What is inflation?
Inflation is a measure of the rate of rising prices of goods and services in an economy. Cost-push inflation occurs when the aggregate supply of goods and services decreases due to an increase in the cost of production. Demand-pull inflation is an increase in the aggregate demand within an economy. Both cost-push and demand-pull inflation cause inflation and often occur simultaneously or, as a result of one another.
What is driving the current rising inflation in Australia?
Inflation in Australia has now reached the highest level since the early 1990s, and is forecast to continue rising for longer than initially envisaged. The June quarter saw headline inflation reach 1.7% (seasonally adjusted), and 6.1% year-on-year (RBA Statement on Monetary policy – August 2022).
The inflation currently being observed within the Australian economy is a culmination of extreme monetary and fiscal policy employed in response to the COVID-19 pandemic, coupled with persistent global supply constraints.
The Reserve Bank of Australia (RBA) employed a range of comprehensive measures to support the Australian economy throughout the pandemic. These measures ranged from conventional monetary policy such as lowering the cash rate target, to more unorthodox tools, such as providing a term funding facility (TFF) for the banking system and a government bond purchase program. The RBA utilised these tools to lower funding costs and support the supply of credit to the economy, however, contributed significantly to the inflation currently observed within the Australian economy. An expansionary monetary policy aims to stimulate the economy and achieve increased aggregate demand, which inevitably, as observed, contributes to higher inflation.
In addition to excess aggregate demand within the economy, global supply constraints have resulted in the pass-through of upstream cost pressures. Russia’s invasion of Ukraine, for example, generated concerns about the supply of gas, oil, wheat, and other commodities from eastern Europe. As a result, prices skyrocketed. Brent crude, European natural gas, and wheat have surged in excess of 30% since the start of 2022 (RBA, April 2022).
How do inflation changes impact the property market?
The property market is impacted both directly and indirectly by inflation. Inflation influences investment decisions as ultimately, a higher inflation rate reduces the real return on the investment. Consider the effect of higher inflation than expected at the time of loan origination; the interest received by the lender is relatively less, as the purchasing power has diminished. This is inherently beneficial for the borrower as the real rate paid by the borrower has decreased. Coupled with this, inflation typically directly increases the nominal value of the property, resulting in the borrower realising a larger equity value and lower loan-to-value ratio. Mortgagees and investors will often attempt to prevent the real return from decreasing and counteract the real loss incurred by inflation by raising rates or rents.
Supply constraints on key materials required for construction has resulted in cost-push inflation, additionally increasing the nominal value of property. This can currently be observed within the Australian property market, where continuing supply constraints for timber and metals, high freight costs and labour shortages have contributed to higher construction costs and ultimately property appreciation. “Sustained strong demand for housing construction has enabled builders to pass through increased costs for labour and building materials; prices for building materials increased by 4.3 per cent in the June quarter and 17.3 per cent over the year” – RBA Statement on Monetary Policy August 2022.
The RBA targets a core inflation figure within the 2% to 3% band, on average, over time. The RBA believes this target is “sufficiently low that it does not materially distort economic decisions in the community”. To revert from the ‘emergency low’ cash rate settings in response to COVID-19, and counteract the current 4.5% core inflation figure, the RBA is hiking the cash rate at the quickest rate observed since the 1990s. “There is a structural inverse relationship between the cash rate and the value of property, evidenced by slowing purchases and falls in the current housing market,” noted Philip Ryan, Managing Director of Trilogy Funds, “however the key determinant will be the time period and point in previous cycles where the property was bought, possibly mitigating the magnitude of current price drawdowns to individuals.”
How do fund managers like Trilogy Funds navigate inflation changes for their property-based funds?
Trilogy incorporates a range of detailed measures to minimise inflation risk from an investment manager’s standpoint. Within the Trilogy Industrial Property Trust (TIPT), examples of key measures implemented to navigate inflation changes are:
- Showing caution around the capitalisation rates we acquire properties at
- Including ratchet clauses within our agreements that usually link to CPI such that we are able to stay at the same level of income return on a real return basis
- Reviewing the financial strength of each tenant; those with stronger balance sheets are usually able to perform through all economic cycles
Similarly, the Trilogy Monthly Income Trust incorporates numerous measures to mitigate, and in some scenarios capitalise, off inflationary movement. A couple of the strategies used to mitigate risk, including inflation risk, within the Trilogy Monthly Income Trust are as follows:
- Building in contingencies across projects to mitigate shifting economic conditions. This, alongside the strength of the underlying security as initially and continuously assessed, are key in monitoring the financial strength of each project.
- Maintain a low weighted average loan expiry to enable frequent repricing in accordance with market conditions. As at 31 October 2022, the weighted average loan expiry within TMIT was 6.23 months.
- Allocate a significant proportion of cash-style investments towards floating securities to capitalise on increases in the benchmark rate, typically the RBA official cash rate target or the BBSW.
This article is issued by Trilogy Funds Management Limited ABN 59 080 383 679 AFSL 261425 (Trilogy Funds) as responsible entity for the management investment schemes mentioned in this article. Application for investment can only be made on the application form accompanying the relevant Product Disclosure Statement (PDS) and by considering the Target Market Determination (TMD) available at www.trilogyfunds.com.au. The PDS contain full details of the terms and conditions of investment and should be read in full, particularly the risk section prior to lodging any application or making a further investment, together with the TMD. All investments, including those with Trilogy Funds, involve risk which can lead to no or lower than expected returns, or a loss of part or all of your capital. Trilogy Funds is licensed to provide only general financial product advice about its products and therefore recommends you seek personal advice on the suitability of this investment to your objectives, financial situation and needs from a licensed financial adviser. Investments with Trilogy are not bank deposits and are not government guaranteed. Past performance is not a reliable indicator of future performance.