Rate Hikes, Inflation and Investment

What is the impact of interest rate hikes on the attractiveness of property as an investment? We look at the current conditions we’re facing and the long-term prospects for property asset holders in Australia.

Increased interest rates are front of mind for many Australians at the moment— and with good reason. As we know, they affect all asset prices, and have a particular impact on property owners and investors, with increased debt repayments and a reduction in borrowing capacity placing short-term pressure on market activity. The implications are real, and are worth being across, with a fair bit of media and industry space dedicated to this conversation.

To make things more complicated, the recent interest rate hikes are set in a context of rising inflation levels—which we’re not used to—compounding market affordability concerns. But this is part of a natural cycle. Strong government-motivated economic stimulation during the height of Covid and disruptions to global supply chains following Covid have created imbalances that these interest rate hikes are, in part, addressing.

So, a knee-jerk reaction such as a sale or market avoidance isn’t necessarily the right one. Because, as we know, the economic system is much more complex than a simple cause-and-effect equation. And, importantly for investors, long-term inflation  results in higher asset values — so we believe staying calm and playing the long game can be a smart strategy.

The wider view
There has been a lot of attention (and in some cases, hysteria) given to the current interest rate hikes. The sudden and significant moves have created shockwaves, however it is likely that more subdued movement is on the horizon. While recent data suggests that inflation is still historically high, The Reserve Bank has a core aim of bringing inflation under control, and forecasts support this. Governor Philip Lowe stated in the February meeting that, “Inflation is expected to decline this year in response to lower energy prices, the resolution of supply-chain problems and the tightening of monetary policy.” 

Once you zoom out, there’s some comfort in seeing that the current rate hikes are natural, and in fact, due. Mid- and long-term investors are generally prepared and able to ride market fluctuations like interest rate hikes with some measure of calm. Because whilst decline or stagnation in property values will be short-lived; rising population and undersupply make long-term rises inevitable and substantial.

Interest rates are also not the be all and end all. The primary drivers for real estate investment are tax effective income and capital growth and we believe there will be excellent opportunities for property investment during the market downturn. Investors should be aware that property is one of the best strategies to protect against inflation as a lower-risk, long-term investment.

Why to invest in a high inflation environment
With the above in mind, there are particular considerations for prospective investors in this high inflation, higher interest rate environment:

Supply Shortages
There will likely be property shortages and lack of supply (this is one of the precursors to interest rate hikes) and this has been compounded by the slow-down in development activity forecast over the year. In Australia, this will be exacerbated by the surge of demand from re-set in migration and return of temporary visa holders (approximately an extra 343,000 people). In addition, we’ve seen a change in household formation post-Covid with more people opting to live alone or in smaller household units. According to the RBA, cited in this article, the average household size dropped to 2.47 per household in 2022, compared to 2.57 in 2016.

Forecast Wage Growth + Promised Tax Cuts
Wage growth has started to filter into the economy, although the disparity in industries and public vs. private sectors is considerable. With inflation still high, wage growth will not be felt until we see inflation slow.  However, when inflation does slow, what may compound the effect on disposable incomes is the upcoming Stage Three Tax Cuts.  If implemented, they are expected to come into effect from July 2024 and the effect of these cuts will be substantial with the tax rate dropping to 30% in the new $45K-$200K bracket. Currently, the bracket of $120k-180k has a rate of 37% and $180K+ is 45%, so the drop will be material and have an immediate effect on disposable income, which will translate to property affordability.

Effects of Inflation Long Term
Inflationary pressure can take some time to flow through the market, but inevitably inflation affects the price of everything. Tangible assets, like real estate and commodities, have historically been seen as inflation hedges and during inflationary periods, experts suggest making the most of your returns by investing in assets that have historically delivered returns that outpace the rate of inflation.  So buying in a dip, if you can afford it, should translate to improved long term returns. 

So, it’s a matter of timing.  Property will continue to be a smart investment that speaks to current and future demographic trends. And we believe there is opportunity for long-term investors to take advantage of the current fear in the market. We therefore believe investors should stay cautiously optimistic about a market downturn over 2023.  Staying active in the assessment of quality investments over the next 9 months could produce excellent opportunities for improved long term returns.

As a simple rule, whilst interest rates climb, borrowing is down and property markets will stall, but property can still be an attractive asset class to invest in during these times. Inflation will be a property investor’s friend over the long term — as long as you protect yourself from a cash flow perspective.

In fact, it’s becoming a buyer’s market with the availability of quality and well located property increasing, and negotiating conditions therefore improving. As long-term inflation results in higher asset values, remaining focussed on opportunities for quality investments over 2023—if you can afford it—will most likely result in attractive long-term capital upside.

At Propel, all market fluctuations are being considered in our search for investment and development opportunities. And as always, the game strategy is keeping calm with our eye on the long-term prize.