property, however, continues to perform well, not least because the market is underpinned by a continuing imbalance: on the one hand, huge demand for homes; on the other, severely constrained supply. That imbalance has been a key reason for the property sector’s strong performance record and there’s little sign that it will change, even in these challenging times.
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To find out more about investment opportunities in residential markets across the UK, please call our advisory team on 01244 343 355.