Estimating the risk of inflation in property investments
| Pages | 452-461 |
| DOI | https://doi.org/10.1108/14635780610691922 |
| Date | 01 September 2006 |
| Published date | 01 September 2006 |
| Author | Ernest Wood |
| Subject Matter | Property management & built environment |
PRACTICE BRIEFING
Estimating the risk of inflation in
property investments
Ernest Wood
Southport, UK
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.
Keywords Inflation, Retailprice index
Paper type Research paper
Introduction
It is widely accepted that rational appraisal and valuation methods for property
investment purposes are those based on discounted cash flow (DCF) techniques[1]. The
essence of DCF is the discounting of expected cash flows, both of income and capital,
over a future time or project life. The rate of discount is derived from comparis on with
an alternative “target yield” for investments having similar or comparable risks. It is
further recommended that the basis of the comparative test is to adjust the yields used,
by appropriate premiums, for the differences in risks. In particular in a real value
approach these risks include the presence of expected or anticipated inflation and to
use net of tax cash flows. These are the two most significant differences between
business practice and property investment practice.
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1463-578X.htm
JPIF
24,5
452
Journal of Property Investment &
Finance
Vol. 24 No. 5, 2006
pp. 452-461
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635780610691922
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