Updated: Jun 27, 2020
Although often misunderstood and frequently overlooked inflation can be a buy to let property investors best friend.
Understanding how inflation works should be on every property investor to do list.
If used well inflation can make any property investor very wealthy but equally if ignored can leave anyone poor.
Inflation punishes those who save and rewards those who take out good debt.
What is inflation
Inflation is an increase in the general price level of goods and services over time.
How is inflation measured?
The most well-known indicator of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households.
In the early 1970`s the average price of a loaf of bread was 8 pence, in the shops today a loaf averages at 60 pence bread hasn’t become more expensive to produce its actually now cheaper yet the difference in price is due to inflation.
The history of inflation
Since 2000 inflation has increased at an average of 2.8% every year, meaning that something that cost £100 last year will cost £102.80 this year, now this doesn’t sound like anything to get excited about however over the long term the increase can make a real difference, especially when investing in property.
Why does inflation happen?
There are several reasons why we see an increase in inflation, the most common reasons are below,
1. Supply and demand – If there is more demand than supply the price of the goods or service in demand goes up as people will be prepare to pay more.
2. Quantitative easing (QE) – This is an increase in the money supply basically when the government adds more money to the economy.
3. The UK government target inflation at 2% per year and benefit greatly from a gradual increase.
Why does the government encourage a steady growth in inflation?
The government encourages inflation as it helps the economy grow. Inflation also helps to erode the government debt which as we all know isn’t small.
How inflation affects your savings
It’s a common belief that inflation doesn’t really matter if wages rise at the same rate or higher than inflation, however inflation has a huge effect on savings. If a savings account is providing no interest, then the fixed amount in the account is decreasing in value as time goes on. When the saved amount is extracted at a later date it will be worth less than it did when it was put away.
Most savings accounts offer an interest rate that is lower than inflation meaning that if you have savings in the bank the amount is slowly becoming worth less over time. Unless the interest rate on your savings is higher than 2.9% (average annual inflation rate increase) then you are becoming poorer over time by saving money.
Inflation is seen as an invisible savings thief; you don’t see the money being taken but the value is invisibly decreasing over time.
As an investor your investments need to be generating more than inflation to for you to simply stay afloat.
Remember when working out your return you must subtract inflation to get a true return on your investment.
You generate a 10% return on investment.
Once the rate of inflation has been subtracted 10% - 2.8%.
You are actually generating a 7.2% return on your investment not 10%.
This example makes inflation sound bad, however as a property investor inflation is can be used as a very powerful tool.
What should I do?
As a property investor it’s important to know that inflation will always happen and will always be there so understanding it and leveraging it is the winning formula to success.
Rents tend to rise in line with inflation. If income increases with inflation, then renters have more disposable income meaning they are willing to pay more on rent. An investment property can be an inflation beating asset.
By combining inflation with leverage, you can do very well as a property investor.
Debt is eroded by inflation
If you were to borrow £75,000 and you use an interest only mortgage product putting down a 25% deposit (£25,000) but don’t pay any of the debt off over a 25 year period the total amount that you will have to pay down at the end of the term will be worth far less.
My parents bought their first family home in 1970 they took out a £3,000 repayment mortgage and paid the debt down over time, imagine if they had used an interest only product and still had the debt today, £3,000 seems like pocket change compared to the value it was back then.
The winning combo
Inflation becomes even more exciting when an investor uses leverage. Not only is the debt on the property decreasing overtime the property is also increasing in value, both with the investor doing nothing.
On average house prices across the UK rise faster than inflation meaning that even if you went out and put all of your hard earned saving into one buy to let property you would be in a far better position than if you had it sat in a bank account.
With the value of your debt going down and the price of your property going up property investing can create a savvy investor exceptional long-term wealth.