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What impact could deflation have on housing markets?

Guest post from Dr Tim Havard, Director of Professional Services UK, Estate Master

There has been a lot of chatter on the news recently about deflation. It has already been established in the Eurozone and there are worries that it will happen here in the UK. I am writing this in the middle of January when UK headline inflation has reached a record-equalling new low of 0.5% p.a., something which requires the Governor of the Bank of England, Mark Carney, to write a letter of explanation to the Chancellor.

So what is deflation? And why is it viewed with such alarm by economists and governments?

We are all used to inflation, the increase in prices over time. Inflation is something that is a feature of market economies, indeed it was the thing that most governments struggled with from the 1970s onwards when inflation ran out of control. The fact that costs and values would rise over time was something that anyone involved with a long term project had to take into account, particularly if costs and values change at different rates. This is something that tends to be true with property and is why, for example, Estate Master’s DF development appraisal software has a sophisticated and comprehensive escalation module that allows the modelling of cost and value changes over the lifespan of a development.

Deflation on the other hand, is a fall in prices and values over time. What is the problem with that, you might ask? Well, if you think about it, if you are rational and know that something you are going to purchase is going to be cheaper next week or next year and that you can wait to obtain it, then you should defer buying it. That is fine but the cumulative effect on an economy of most people doing the same thing is for investment to be delayed, for consumption to fall and for the economy to either stagnate or shrink, which also leads to a reduction in tax income for the government. This process actually increases deflationary pressures in the economy and reduces the ability for governments to stimulate the economy, so once you are in a deflationary spiral it is very difficult to get out of it. This was something that Japan experienced for more than 20 years from the early 1990s with government after government failing to get the country out of it.

A little bit of inflation is not a problem, indeed the general consensus is that you need some inflation in an economy to stimulate activity. It should be noted that the target inflation figure that the Government ask the Bank of England to achieve is 2%. In contrast, deflation is the big scary bogyman to governments and economists. It was the main reason for the Bank of England’s Quantitative Easing (QE) programme. QE is the modern equivalent of printing money, those with a decent history education will know that simply printing money is associated with hyperinflation (Weimer Germany and Zimbabwe are just two examples) . It should tell you a lot that the Bank and the British Government felt it was more important to risk inflation than to leave things alone and risk the economy falling into deflation.

Dr Tim Harvard is director of professional services UK at Estate Master

Dr Tim Harvard is director of professional services UK at Estate Master

So, if it does happen in the UK, will it affect the local and national property markets?

If deflation is established and it becomes a long term trend, then yes, it will do because the market for property is demand that is fundamentally derived from the underlying economy. If the economy is in a deflationary spiral then jobs and growth will suffer which will in term affect property markets. The situation in the Eurozone is a concern because the EU is an important market for the export of our goods and services. In practice, however, deflation of the type we may see in Britain is less of a worry for the economy in general and property in particular.

For one thing, experience tells us that general inflation and property inflation are often very different animals. You can have high levels of general inflation but low or negative property inflation. You can also have – and this is more common – low general inflation and high property inflation, in fact whilst the UK fails to build sufficient housing to meet demand, this is almost certain to continue.

Secondly, one concern, particularly for regional property markets, will be delayed by low or negative inflation, namely the expected rise in base interest rates and, therefore, mortgage rates. It was expected that the Bank of England would start to raise interest rates progressively from early this year to combat expected inflation and that this might squeeze regional markets such as the North West. The fall in inflation has kicked any potential rise in rates well into 2016.

Finally, much of the cause of Britain’s fall in inflation is down to a largely unexpected fall in fuel prices. Partly this is due to a fall in demand from China and the EU but it is mainly due to a glut of oil from US shale oil and fracking.  Everything that uses fuel as part of its production process – including property development – will benefit from the lower cost.  Lower costs tend to mean higher profits, particularly when the underlying economy is enjoying strong growth. Not all of the effects of lower oil prices are good, a degree of impetus for combating climate change was down to rising energy costs, but the fall will generally benefit the local and national property markets.

So yes, deflation is a concern, but it depends on the type of deflation and what we look to be going into looks to be reasonably ‘good’ deflation!

If you are involved in property development and investment you will still need good, robust financial models to explore the impact of rising and falling costs and values, and to factor in future changes in interest rates but, overall, Britain’s low or negative inflation rate is nothing to fear.

Delivering the right product is the challenge to successful PRS investment

Dr Tim Harvard, director of professional services UK at Estate Master, sees excitement – but also challenges ahead – in developing an investment grade product for instutional investors in the private rented sector:

Delegates at the recent RESI2014 could have been forgiven for thinking that there is only one game in town as far as residential property goes – PRS, the private rented sector. Session after session focused on the sector.

You might, quite rightly, think that the UK has had a private rented sector since the year dot. It is a sector that has grown in the last 30 years since the demise of the council house sector and is dominated by myriad small, buy-to-let investors building a little property empire or a private retirement fund. Well this is NOT what is strictly meant by the acronym PRS as it is currently being used. What someone talking about PRS today means is the provision of relatively large private sector housing schemes funded and owned by institutional investors – pension funds, life assurance and property companies.

Historically these organisations have not invested in residential property, making the UK almost unique in the developed world. In the US and continental Europe, residential property is an important component in investment portfolios but not here.

So why not?

The reasons are down to investment quality and cost. Residential investments are management intensive, they involve lots of small, often short-lived tenancies that the landlord has to constantly keep on top of.  There are numerous outgoings that the owner has to bear, some but not necessarily all, which have to be recovered from the tenant. Providing this level of management is expensive, particularly when compared with a commercial investment. What generally barred institutional investors though was the quality of the income stream; private tenants tended to be from low income groups making rent arrears more likely. There is nothing an institutional investor likes worse than an expensive to manage investment with an uncertain income stream.

So what has changed?

Essentially the country has. There have been some very profound socio-economic changes over the last 20 years. A big clue can be found in the level of home ownership. Having increased constantly throughout the last century, this one has seen the level of home ownership start to decline. Partly this is due to a rising population and a shortage of supply (we probably never will build enough to satisfy demand) but mainly it is down to a lack of take up by the young professional demographic group.  Often it is because they simply cannot afford it, this is a group that are going into relatively well paid jobs but carrying huge levels of student debt. Combine this with supply constricted house prices and the chances of getting onto the property ladder where the jobs are minimal. The second reason is, however, this group often do not want to buy. A job or career is not for life any more, the professional job market is fluid, short term, insecure. A young professional often needs to be footloose – and owning property ties you to one location.

So suddenly the game has changed. Certainly there is still the need to build houses for owner occupation but these will primarily be for older, more family orientated people. The major need to be met is for a relatively demanding, relatively affluent (ignoring the long term debt), footloose and educated population who want good quality, well located, well specified, easy to manage rented property close to centres of employment. Serving this demographic is far more attractive to an institutional investor, particularly since the future of some of the traditional stars of property investment – retail and offices – is so uncertain given technological change.

This type of scheme appeals to the Government too. They know the provision of housing of all tenures needs to increase but they are not willing to pay for it themselves, the public finances simply cannot stretch to this type of thing, nor are they willing to liberalise the planning system to free up the supply of housing land as voters would soon react to such a move. The idea of the big financial institutions bearing some if not all of the cost is very attractive, even though this will only be in terms of numbers, I personally doubt that PRS will make much difference to low-income families trying to get accommodation.

It was clear from RESI2014 that many institutions are showing an interest in the sector but all are coming up against the same obstacle: the type of PRS vehicle they need to invest in does not yet exist in the UK. It will, therefore, need to be developed.


Dr Tim Harvard is director of professional services UK at Estate Master

Dr Tim Harvard is director of professional services UK at Estate Master

Surely an apartment is an apartment?

Well actually no, the type of residential property currently being developed for, say, the owner occupation or buy-to-let investor is often not suitable for an institutional, long term investor. Technically, the product produced must be good quality but it also must be made of durable materials that will last tenant after tenant. The building management systems must be designed from scratch for ease of operation to reducing labour inputs and costs.

In investment terms too, what needs to be created is unlike anything the UK investors are used to. Firstly the financing tends to be in two phases; that for the development and then to fund the long term investment. This is not unusual in development but adds complexity to the appraisal. Secondly though, the investment created is going to be quite alien to a UK institution and is going to be difficult to accurately appraise. We Brits are used to commercial property with long, clean, full-repairing and insuring leases and long periods between rent reviews. PRS investments will have a long life (20+ years) but will involve large numbers of small tenants on shorter leases, subject to voids, extensions, annual reviews that will get out of phase, the expenditure and recovery of a variety of costs, as well as having a management overhead in place to keep everything ticking over and growing.

It is no surprise that many developers and investors have brought in US personnel used to working with this type of investment in the States to assist them in planning their schemes. Investors and developers will, however, also need robust and flexible appraisal models for both the development and investment phase of their projects. We at Estate Master know that we can provide this; our DF and DM suite are ideally suited to modelling projects like this whilst our IA (Investment Appraisal) software was designed for the complex, long term, non-standard investments that PRS will produce.

In the meantime though, PRS is an exciting new world for the UK property industry. Many of us may be uncomfortable with the changes in our society that has brought them about but change, like death and taxes, is inevitable. It is how we tackle change that is the key to whether we make a success of this new world.