How to insulate your portfolio against inflation
How Dorado Property is Focusing on Diversification in 2022
April 20, 2022
Dorado Goes Directly To The Source
November 30, 2022After years below 2% p.a., the escalation of inflation this March to 5.1% p.a., together with a sense that the upward trajectory has momentum, now has investors’ radars up.
Coupled with little to no corresponding increase in wage growth, the declining value of money and erosion of purchasing power is causing many to reconsider how to protect themselves from the effects of inflation hikes.
The drive behind this jump in inflation is multifaceted.
East coast heat waves, power station outages and surging coal and gas prices as a result from the war in Ukraine have together boosted demand or crimped the generation of electrons. This has seen the wholesale electricity price in the National Electricity Market rise 141% in the three-month period to the end of March 2022. COVID-19 travel restrictions have created massive demand for lifestyle assets like four-wheel drives, caravans and boats, in turn driving up prices. The costs of building and rent are the largest contributors to rising CPI, compounded by the increasing costs of goods associated with supply chain disruptions and higher shipping prices being passed through by retailers to consumers. Add to this government interventions like low interest rates, stimulus packages like JobKeeper, infrastructure investments like Snowy 2.0 and quantitative easing leaving more cash available for lending to consumers and businesses, and Australia has itself a perfect storm.
Surging gas and coal prices are contributing to rising inflation.
We are already beginning to see complicated effects of inflation on the property industry.
For developers and homebuyers, the rising cost of construction materials is extreme enough to make buying an existing home more attractive than building.
But there isn’t even a clear-cut decision towards housing or commercial real estate asset ownership. It’s worth remembering that when inflation rises, so do interest rates and people’s required rates of return on investments. This means that not only do interest costs increase, but also the required rental yield and capitalisation rate. If a property asset can’t readily increase its rent in-line with inflation, it needs to drop in value to result in an effective increase in the rental yield. From an investment perspective, without properly considering long term inflation, low yielding assets that seemed safe, like service stations, may turn out to be more risky than originally anticipated.
It pays to seek real estate investments which can not only withstand, but also benefit from inflation
Trying to predict an end outcome to inflation is difficult, but investors can prepare by investing in safer assets over the long-term.
First mortgage investments continue to strongly yield in excess of inflation and most mature in a relatively short timeframe compared to other investments, making them a sensible investment in inflationary times.
With respect to direct investment, it pays to seek real estate investments which can not only withstand, but also benefit from inflation. This means finding assets that can see capitalisation rates rise and interest rates increase, while also having healthy or market review-based rent/income increases to counter these effects of inflation. Dorado has found this in property sectors like hospitality and short-term accommodation where COVID has seen values drop, meaning purchase capitalisation rates are reasonable and the income rises as room rates and food and beverage all see prices rise. By increasing room rates and food and beverage income, they can produce rising returns that counter the effect of inflation.
For some sectors, the relationship is less certain. Looking to infrastructure, for example, things like road toll prices can be adjusted to accommodate inflation, but they remain subject to low purchase capitalisation rates and are highly geared making them sensitive to interest rate increases. Child care is also attractive from an inflation-protection perspective as operators can increase the cost per child along with inflation, however, long-term leases can complicate property investment here if there are no market review clauses.
