Estimating the risk of inflation in property investments

Abstract

Purpose

Property returns are normally measured against the target rate for similar investments with comparable risks and liquidity. However, this analysis is normally undertaken in nominal terms and thus the risk of inflation, as it affects different investments, is not fully quantified. This paper seeks to analyse the effect of inflation on property investments.

Design/methodology/approach

This article examines the impact of inflation on gilt returns and relates this to property risk.

Findings

Investors may take a more pessimistic view of future inflation as an investment risk than the current official indices would indicate. In this context it may be that retail price index (RPI) and index adjusted for mortgage payments (RPIX) are not reliable indicators of inflation risk. It has been suggested that the difference between the two species of gilts as “a calculation of inflation expectations should be regarded with suspicion because of the volume of index linked bonds is so small that individual trades can move the market”.

Practical implications

Economists and financial advisers and commentators have long recognised that inflation, in the sense of the tendency of the value of a currency to decline in purchasing power, distorts the picture of the worth, not only of individual assets but also of the whole economy. In this respect investment advisers often, in presenting their arguments, use yields that are net of the rate of experienced inflation taken from the performance of the RPI or the RPIX. Unless there is an understanding of the risk of inflation on property investments, such net rates may be misleading.

Originality/value

This study adds to the literature exploring the effect of inflation on property returns.

Citation

Wood, E. (2006), "Estimating the risk of inflation in property investments", Journal of Property Investment & Finance, Vol. 24 No. 5, pp. 452-461. https://doi.org/10.1108/14635780610691922