Inflation With Real Property

Ahmed Salem
Dan Smyth
Trence Smith
 What is inflation?
“ The general increase in the price level ”

• An inflationary shock is anything that tends to increase

the price level.
• A deflationary shock is anything that tends to decrease
the price level.
• In economics, inflation is a rise in the general level of
prices of goods and services in an economy over a
period of time.
 What is inflation?
• When the price level rises, each unit of currency buys
fewer goods and services; consequently, inflation is also
an erosion in the purchasing power of money – a loss of
real value in the internal medium of exchange and unit of
account in the economy.
• A chief measure of price inflation is the inflation rate, the
annualized percentage change in a general price index
(normally the Consumer Price Index) over time.
What is inflation?
• It is important to clarify the meaning of price index and
the CPI (Consumer Price Index).
• price index ( PI ) : a measurement that shows how the
average price of a standard group of goods changes over
time.
• Consumer Price Index ( CPI ) : a price index determined
by measuring the price of a standard group of goods
meant to represent the “market basket” of a typical
urban consumer.
 What is inflation?
• Inflation can have positive and negative effects on an
economy.
• Negative effects of inflation include;
1. Decrease in the real value of money and other monetary
items over time;
2. Uncertainty about future inflation may discourage
investment and saving;
3. High inflation may lead to shortages of goods if
consumers begin hoarding out of concern that prices will
increase in the future.
 What is inflation?
• Positive effects of inflation include a mitigation of
economic recessions, and debt relief by reducing the real
level of debt.
 Measure of inflation:
• Inflation rate =

PI for a certain year - PI for a comparative year

X 100
PI for a comparative year

PI= Price Index

 Measure of inflation:
• Example :
Year Price index 1) Inflation rate (1995-97)
1995 100 = (120 - 100) X 100 = 20 %
100
1996 110
 2) Inflation rate (1997-2000)
1997 120
 = (123 - 120) X 100 = 2.5 %
2000 123
 120
 Degrees of inflation
• There are different degrees of inflation. It includes mild inflation, strato-
inflation and hyper-inflation.

 Mild inflation is a slow rise in price level of no more than 5 percent per annum.
It is associated with a low level of unemployment and is during the upswing
phase of a trade cycle.

 Strato-inflation, the inflation rate ranges from about 10 percent to several

hundred per cent. Many developing countries particularly those in Latin
America experienced this.

 Hyper-inflation is a very rapidly accelerating inflation which is also know as

runaway inflation or galloping inflation. This usually leads to the breakdown of
the country's monetary system as the existing currency may have to be
withdrawn and a new one introduced ( Zimbabwe).
 Case for inflation
• Zimbabwe is one of the richest countries in Africa.
• in 1980, one Zimbabwe dollar was worth more than US$1.
• Now, Zimbabwe inflation at 231,000,000%.
(http://news.bbc.co.uk/1/hi/8258723.stm)
(16 September 2009)
• This inflation is hyperinflation which is out of control.
• Just an example showing how inflation affecting on the
value of money.
Currency trading now
Prices for some goods
Burning money for heating will be
cheaper than buying coal
 How inflation occurs
Inflation can be caused in two ways;
Cost Push Inflation:
This occurs when business respond to rising
production costs by increasing their prices so as to
continue to have a large profit margin. Happens
due to
Rising imported raw materials costs
Rising labour costs
Higher indirect taxes imposed by the government
 How Inflation Occurs
Demand Pull Inflation:
This is type of cause of inflation is more likely to
happen when there is a full employment of resources
any increase in aggregate demand will lead to higher
prices.
A depreciation of the exchange rate,
A reduction in direct or indirect taxation
The rapid growth of the money supply
Rising consumer confidence and an increase in the
rate of growth of house prices
Faster economic growth in other countries
 Causes of inflation
• Growth of money supply—too much money in the
economy causes inflation.
• Changes in aggregate demand—inflation can occur
when demand for goods and services exceeds
existing supplies.
• Changes in aggregate supply—inflation can occur
when producers raise prices in order to meet
increased costs.
 Wage increases are the largest single production cost
for most companies.
 Wage-Price Spiral
• Increasing wages can lead to a spiral of ever-higher price
because one increase in costs leads to an increase in
prices, which leads to another increase in costs, and on
and on.
 Effects of Inflation
• High inflation is a major economic problem, effecting
purchasing power, income, and interest rates.
 Inflation can erode purchasing power. If the inflation
rate is 10 percent, ₤1.00 will buy the equivalent of
only ₤.90 world of goods today.
purchasing power = real value of one unit of money
( ₤1) = ( ₤1 / price index ) X 100
 Effects on Income
• Inflation sometimes, erodes income.
 If workers’ wages do not increase as much as
inflation does, they are in a worse economic position
than before.
 People living on a fixed income, like retired people,
are especially hard hit by inflation because their
money does not increase, even when prices go up.
 Real income = (nominal income / PI) X 100
 Affects on interest rate
• People receive a given amount of interest on money in
their savings accounts, but their true return depends on
the rate of inflation.
 If the inflation rate is higher than the bank’s
interest rates, savers lose money.
 Real interest rate =
nominal interest rate - inflation rate.
 Headline and core inflation
• There are two types for inflation :
 Headline inflation: a measure of the total
inflation within an economy and is affected by
areas of the market which may experience
sudden inflationary spikes such as food or
energy. As a result, headline inflation may not
present an accurate picture of the current state of
the economy.
 Core inflation: a measure of inflation which
excludes certain items that face volatile price
movements, notably food and energy.
Global Inflation
Global Inflation
Why investing in property combats
inflation
Property and shares are expected to be hedges against
inflation because the expected real returns should be
independent of the rate of inflation, and should
instead be determined by the real factors affecting
supply and demand in the relevant markets.”
(Tarbert, 1996)
 Why inflation causes investors to
add property to their portfolio.
While it may depend on the period or type of
inflation it has been found that by investors
“incorporating real estate in portfolios of assets, the
risk per unit return was lowered and inflation hedging
was improved.” (Rubens, Bond and Webb, 1989)
By investing in property it gives the portfolio another
outlet to diversity so as to combat inflation. “that
commercial property has relatively superior hedging
qualities and inclusion in a portfolio would reduce
overall inflation risk.” (Tarbert, 1996)
 Expected and unexpected
“Inflation is decomposed into two components, expected
inflation and unexpected inflation.” (Matysiak and Hoesli et la,
1996)
Expected inflation is usually calculated using yield on 3 month
treasury bills. It can be planned against were as, Unexpected
inflation is calculated by deducting the forecast expected rate
from the actual rate when this occurs it leaves investors with a
level of uncertainty.
The many investors that make purchases in property do so as
they believe it is the best way in which to hedge against
inflation. However this method of hedging is different at times
of expected, unexpected and actual inflation. The chart below
shows just how difficult it is to predict inflation.
Outcome of inflation
 Hedging against inflation
Previous research believed that property was a
complete hedge against inflation, but newer research
has shown that it is deemed to only be a particle
hedge against inflation. “The correlations are
considerably lower than one, which indicates that
property is only a partial hedge.” Tarbert, (1996)
“Clearly, if property is an inflation hedge, it does not
offer full hedging.” (Barber, et la, 1997).
 Hedging against inflation
Many researchers are in agreement that while property is a
partial hedge against inflation, It is however a stronger hedge at
times of unexpected inflation. “These results suggest that
property does play a role as an inflation hedge but only to
unexpected inflation shocks, not anticipated inflation trends.”
(Barber, et la1997).

“It was also reported that property was a better hedge against
unexpected rather than expected inflation.” (Barber and White,
1995)

In order to see tthe full benefit of property investing as a hedge

against inflation, property should be broken into sectors.
 Property Sectors
Through the research most authors tend to side with the
industrial sector being the best investment at times of
unexpected inflation. So at times when inflation is
predicted incorrectly you may see a rise in investment in
the industrial sector.
The analysis was also undertaken at a sector level, and it
was found that the industrial sector exhibited the best
hedging attributes.” (Barber and White, 1995)
The same conculsion is found by Limmack and Ward
(1988) and Barkham and Ward and Henry (1996)
 Property sectors
While industrial sector seems the best to invest in to hedge
against inflation. Other types of property can also do this
job, with some property investment out performing others.
 “that property shares may not be as effective a long-term inflation hedge as direct
commercial property” (Matysiak and Hoesli et la, 1996)

This shows that inflation affects investment in property by

sector and that if an investor were likely to invest in
property when there is an expected high inflation rate, they
would most likely put their money into commercial
property.
 
 Timing and Causes
There is also the view which suggests that one sector
of property may perform better than another against
inflation at different time periods or against different
factors that cause inflation e.g. Demand Pull or Cost
push. “commercial property has not been a very
effective inflation hedge also reveals that over some
periods the real performance of commercial property
has been very impressive, whereas in other periods it
has been disastrous. Instead the chart suggests that
property offers a hedge against only particular periods
or types of inflation.” (Barber, et la, 1997).
The Rent Review Clause, Inflation and
Property Investment
 The Nature and Purpose of Rent Reviews
Commercial property leases grant tenants a significant
period of occupation.
Prior to 1960s rents often fixed for the entire term on the
lease.
Rent reviews came into being in response to two
economic factors:
1. Inflation
2. Fluctuating value of property in real terms.
 Rent Review: Corrective Mechanism
The rent review clause is design to allow periodic
adjustments to rents taking into account the impact of
inflation and changes in real rental values.
Corrective mechanism and commercial properties ability
to hedge against inflation.
Rent Review: Hedging Against Inflation?

“rent reviews have not been used as an opportunity to gain

compensation in the form of cost pass-throughs for previous one-off shocks to prices. In
contrast, rents do respond to persistent inflation changes. Because inflation changes have a
long-lasting and permanent effect, rental and capital growth in part change in the face of
inflation changes”( BARBER)
 Rent Review: The Real World

Historically numerous types of rent review have been

written into commercial leases.
In practice, the vast majority of rent reviews in
commercial leases are upwards only i.e. At review the
rent can only go up and can never fall.
 Rent Review: Upward Only?
December 2009 upward only rent reviews are
banned in the Republic of Ireland.
Property consultants CB Richard Ellis have
denounced the decision by The Minister for Justice,
Equality and Law Reform, Mr Dermot Ahern, TD, to
sign legislation banning upwardly only rent review
clauses in business leases. The Minister signed a
banning order on upwardly only rent review clauses
under section 132 of the Land and Conveyancing Law
Reform Act.  The section will come into operation on
28 February 2010.
 Rent Review: Upward Only?
 The UK government has been  The consultation paper’s
considering legislating against findings reported on a number
upward only rent reviews. of key areas:
 May 2004 the Office of the 1. Lending
Deputy Prime Minister (now 2. Investment
Communities and Local 3. Development
Government) published a
consultation paper, Commercial 4. Regeneration
property leases: options for
deterring or outlawing the use of
upward only rent review clauses
References
 Alexander, J (2001) “Rent Review” Blackstone Press Limited, London
 Barkham, R, J., Ward, C, W, R., Henry, O, T. (1996) “The inflation-hedging characteristic of UK
property” Journal of property finance, 1:7, pp. 62-76, Economics Help (2010) Helping to simplify
economics [online] available at
http://www.economicshelp.org/macroeconomics/inflation/definition.html [accessed on 17/02/10]
 Barber, C. and White, M. (1995) “Property and Inflation“, Barber White Property Economics,
London.
 Barber, C., Robinson, D., Scott, A. (1997) “Property and inflation: The hedging characteristics of U.K.
commercial property, 1967-1994” Journal of real estate finance and economics, 15:1, pp.59-76
 Brett, M (1997) “Property and money” 2nd Ed EG Books
 Brueggeman, W and Fisher, J (2002) “Real Estate Finance and Investments” McGraw-Hill Irwin,
Boston
 Hill and Redman (2001) “Guide to rent review” Butterworths
 Isaac, D (1998) “Property Investment” Macmillan
 Matysiak, G., Hoesli, M., Mcgregor, B., Nanthakumaran, N. (1996) “The long-term inflation hedging
characteristics of UK commercial property” Journal of property finance, 7:1, pp, 50-61
 Limmick, R, J., Ward, C,W, R. (1988), “Property returns and inflation”, Land Development Studies,
Vol. 5, pp. 47-55.
References
 Rubens, J., H., Bond, M., T., Webb., JR. (1989) “The Inflation-Hedging
Effectiveness of Real Estate” Journal of Real Estate Research 41, pp. 45-
56.
 Tarbert, H. (1996) “Is commercial property a hedge against inflation, A
co integration approach”, Journal of property finance, 7:1, pp.77-98
 Bank of England www.bankofengland.gov.uk
 Office of National Statistics www.statistics.gov.uk