Property is generally considered an effective hedge against inflation, with most properties offsetting rising prices through higher rents. When global inflation began surging in 2020, enthusiasm for buying homes grew and house prices rose dramatically worldwide. However, New Zealand’s money markets began raising interest rates from late 2021 to counter growing inflationary pressure, and enthusiasm for property investment also cooled. Take the lowest one-year home loan rate offered by the major banks: it was 2.25% in May 2021, but had doubled to 5.35% by June 2022. New Zealand has also removed mortgage interest deductibility for existing investment homes, drawing increasing attention to commercial property. CBRE New Zealand recently published a report titled ‘Inflation, Interest Rates & the Property Market’, examining the background and outlook for inflation and borrowing rates in New Zealand, their effects on commercial property, and expected investment performance across different market sectors. YIJU’s editorial team has compiled the following key points to share with you.
Inflation and borrowing rates in New Zealand
New Zealand’s inflation rate reached 6.9% in the first quarter of 2022, its highest level since 1990. Both businesses and consumers expressed concern about the outlook, with cost expectations, pricing intentions and inflation expectations at or near long-term historical highs.
New Zealand’s historical inflation rate
(Source: CBRE and Stats NZ)
New Zealand inflation forecasts
(Source: CBRE, ANZ Research and Macrobond)
CBRE forecasts that New Zealand’s inflation rate could peak around the middle of 2022, based on the Reserve Bank of New Zealand continuing to raise short-term interest rates aggressively. Although this forecast carries considerable uncertainty, economists expect inflation to return to the Reserve Bank of New Zealand’s target range of 1% to 3% by the end of 2023.
The OCR is forecast to peak in mid-to-late 2023, following a further rise of 150–200 basis points. Swap and bond rates are expected to peak at the end of 2022, some 25–50 basis points above current levels. This implies only moderate upward pressure on fixed interest rates, with possible relief beginning in 2023.
Construction cost expectations appear to be easing. ANZ’s survey for April 2022 showed that expected growth over the next three months had fallen from 7.6% to 6.4%. However, cost pressures appear to be intensifying in other industries, most notably agriculture and retail. Pricing intentions across industries show a similar pattern to cost expectations, with most businesses looking to pass higher costs on through their prices.
How inflation affects commercial property investment returns
1
There is no particularly direct relationship between inflation and property investment returns.
2
An indirect negative effect arises from the link between inflation and borrowing rates. This largely depends on the balance between GDP growth and inflation, and on supply and demand fundamentals.
3
Higher interest rates increase debt costs, affecting commercial property investment returns. Rising financing costs also erode the value of the property itself.
4
For commercial tenants, rent is generally regarded as a business cost that, like other costs, rises with inflation.
5
Lease terms are crucial. Leases allowing CPI-linked rent reviews support rent increases, particularly for shopping centres, prime offices and industrial premises.
6
Rising construction costs may mean fewer new developments, supporting occupancy and rents. Higher construction costs also push up rents for new developments, lifting rents across the commercial property market.
7
Capital returns are highly sensitive to changes in borrowing rates, but income growth and investor sentiment can outweigh the effect of borrowing rates on those returns.
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Effects on commercial property and the outlook
Overall, the outlook for the supply–demand balance provides a positive foundation for rental income growth. Secondary CBD offices are an exception, with vacancy and rental pressures expected to persist.
Commercial property rental yields remain relatively attractive. However, investors who rely more heavily on debt are beginning to feel the pressure of higher borrowing rates.
Investors currently favour strategies focused on stable, certain and growing income. Capital will flow towards sectors and submarkets with these characteristics, which will remain more resilient in pricing terms. Conversely, sectors and assets without these characteristics will face higher discount rates.
The pressure that borrowing rates place on capital returns appears temporary, with the interest rate outlook suggesting it could disappear in 2023. In the current environment, investors with less reliance on debt may begin improving their liquidity, viewing the present market impasse as an opportunity.