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Is residential real estate still a good hedge against inflation in Malaysia?

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It is imperative that real estate investors and prospective house buyers understand the hedging abilities of property against inflation, both in the long and short terms, in order to minimise exposure to inflation risks in their real estate portfolios.

Real estate has traditionally been viewed as a safe investment with powerful inflation hedging capability. It is even perceived as a better investment option than other assets like stocks and bonds. This is because not only does real estate investing serve the need for housing, inflationary pressure will cause an increase in the cost of building new houses, which in turn increases the prices of existing houses.

 

According to PropertyGuru Malaysia’s H12022 biannual consumer sentiment study, with the emergence of inflation just as the economy was starting to recover from the COVID-19 pandemic, more Malaysians view real estate favourably as an alternative investment to the uncertain stock market.

 

How does COVID-19 impact real estate?

 

However, we know that soaring commodity prices and supply chain issues brought about by the pandemic can push house prices upward. Also, the Malaysian housing market has long been marred by inventory overhangs, rising costs of doing business, decreasing affordability, higher household debts, tighter credit standards and subdued buying sentiments. Given all these, there is concern that house prices could decline due to an imbalance in supply-demand and jeopardise the real returns on investment.

 

Globally, the rampant house price surge since the Covid-19 outbreak has put the housing market at a risk. When a housing bubble bursts, the resulting panic/fire sale will cause a drastic fall in house prices. This in turn leads to a crash in the housing market, which can have detrimental effects on the entire economy. Moreover, one worry faced by highly indebted economies is that deflation – the consequence of falling prices in various sectors of the economy, especially in the financial sector – would inflate the value of their debt in real terms.

 

Since deflation is often associated with a sharp fall in real asset values, firms and households would become more likely to default on their property loans. The effect will likely be magnified as the values of collaterals on which loans are secured degrade accordingly. Combined with lower income growth prospects, a negative-demand shock would exert upward pressure on property yields, leading to significant capital value erosion.

Inflation and the Malaysian House Price Index

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Malaysia has been experiencing low and stable inflation (Figure 1). History shows a low inflation rate in the early 1960s (with some situations of deflation in 1961, 1964, 1965, 1968 and 1969, followed by a high regime of inflation in 1974 and 1981, and finally a rocky path downward in 1985. Since then, the country’s inflation rate has been consistently maintained at a level below 5% for more than three decades, except for 1998 (5.2%) and 2008 (5.4%) due to the global financial crisis.

 

In the last few years, however, disinflation is observed in Malaysia, where the inflation rate slows down from 3.7% in 2017 to 1.0% in 2018 and 0.7% in 2019. In 2020, the country even experienced its first deflation since 1969 (-0.41%), with the lowest ever inflation rate recorded at -1.2%.

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Figure 1: Malaysian annual inflation trend, 1960 – 2020

Given that house prices tend to rise with inflation, as higher economic growth will encourage consumption and further lead to the rise in prices of assets, a synchronised movement between inflation and the returns gained from property investment should indicate a good hedging capacity. In fact, a co-movement between the Malaysian House Price Index and Consumer Price Index (CPI) is observed, where both indices seem to rise indefinitely for the past three decades.

 

With exceptions in 1998 and 1999, the Malaysian House Price Index has climbed steadily each year from 1990 to 2009 with a CAGR of 5.32%. Correspondingly, CPI has also displayed an increase throughout the same period, though with a relatively lower CAGR of 2.93% (Figure 2). This should imply that real estate investment is capable of keeping up with inflation in the long run.

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Figure 2: Malaysian House Price Index and CPI, 1990 – 2020

Most importantly, a steeper increase in the Malaysian House Price Index since 2010 (with a CAGR of 7.2%) has greatly outpaced the growth of the CPI (with a CAGR of 1.85%) despite challenges faced by the housing market in the last few years, including the global economic downturn that began in early 2018 due to the US-China trade tensions, and the COVID-19 pandemic in early 2020. This signifies that homeownership can be an effective inflation hedge, even during deflations, as observed in 2020 when investors still could profit from housing investment returns alongside a decline in CPI.

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Figure 3: Residential property investment return vs. inflation, 1990 – 2020

Is real estate a good bet against inflation in Malaysia?

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Plotting residential investment return against the inflation rate also yields the same result. The average annual inflation rate from 1990 to 2020 is 2.6%, which is lower than the investment return of 6.1% (Figure 3). While the annual investment return does display larger volatility than the inflation – implying a relatively higher risk of returns from housing – the average investment returns calculated for every five-year-interval sub-period confirm the above analysis, in which house prices appreciation can really act as protection against inflation, even during fluctuating economic conditions. For example, there is a higher positive mean return on housing investment from 1995 to 2000 (4.6%) during the Asian Financial Crisis compared to the actual inflation (3.2%).

 

However, by conducting a correlation analysis to examine how significant the relationship is between residential property investment returns and inflation of the same period – where a perfect inflation hedge would have a correlation close to +1.00, indicating that both the tested variables increase proportionally at the same time, and a correlation of -1.00 would indicate the exact opposite – we get a different insight. In general, we see a low correlation (+0.22) from 1990 to 2020. While this is rather low to qualify for a perfect inflation hedge, a positive correlation indicates that returns gained from property investment will counterbalance, at least partially, a rise in inflation.

 

Further analysis shows that correlations vary over time. By using a rolling window approach (five-year-intervals to control for the possible structural changes in the economy) to investigate the changes throughout the study period, we see the relationship between inflation and real estate returns as well as their significance in correlation has been changing five times under different economic environments (Figure 4).

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Figure 4: Rolling window correlation of real estate investment returns with inflation

Starting in 1990, residential property investment returns are moderately correlated with inflation (positively correlated but less than +0.5). The first change takes place from 1998 to 1999 when investment returns become negatively correlated with inflation in conjunction with the Asian Financial Crisis. The second change happens soon after, when investment returns begin on an increasingly negative correlation trend and with a trough around 2002 to 2003. The lowest level of correlation for all time is also recorded during this period at -0.95. The third change happens in tandem with a drastic house price surge in 2010, where the correlation trend not only reverses to positive but tops at +0.6 in 2014, signifying a rather strong correlation between the two variables. In the fourth change, the correlation plunged to -0.55 in 2017.

 

Despite an apparent slowdown in the country’s housing market with house prices in plateau, there is a reverse in correlation in 2018. Depicted as the fifth change, the upward trend of correlation reaches its highest ever level at +0.86 in 2020. This shows that, while house prices have not changed in recent years, falling inflation at a higher pace has led to an equilibrium in investment returns and inflation, making real estate a rather good hedge against inflation, albeit imperfect.

So, is it a good time to buy property in Malaysia?
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As shown above, one can expect that real returns from real estate are not adversely affected by inflation. Even if it does not provide a complete hedge against inflation, a move that is in line with inflation could still make it a valuable asset, given that house prices grow much higher than inflation in the long run, while also being able to respond instantly in the short run when there is inflationary pressure.

 

Having said that, the traits of real estate investments described above are powerful only if there is no oversupply in the market. Local housing markets are susceptible to supply excesses. Even if inflation is high and pushes house prices up, an oversupply of houses will inevitably bring prices down. Power would shift to tenants who can negotiate favourable terms no matter what the inflation environment might be. As such, real estate investors should be sensitive to the domain differentiation in each individual local market so as to establish a productive long-term real estate investment strategy and management mechanism.

 

Another far-reaching implication to be drawn from the above findings is that, while investors can take advantage of the rise in house prices during inflationary pressure, they need to pay close attention to rapid house price surges. While a rise in house prices is good for investors and house owners, it might be counterproductive in that it will widen the gap between household income and house prices. This will make the property less affordable for first-time buyers and the younger generation. After all, real estate is a good investment only if people can afford it.