Inflation on the rise

The Reserve Bank of New Zealand (RBNZ) recently lifted the official cash rate (OCR) by 25 basis points to one percent, and in his first Monetary Policy Statement (MPS) for the year, Reserve Bank governor Adrian Orr indicated further rate hikes were coming.

“The Monetary Policy Committee agreed that further removal of monetary policy stimulus is expected over time given the medium-term outlook for growth and employment, and the upside risks to inflation,” Orr said.

The RBNZ is now forecasting the OCR to peak above 3.25 percent by 2024. In its earlier November statement, it had forecast a peak of 2.5 percent. As a result, banks are raising borrowing and deposit rates.

For example, ANZ raised its home loan floating mortgage rate to 5.04 percent from March 1 for new loans and mid-March for existing mortgages, and was also planning to raise some deposit rates. Fixed loan rates are expected to follow suit.

However, independent economist Cameron Bagrie says there are winners and losers from the unfolding scenario.

“Offsetting interest rate and inflation rises, some manufacturing could come back to New Zealand benefitting commercial property. Central business district retailing isn’t doing very well, but suburban retailing is doing better. And while working from home isn’t great for office property, it’s good for the suburbs.

“Industrial property has become popular, with online shipping warehouses coming to the fore during the COVID-19 pandemic, and in line with longer-term trends.

“So it’s not one-way traffic, we’re seeing some substitution effects. There will be bumps but markets will take it in their stride. Quality will count.”

Bagrie says commercial property and land assets have traditionally offered some protection against inflation. Currently, the replacement cost of a building is sky-rocketing, he says.

“Interest rates are heading higher and if you believe the Reserve Bank, they’ll be a lot higher in two years.

“We have a fundamental problem with inflation at 5.9 percent and still rising. COVID-19 accounts for some of that but a lot of it just reflects an economy that is overheating on many levels despite many sectors – such as tourism – struggling,” Bagrie says.

The RBNZ is heading for an inflation battle and has said it will aim to return inflation to two percent.

“Government expansionist and ultra-low interest rate policies have worked well, but now it’s morphed into a boom that no one expected. The follow up to a boom is inflation, and containing inflation is not growth or asset price friendly.”

Bagrie doesn’t think New Zealand will return “to the bad old days” of double-digit inflation but there will be challenges that suggest inflation could be more sticky and persistent, he says.

“Some of the forces that have kept inflation low for a long time are unwinding. Labour is in short supply and I think that’s going to be around for a while. So there will be bigger pay rises and that will feed through to inflation. There’s also rising benefit dependency and the Russian situation is not positive.

“People are starting to spend their retirement nest-egg as opposed to saving. Climate change policies will add to costs and we’re in an era of big government. There are whole lot of things that are evolving and the Reserve Bank won’t find it easy to get inflation back to two percent.

“I suspect we are headed for an awkward juncture when the costs of getting inflation back to two percent in the form of less growth and pressure on asset prices becomes too large and we end up with softer inflation targets,” Bagrie says.

“Commercial property will face challenges over the next 24 months. When interest rates went down, capitalisation rates did too, which raised property prices. It works in reverse as well.”

Markets were being a lot more selective, so landlords will look at what more they can do to get the best out of their assets, he says.

“Facing a rising interest rate headwind, investors need a strong focus on extracting additional income and adding value to the asset. There will be overs and unders,” Bagrie says.

Bayleys Realty Group’s head of insights, data and consulting, Chris Farhi, says one of the positive aspects of the current environment is rental growth is benefitting some commercial landlords.

“Assets with strong occupier demand and constrained supply are seeing strong rental growth. We’re seeing this across industrial property generally, but also in quality assets where the flight-to-quality across a range of markets is benefiting the owners of higher-quality properties. Rising construction costs are also affecting the delivery of new and refurbished commercial spaces.

“This compounds the flight-to-quality as it puts pressure on existing supply and means even higher rentals are needed for new spaces.

“Whilst all else being equal, higher interests rates will generally translate to softer yields, there are complicating factors such as the flight-to-quality by both investors and occupiers, and the weight of capital seeking placement into real estate. This will help insulate some of the asset classes – particularly those that have proven resilient during the pandemic such as industrial property and large format retail with essential service tenants.”

“We’re also conscious that inflationary environments tend to benefit real estate and equities. Some investors view income generating real estate as an inflationary hedge, so it’s foreseeable we’ll see larger diversified investors increasing their exposure to real estate. This is likely to support the capital markets edge of the spectrum.

“All investors also need to consider their alternatives. Whilst we have seen increases in interest rates, the returns on term deposits remain poor and at the moment represent negative real returns after you account for inflation. Meanwhile, real estate provides the opportunity for both income growth and capital growth. For existing property investors, care will be needed in the short term around the rent review mechanisms applied in new leases. Market and CPI indexed reviews will likely deliver stronger income returns than the fixed growth arrangements that have been common over the past few years,” Farhi says.

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