Deflation and development: Implications for the property market
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.
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.
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