It can be argued that a little bit of inflation is a good thing, it rewards productivity and provides the incentive to save and invest, but perversely high inflation erodes purchasing power without adding value. When entrenched in a feedback loop, inflation ‘degrades’ the capacity of a ‘cash-savings-strategy’ to finance* investment. (*e.g. saving a deposit for a home).
The impacts of persistently high inflation are most pronounced in sectors where it takes years of investment to create supply, such as residential housing. Whether it’s a pristine subdivision, splitting a suburban block or building a multi-storey, inner-city apartment, the planning, approvals, and infrastructure can take years. How much should a developer pay for each step? How many years will it take? What can they sell it for, and will it all be worthwhile? These are all hard enough questions to answer without the complexity of rampant inflation.
Just like the American fable, ‘The Little Red Hen’, we all want the fresh bread, but we reap what we sow, and the bread only comes after the fields are ploughed, crops planted, tended and harvested, the wheat winnowed and milled, and the dough kneaded and baked.
Affordable housing takes years of planning and investment, and while short-term peaks and troughs in population growth and interest rates can be disruptive, the longer-term structural issues are far more important for ensuring affordable supply.
I would also hasten to add, that for the buyers, be they an investor or owner occupier, paying for a residential property can take decades, with all the ensuing sacrifice and risk. It will typically take a first-time homebuyer 5 to 10 years to save a deposit, generally as a couple, and often as not, by the time the finance is arranged and the contract signed, there are children on the scene. So, the recent bout of high inflation and higher interest rates will have priced many first-home buyers out of today’s property market; deferring the purchase by several years, while they continue to rent and accumulate a larger deposit. So not good news for first-home buyers, but equally not good news for any ‘first-home buyer’ buildersi, who will have invested heavily, over many years, to bring product to market, only to find the potential buyers have been priced out by inflation and interest rates.
According to the ABSii, the value of Australia’s housing stock climbed from circa $7.2 trillion in March 2020 to just over $10 trillion in March 2022. Close to a 40% lift in 2 years. While the total number of dwellings increased by only 3.3%, from 10.5 million to 10.85 million. However, that’s not the end of the story. If you had to borrow to buy, interest rates moving from 3% to 6% on a 20 year loan will have added close to 35% to your monthly repayments. All up, assuming you were going to buy, in March 2024, the same place you ‘could-have’ bought in March 2020, you would need a 90% pay rise over 4 years to cover the higher purchase price and higher loan repayments (or 110% after income tax bracket creep, assuming a 20% deposit and 20% of your after-tax income being allocated to repayments).
So where did the inflation come from and why hasn’t it reversed?
Unlike traded goods (imports), where inflation is almost back to 0%, for non-tradeable (made in Australia: housing, healthcare, education etc) goods inflation is 5%iii. Some of this will be wages, for example in the construction sector the wages bill increased by 12.7%iv in 2022/23 while the total number of workers in the construction sector only increased by 1.8%. Equally energy costs are a major contributor to the cost of building products and there have been no energy subsidies for the producers of concrete, steel, aluminium, glass, bricks, roof-tiles, floor-tiles, plastics etc; consequently, the cost of construction materials have increased by 40%v over the last 4 years.
The property construction sector employs close to 10% of the Australian workforce; is responsible for 10% of the GDP and accounts for over half of Australia’s household wealth. A 40% property price increase is great for owners, but not so great for would be buyers. What we really need is stability in the property sector, if inflation is to return to the RBA’s target range. Higher property prices will either drive higher wages or a property price correction.
First home buyers need time to accumulate their savings, while investor will need some certainty that they won’t be penalised for building rental properties. To be honest, it is hard to justify negative gearing. The investor is effectively subsidising the tenant because the rent doesn’t cover the full cost of financing and maintaining the property. The investor could simply increase the rent to a point where they are not losing money, but I’m not sure that’s the answer. Arguably, having the investor bear the cost and the risk, in the hope of future capital growth, is a better outcome than higher rents and or fewer rental properties. You don’t need to read too much economic history to know that property prices don’t always go up. It was the property market bust in America and Europe which created the GFC, and the property market bust in Japan, which saw the Japanese economy enter a 20year recession. Don’t get me wrong, residential property should be one of the best investments we all make, but there are no guarantees.
I know there is a big focus right now on ‘made in Australia’ but in the last 3 years, the high cost of energy has seen the closure of: a fertiliser plant, an oil refinery, an alumina refinery and a plastics plant. What’s more some of our largest and most successful industries, coal, oil, gas and university education seem to be in the political firing line. For inflation to abate, we need stability in policy, so ordinary Australians can adjust their spending and saving, invest in productivity and focus on the important things in life, like family.
Contact Ken Howard
If you have any questions about your financial plan or investment strategy, please call 07-3334 4856 or email [email protected]
[1] Insolvency in the construction sector is currently running at post GFC highs. https://asic.gov.au/regulatory-resources/find-a-document/statistics/insolvency-statistics/
[1] https://www.abs.gov.au/statistics/industry/industry-overview/australian-industry/latest-release
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