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Inflation And Its Effect On Property

The property market has always been a prime focus for investors, but recent surges in inflation have caused many to second-guess their next move, as Sally Lindsay discovers.

By: Sally Lindsay

1 September 2023

Landlords who don’t have borrowing to consider are weathering the inflationary storm well.

One of the reasons investors favour real estate is due to its ability to weather the pressures of rising inflation and emerge with its values intact, even improved.

However, recent rising inflation is having differing impacts on the New Zealand real estate sector. It’s tough to enter the property market, agents are having a harder time finding buyers, and renters are struggling to find affordable options.

Conversely, landlords unburdened by rising borrowing costs are riding the storm comfortably.

Inflation relates to an increase in the average prices of a particular economy’s goods and services over a set period of time. In New Zealand, this is usually measured in how much prices may have changed over a quarterly period and is tracked by Stats NZ within the consumers price index (CPI).

Another way to look at inflation is as a reflection of the drop in the dollar’s buying power.

There is a correlation between inflation and house prices. However, NZ’s has been soaring and house prices have been falling. This has meant a quick drop in real house prices. When adjusted for inflation, house prices have fallen more than 23 per cent from their November 2021 peak.

Reserve Bank economist Andrew Coleman says interest rates are an important determinant of property prices as they affect the annual “user cost” of purchasing a property, which affects the quality of a house structure people can afford.

In an April discussion paper on demand for better housing creating unsustainable house prices, Coleman says there is considerable international evidence that property prices are inversely related to interest rates.

“There are differences in the effect of changes in long-term and short-term interest rates, and also the role of inflation, but in most countries persistent changes in real interest rates are associated with persistent changes in house prices. The long decline in interest rates since the deflation of the early 1980s is widely seen as a major determinant of the sustained increase in real house prices in most OECD countries.”

The impacts of inflation are being felt by homeowners and investors in all of their everyday spending.

Increased Costs

Inflationary times inevitably lead to increased costs involved in borrowing. To protect their profits, banks will increase the interest rates for borrowers and tighten their underwriting, thus offering fewer loans to mitigate risk.

Homeowners and investors across the country are feeling the inflation pinch on every aspect of their finances. Half of the inflation has come from overseas (ie imported crude oil, transportation charges) and the other half has been domestically-generated, mainly in the housing market – building costs are up 18 per cent over the past year, rents are rising and house prices dropping – and sat at 6 per cent for the June quarter of the year, even though the Reserve Bank’s remit is to keep inflation in the 1-3 per cent band.

Inflation and mortgage interest rates have risen quickly over the past nine months. In December last year the interest rate was at 3 per cent. A one-year fixed rate is now at 7.79 per cent at some banks.

This is causing affordability problems, particularly for mortgage holders rolling off low fixed interest rates of 3 per cent and below taken out in 2021.

Fighting Inflation

Independent economist Tony Alexander says the higher the average rate of inflation, the higher the average rate of increase in house prices over the long term.

“Even though house prices are falling and inflation rising that is not unusual,” he says. Fighting high inflation can cause falling house prices.

“So, there’s two dimensions here. If you give me an economy where inflation averages 5 per cent versus one where inflation averages 2 per cent, I would expect, on average, house prices to rise about 3 per cent more.

“In that first economy, everything’s just being repriced, on average, at a faster rate. But fighting inflation, of course, involves pushing interest rates to high levels where households cut back on their spending. And during that process you’ll get the house prices either rising less rapidly, holding steady or falling, just depending on how bad the inflation fight is.”

Alexander says with inflation at 6 per cent, the fight has to be tough, but it’s only ever as tough as it needs to be to get inflation down. A 5.5 per cent cash rate, fixed mortgage rates of 6.5-7 per cent should be enough to get inflation back down to between 1-3 per cent.

Diverting Income

CoreLogic chief property economist Kelvin Davidson says the recent fast rate of inflation means homeowners have to divert more of their income towards buying food or paying utilities, so they might have less available to spend in the housing market.

“It’s about inflation going up, monetary policy tightening, which affects mortgage rates and that affects the housing market. But there could be other impacts, in the sense that if the Reserve Bank tightens monetary policy, that’s also going to tend to undermine the economy, weaken the labour market and that will affect the housing market too.”

Davidson says even though interest rates have risen while the OCR has stayed at the same level since May, people have a misconception that the only driver of mortgage rates is the OCR, and actually that’s far from true.

“Interest rates offshore have jumped around and that is feeding into domestic mortgage rates here. It’s not just about the OCR. Banks are also competitive, and they adopt different strategies if they want to win market share or not. In all the OCR plays a part, competitive behaviour is part of it as well as what’s happening to offshore interest rates.”

Bank Margins

While people might be grappling with banks’ interest rates hikes in July, Alexander says bank margins have been under quite a bit of pressure over the past few months, so there was some catch-up to be done to get margins back towards some concept of normal.

He says mainly fixed mortgage rates have gone up because of an increase in the cost of New Zealand banks’ borrowing. “That increase has come about not because of anything to do with the New Zealand economy, but solely because of higher-than-expected inflation, or at least interest rate increases in the United States. So, where US monetary policy goes, it has an influence on interest rates around the world. And that influence has come along and affected us here in New Zealand over the past three months.”

He believes OCR rises have peaked. “I don’t think the Reserve Bank feels the need to increase further. It seems to have made some firm comments indicating it feels inflation is tracking at the right direction, even though it’s still absurdly high. There are also still tens of billions of dollars’ worth of fixed-rate mortgages to roll from maybe 3.5 per cent towards 6.5 to 7 per cent, meaning extra restraint on the economy.”

How big the effect of borrowers rolling from low interest rates to higher will be, Davidson is not sure. “A wave of people are still to roll off lower rates and have not yet fully seen the impact of higher mortgage rates on their household finances.

“If they’re diverting more money towards the mortgage over the next 12 to 18 months, it’s less money to spend in the economy. Basically, the impact will be money going into the banks rather than into the shops and consumer spending. It takes money out of circulation and that helps to bring inflation down.”

Time And Speed

While inflation is expected to fall away a bit in the next quarter, Alexander says the question is where it’s likely to go over the next 12-18 months. “That track is downwards towards hopefully 3 per cent by the end of next year.”

Interest rates falling over 2024 is pretty much the universal expectation, says Alexander, but picking the timing and the speed of decline is anyone’s guess.

Coleman says central banks have preferred to use interest rate policy to achieve their inflation and employment objectives, and macroprudential policy to achieve their financial stability objectives. “Most central banks do not choose either interest rates or macroprudential policies to deliberately target house prices, except to the extent that they affect their inflation, employment and financial stability goals.

“As such, while it is widely agreed interest rates are more effective than macroprudential policies at affecting house prices, most central banks do not consider they have a mandate to use interest rates to target house prices.”

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