Inflation, interest rates and property pain

The BoE has set interest rates to 5%, the highest in 15 years, and markets are now pricing in a peak rate of 6.5%, and some banks are even suggesting that they could even go above 7%.

This seemed unimaginable just a few months ago but recent inflation data is suggesting that inflation will stay higher for longer - and therefore rates will follow.

The property sector is built on debt and credit and so rising debt service and reduced credit facilities paint a bleak picture.?

On the wider canvas, inflation seems to be cooling down in other parts of the Western world with both the US and EU seeing a solid downtrend in inflation prints. Meanwhile, the UK appears to be an outlier, unable to get inflation in check.

But is it really an outlier, or is it simply lagging??

I believe that inflation will fall faster than people expect and here’s why.?

Using Truflation, a real-time inflation tracker, we can see that current inflation is at 11.37%. The UK govt reported rate is only 8.7% (yikes). Both of these are terrible numbers and obviously much higher than the 2% BoE target.?

But, before you get all panicky on me, let’s look at the trend.?

UK inflation peaked at 21.71% on December 22nd 2022.

Cast your mind back: energy prices were through the roof, the holiday season was in full swing and there were staff shortages around restaurants and supermarkets. All of this compounded into higher prices.?

Now, look at where we are today.

Inflation has nearly halved since that date, mainly due to falling energy prices.?

Well, what’s driving inflation today??

Food prices. Also, not a very good thing to measure as it is an inherently lagging indicator. Most food is produced 3-6 months in advance, which is why food prices spiked in March/April as producers had to offset their increased energy costs over the winter. We can expect this to come down as energy prices continue to fall.?

The UK also had a minimum/living wage increase of 10% which will have impacted supermarkets, leading to the recent increase in prices. Again, expect this to stabilise over time.?

Additionally, fertiliser, which rocketed in price following Russia’s invasion of Ukraine, has also dropped significantly over the last 12 months which leads to lower production costs.?

So here’s my thinking:?

Inflation is measured year over year. As CPI peaked in the autumn/winter of 2022, we should get lower and lower inflation prints this winter as energy prices will actually contribute to deflation.

It is also forecasted that by the end of the year, the excess savings that were built up during the pandemic will be exhausted.?

Wages (and potentially food prices) will likely keep inflation higher than the 2% target, but much lower than present levels. Heading into 2024, wage pressure will slow, energy prices may continue to fall (or at least stabilise) and therefore inflation will continue to drop.??

Let's also take a look at the PPI chart (which leads CPI). Headed lower and lower.

Don’t fight the trend. Inflation will fall, it’s the speed at which it will that is the unknown.?

See the US inflation chart - their CPI peaked last summer and it has continued to tumble over the last 12 months. I believe the UK’s will be similar, albeit perhaps a bit more rocky.

So where does this put interest rates??

The BoE has no incentive to keep rates high and crash the economy. Current interest rates are unsustainable given the amount of debt the country and at a certain level higher rates = higher inflation (see this great piece from Lyn Alden ).?

Let’s also remember that there is a general election in late 2024 and if Sunak wants to have any chance of winning, he will have to be able to make a credible case that under his leadership inflation has dissipated and interest rates are on the way down.?

There is no MPC meeting in July and so I’d expect the BoE to raise 25bps in August and another 25bps in September and then be data-dependent from there.?

My guess is that rates will peak between 5.5%-5.75% depending on how fast inflation begins to fall in the winter.

As inflation begins to fall quite quickly, they will keep rates there for Q4 ’23 + Q1 ’24, then I think they will look to cut from Q2 onwards to try and walk the fine line of reducing the money supply without crashing the economy.?

What does this mean for property??

Well, in my mind, property is simply a liquidity game. When credit is tight, yields go up. There is a higher (and harder) cost of borrowing and so higher yields compensate for that extra effort. But, eventually, credit conditions loosen, yields compress and the value of the property goes up.?

We are clearly in a buyer's market. Properties in strong markets are being sold for 7-8% yields (2% above the risk-free rate) and in 2026, when the BoE interest rate is 2-3%, they will be refinanced at a 5-6% yield and the owners will enjoy the cap gains (as well as making some rental income).?

As developers, we need to understand what market we will be selling into. It will take 2 years to complete a development from start to finish so there’s no point looking at current conditions, we need to be thinking about what the environment will look like in 2025-26 when we look to sell.?

There is widespread fear and uncertainty in the market and it is difficult to get a reasonable loan.

But on the other side of that, I see opportunity.

We have a structural housing problem and fewer homes are being built currently than in the last 14 years.?

Anecdotally, we are hearing from more contractors/consultants looking for work so build costs may be lower as they want to keep their team employed.

And, in an inflationary environment, rents will also continue to rise which will lead to higher GDVs when credit conditions improve.?

Ultimately, it is always about assessing the risk/reward of any bet. And if you can find a project that works in this environment, there is far more upside than downside.?