House prices will never outpace inflation over time, its impossible.

206 Replies

Let me start by qualifying the title of this post with a couple statements. First, I’m not talking about your neighborhood specifically, although given a long enough period the title is likely to be very close to applicable there as well, if not spot on.

Second, what I am talking about is national averages because that is how inflation is normally measured. You may say ‘NYC housing prices have soared over inflation with time!’, to which I would reply, ‘Yes, but have they soared over NYC inflation with time? Also, in NYC’s case, is it caused by market interference such as government imposed price restrictions?’ (A topic for another post)

What I seek to explain is a phenomenon central to, but rarely understood by, beginning real estate investors. House prices are simply a reflection of what people are willing and able to pay to live in a given area. Nothing more. Just like the cost of a bottle of Coke, or an Ipad, or a lap dance are real-time reflections of what the market will support for said product or service.

My quick Google search just now turned up the number of 26.88% as the average amount total pre-tax income that the average American family spent on housing in 2013. Depending on how you calculate it, this number could move up or down a bit but, for argument’s sake, lets assume it’s truth as is. The only possible way national housing price averages can or would diverge from inflation is A) a market correction or B) if the percent of total income people were willing/able to allocate toward their housing expense changed across the board. Ill address A) later in the article but for now lets focus on B).

Our Federal Reserve Bank aims for a 2% rate of inflation. Lets assume they are on track and achieving this goal of 2% consistently. Further, lets assume that average wages are rising at that same 2%. So basically, prices rise at the same pace as incomes so things may appear more expensive BUT the average item actually requires no larger percentage of your pool of money from which to pay. Finally, lets assume that I’m wrong and housing prices are actually beating inflation by a measly 1%, rising by 3% per year on average over time. What effect do you suppose this would have on the percentage of total income each family must spend on housing over time? Lets run some numbers.

My same Google search turned up these numbers for 2013. Average before tax family income was $63,784 and the average amount spent on housing was $17,148. From these numbers I derived the 26.88% figure mentioned earlier. If you assume that house prices will consistently rise by 3%, and wages/inflation by 2%, then with about 5 minutes and an excel spreadsheet you can see that in or around August of the year 2147 housing will cost 100% of the average family’s pretax income. But most real estate investors I know would be disgusted with a return that only beats inflation by 1% on average. If you assume that the Fed’s goal of 2% is still being achieved, however housing values are growing by 5% on average with time, a mere 3% above inflation, then you can pretty quickly figure out that in or around April of 2058 house prices would effectively eat up 100% of the average American family’s pre-tax income. Folks, April of 2058 is not all that far away.

Of course this would never happen, people have to pay taxes and eat food and buy diapers and indulge in the occasional lap dance, among other things. So if you observe housing prices outpacing wage growth with time know that something just isn’t right.

Fake increases in value because of lending ‘innovations’ allowed people to buy more house with less money out of pocket leading up to 2008. Our financial system created a fake disconnect between value and the price people had to pay for that value. What was the result? I seem to remember something about falling house prices recently…

Housing costs, cannot, continually occupy a growing percent of total wages on average. To operate under this premise, as a real estate investor, is to think the odds at a slot machine are in your favor. Its simply wrong. In fact, you should probably choose the later, slot machines rarely eat up 100K+ at a time.

As for A) above, this is where talented real estate investors live, and many untalented ones accidentally find themselves profiting in. Real estate exists in a very, very complex world with any large number of factors affecting possible investment outcomes. Additionally, the market is rarely, perhaps never, a perfect representation of its underlying fundamentals. In the Detroit area right now lots houses are failing to close at prices agreed to by both the buyers and the sellers because the appraisals are coming back low. These low appraisals are based on other recent sales with the same problem. Hence, the observed market price of houses is suppressed and the only way to fix it is to have a disproportionally large number of buyers come out of pocket with extra cash at closing, not likely in the short term. Across American banks would love to lend more money to homeowners or potential buyers but face having to keep the loans on their books if they don’t conform to stringent standards for reselling to Fannie or Freddie. Banks don’t like this so demand for capital is unmet due to a countercyclical regulatory hangover from the 2008 crisis. Being able to consistently generate above average returns in real estate, especially on a larger scale, takes the ability to spot markets that are out of sync and exploit them. This, people, takes homework, hard work, and talent.

Quitting your job and making millions in real estate is possible, not probable. Lots of people ‘in real estate’ may tell you otherwise. I’d contend that most of them are actually ‘in marketing’ and real estate is simply the seasoning they put on the crap they feed you. Like being good at anything else in life, you can do this, but its not easy.

So back to the title of the article and the main point behind it.  If you buy for appreciation only and disregard cash flow, you had better know exactly what you are doing. Buying for appreciation is highly speculative, capital intensive and its outcome is anything but guaranteed. Realize the driver of residential real estate prices is jobs and act accordingly. Don’t lie to your self and assume that house prices can increase at an increasing rate, or even consistently at an unreasonably high rate over time. Know that you CAN make money in real estate, but beware that its not as easy as many gurus may tell you.

Same can be said about the cost of education and health care or the rapid rise in stock market valuations, vastly exceeding the rate of inflation. Artificial economic factors will cause economic outcomes that deviate from natural market equilibrium.

I agree Tom, with the exception of the stock market.  That has consistently beat inflation over time and I assume its because people are investing capital in business that create value.  But yes, education, healthcare and the rest are all crowded out from growing too much as a portion of total spending with time because all are necessities.  Even if you 'need' more house or healthcare, at a certain point you 'need' other things just as much.

@Ron Thomas

 Stocks are more highly correlated to factors like productivity, GDP etc. because they are businesses and the ability to raise prices (i.e. inflation) domestically is far from the only driver. So I would not say they beat inflation more that its not as related to inflation.

As far as real estate I agree to the extent that over the really long term this holds true and on average. I also agree that relying on appreciation is problematic because there are so many hard to predict factors if you are relying on appreciation on a negative or very low cash flow property. 

Where I diverge is that there are numerous factors that can push up prices beyond just plain old affordability or law of large numbers

1) Greater shift into real estate related investments by investors, which is already happening. This forms a bubble eventually (maybe) but as you see with various types of stocks momentum can play a big role in the medium term on pricing and if the shift is more long-term it can last for a very long time.

2) Foreign money - I personally think is short term esp as the dollar is just soaring and as governments try and bring capital back but it does affect prices.

3) Shifts in homeownership. Shifts between renters and buyers can affect home prices and types of homes that are in favor just like demographics affect stock markets.

4) Rises in prices foreshadow further rises in prices. As you may have noticed people are tapping their home equity to buy more properties. This creates demand which pushes up prices and is not tied to wages or how much you pay at the grocery store.

5) Inflation is not a "real" number. A basket of goods might so down while one goes up. Should prices fall on other items (i.e. productivity gains or margin compression) prices paid for another item can go up while inflation stays the same. 

 Almost as important your comments really reflect the average prices. Most people on here don't buy average homes on a national basis. So while it is true that over the long-run average prices are unlikely to outpace inflation, without long-term changes in some factors above, that market is comprised of A, B, C and D class areas and housing stock. It does not account for people moving from more expensive to less expensive areas, who is a renter vs. a home buyer, how much inventory can be purchased profitability by an investor etc.  Chances are that someplace somewhere there is a market that is a good one.  True not everyone will find it but thats what makes a market like any market. 

Hi Ron Thanks for starting this interesting discussion. Inflation, as I understand it, is a measure of what has happened in the past. Much like having your books done for tax purposes. They can tell you where you have spent money, but not where you will make money in the future. That is the challenge of relying only on accountants for financial advice. Economists attempt, not always successfully to predict the movement of global, national and state based economic drivers to help guide us to where the profits might be, t what might happen to interest rate sand thus the effects of possible inflation. Financial advisers try to predict the future in their field, mostly equities, especially in my home country. That leaves us investors with not a lot to go on.

You mentioned in your post that different areas reflect different results for the actual cost of inflation. However, and of equal or greater importance to the property investor is the real EFFECT of inflation on an area. In more affluent areas a small rise in the cost of living, of say 2%, would not necessarily change anyone's buying habits. However, in areas where household incomes are low this could have a dramatic effect on their lifestyle choices. This can give us an indication of some form of hedge we can take against inflation when making our investment decisions. One truism of making money from property is you make money when you buy. You need to buy the right property for the right reason and make sure that you can add value at the start of the investment and not be reliant solely on the market moving in an upward direction.

Assuming an investor understands the buying concept, here is a simple formula I use to help me make my final decision on which properties to invest in. It is also a good indicator of where an individual market is in the investment cycle. If the property purchase price is equal to or less than 4 times the average household income for that area, street neighbourhood, zip code or whatever geographic measure you use to determine your individual markets, then the property in my opinion would be classified as affordable. If the price of the property is between 4 and 6 times the average household income then I would classify it as sustainable. and if the price of the property is more than 6 times average household income then I would classify the property as unsustainable.

Affordable, sustainable and unsustainable are my measures of affordability and allow me to clearly identify a change in economic factors, such as rising interest rates, rising inflation etc and what likely effect any of these issues would have on my investment. If inflation rose in an area that I assessed as affordable the small rise in inflation would not necessarily effect my investment property's value. If my property was rated sustainable a small change in inflation could be sustained for a short time but I would then reassess this property against the new set of figures as mentioned. If the property was in the unsustainable bracket a small change in inflation could force vendors to start liquidating and thereby create a greater supply of product on the market and thus drive prices down. I would want out of the property.

As this is a guide only it is important to note that areas with higher income households tend to have greater resilience to small moves in inflation and interest rates whereas households with lower incomes have less resilience. This helps me mitigate my risk exposure to moves in inflation and or interest rates.This can all be determined before we invest. Remember, we make our money when we buy, not when we sell.

Originally posted by @Ron Thomas :

Let me start by qualifying the title of this post with a couple statements. First, I’m not talking about your neighborhood specifically, although given a long enough period the title is likely to be very close to applicable there as well, if not spot on.

Second, what I am talking about is national averages because that is how inflation is normally measured. You may say ‘NYC housing prices have soared over inflation with time!’, to which I would reply, ‘Yes, but have they soared over NYC inflation with time? Also, in NYC’s case, is it caused by market interference such as government imposed price restrictions?’ (A topic for another post)

What I seek to explain is a phenomenon central to, but rarely understood by, beginning real estate investors. House prices are simply a reflection of what people are willing and able to pay to live in a given area. Nothing more. Just like the cost of a bottle of Coke, or an Ipad, or a lap dance are real-time reflections of what the market will support for said product or service.

My quick Google search just now turned up the number of 26.88% as the average amount total pre-tax income that the average American family spent on housing in 2013. Depending on how you calculate it, this number could move up or down a bit but, for argument’s sake, lets assume it’s truth as is. The only possible way national housing price averages can or would diverge from inflation is A) a market correction or B) if the percent of total income people were willing/able to allocate toward their housing expense changed across the board. Ill address A) later in the article but for now lets focus on B).

Our Federal Reserve Bank aims for a 2% rate of inflation. Lets assume they are on track and achieving this goal of 2% consistently. Further, lets assume that average wages are rising at that same 2%. So basically, prices rise at the same pace as incomes so things may appear more expensive BUT the average item actually requires no larger percentage of your pool of money from which to pay. Finally, lets assume that I’m wrong and housing prices are actually beating inflation by a measly 1%, rising by 3% per year on average over time. What effect do you suppose this would have on the percentage of total income each family must spend on housing over time? Lets run some numbers.

My same Google search turned up these numbers for 2013. Average before tax family income was $63,784 and the average amount spent on housing was $17,148. From these numbers I derived the 26.88% figure mentioned earlier. If you assume that house prices will consistently rise by 3%, and wages/inflation by 2%, then with about 5 minutes and an excel spreadsheet you can see that in or around August of the year 2147 housing will cost 100% of the average family’s pretax income. But most real estate investors I know would be disgusted with a return that only beats inflation by 1% on average. If you assume that the Fed’s goal of 2% is still being achieved, however housing values are growing by 5% on average with time, a mere 3% above inflation, then you can pretty quickly figure out that in or around April of 2058 house prices would effectively eat up 100% of the average American family’s pre-tax income. Folks, April of 2058 is not all that far away.

Of course this would never happen, people have to pay taxes and eat food and buy diapers and indulge in the occasional lap dance, among other things. So if you observe housing prices outpacing wage growth with time know that something just isn’t right.

Fake increases in value because of lending ‘innovations’ allowed people to buy more house with less money out of pocket leading up to 2008. Our financial system created a fake disconnect between value and the price people had to pay for that value. What was the result? I seem to remember something about falling house prices recently…

Housing costs, cannot, continually occupy a growing percent of total wages on average. To operate under this premise, as a real estate investor, is to think the odds at a slot machine are in your favor. Its simply wrong. In fact, you should probably choose the later, slot machines rarely eat up 100K+ at a time.

As for A) above, this is where talented real estate investors live, and many untalented ones accidentally find themselves profiting in. Real estate exists in a very, very complex world with any large number of factors affecting possible investment outcomes. Additionally, the market is rarely, perhaps never, a perfect representation of its underlying fundamentals. In the Detroit area right now lots houses are failing to close at prices agreed to by both the buyers and the sellers because the appraisals are coming back low. These low appraisals are based on other recent sales with the same problem. Hence, the observed market price of houses is suppressed and the only way to fix it is to have a disproportionally large number of buyers come out of pocket with extra cash at closing, not likely in the short term. Across American banks would love to lend more money to homeowners or potential buyers but face having to keep the loans on their books if they don’t conform to stringent standards for reselling to Fannie or Freddie. Banks don’t like this so demand for capital is unmet due to a countercyclical regulatory hangover from the 2008 crisis. Being able to consistently generate above average returns in real estate, especially on a larger scale, takes the ability to spot markets that are out of sync and exploit them. This, people, takes homework, hard work, and talent.

Quitting your job and making millions in real estate is possible, not probable. Lots of people ‘in real estate’ may tell you otherwise. I’d contend that most of them are actually ‘in marketing’ and real estate is simply the seasoning they put on the crap they feed you. Like being good at anything else in life, you can do this, but its not easy.

So back to the title of the article and the main point behind it.  If you buy for appreciation only and disregard cash flow, you had better know exactly what you are doing. Buying for appreciation is highly speculative, capital intensive and its outcome is anything but guaranteed. Realize the driver of residential real estate prices is jobs and act accordingly. Don’t lie to your self and assume that house prices can increase at an increasing rate, or even consistently at an unreasonably high rate over time. Know that you CAN make money in real estate, but beware that its not as easy as many gurus may tell you.

 Great point. I was having a different (but somewhat related) discussion with @Bob Bowlingthe other day. I was telling him that there is "no way that rental income can rise 6% year over year in Hawaii indefinitely". My argument is that eventually, people will have to pay like $5000/month for a 2BR condo, which means they would make roughly $15k/month to live comfortably. Not likely a lot of students, or even professionals would be making this sort of salary.

@Ron Thomas I can see that you love your numbers, despite 61.3% of statistics being proven to be incorrect! 

Most seasoned investors here on BP allude to the fact that their profit is made on the day of purchase (because the properties they buy are ALREADY worth more than they paid for it), and so any future appreciation is a bonus, not a given.

For the unseasoned investor, let those sentiments soak into your being before embarking...

Interesting idea.  Housing value has 2 components.  The monthly payment and the accumulated equity.  I agree that wage growth can be a driver of increasing monthly payments - rent or mortgage.  

While there is a correlation between wage growth and inflation - it is possible for their to be real growth in wages(wage growth in excess of inflation) - we just haven't seen it in a long time.  We may be poised to actual start seeing it as the labor market seems to be getting tighter - so real wage growth would lead to more money that can be put into monthly housing costs.

The assumption is that higher interest rates will decrease housing prices.  I think that likely will be the short-term impact - since it makes the monthly payments less affordable.  However over the long-term it seems to be that high rates correlate with high real estate appreciation.

When interest rates are low people tend to be more leveraged on their real estate - entry level buyers, move up buyers making a big jump, cash-out refinancing.  When money gets more expensive people tend to lower their leverage.  This leads to less exciting gains, but also less dramatic drops.  If people are getting a relatively steady increase in their home value - they are more likely to make a intermediate jump once they pay down their mortgage some - but I would guess move less often since the moves are based more on needs than expectations of a big pay-off.

Markets like New York City and the Bay Area seem to have a permanent housing scarcity, so they definitely don't behave like "normal" markets.

   

@Charles Worth I agree that there are a number of very complicated factors that affect real estate prices.  I was definitely speaking of long term and averages.  My main point was really aimed at more novice investors with a mentality of 'real estate always goes up in value'.  To effectively exploit market variances over the long term, and hence be a real estate investor that endures, it seems like a firm understanding of the industry's economics is important.  In Detroit's suburbs right now, for example, you have to really go out of your way buying single family rentals.  Knowing what you are doing isn't currently a prerequisite to making cashflow there.  And when the market tightens, and people that think 'prices always rise' get squeezed out they will be saying, wrongly, 'there is no money in real estate'.  Thanks for your response.

@David Nolan,

Thanks for the post.  I agree that you make money on the purchase, with an exception however.  You can (and should in my opinion) also make money holding and selling the property.

I was definitely talking big picture economics in my post but my main point is that on the whole, housing prices very closely track inflation with time.  They must.  Inflation is a measurement of real (as opposed to nominal) price changes over time, but price changes are a matter of what the market can afford to pay for any given thing, housing being one of those given things.

The astute real estate entrepreneur will find all sorts of ways to capitalize on real estate for themselves or their investors.  But it seems like the beginner often gets lured in for the wrong reasons, shaky appreciation expectations being one of them.

I like your 4-6 times household income threshold.  I've never tried to calculate that myself but it seems like a smart way of looking at things.

@Andrey Y - That was my point exactly!  I first became interested in real estate back in 2002 or so, in the Detroit area because that is where I was from.  I was 18 then and wanted 'in'.  I was approved for a 150k mortgage, on 14k of annual income (a story for another post) but decided something didn't seem right.  Ive learned a lot since then and thankfully didn't invest right before the bubble.  But my thoughts, even back then, were 'if wages are flat and house prices double every 8 years....then really, really soon everyone will be homeless!'  Rents are simply a product of what people can afford to pay for housing.  So, on the whole, housing prices can only consistently change with people's ability to pay, just like every other thing used to calculate inflation.

If your head is in boiling water and your feet are in ice, on average you should feel just fine. Your logic is based on averages which are totally meaningless. No investor buys the entire US housing market. There is no such thing. 

@Anish Tolia

you are correct, real estate always goes up is a misnomer and is what people said in 2005 - 2007 to package and sell debt at insane prices backed by houses at insane prices from owners that had insane leverage. It is along the same vein as proforma will actually work out so I can buy at an 11% ROI. That is just not the argument I got from your post.

@Ron Thomas  You said "I agree that you make money on the purchase, with an exception however. You can (and should in my opinion) also make money holding and selling the property".

I think you missed the point.  "Holding and (eventually) selling" is not an "exception", it IS where the said day-one profit is cashed-in! Savvy?...

@Anish Tolia

I dont think its meaningless to understand the reasons real estate values cannot increase indefinitely at unreasonable rates.  

If my head was in boiling water and my feet were in ice on average I think I may feel like crap because I'd be dead regardless of my body average body temp!  Lol

Averages do matter, big time.  If I were in a market where residential real estate were increasing at an average rate that exceeds the overall growth of that area I would be very cautious about investing.  I'd want to know why.  If prices are increasing at an exceptional rate but are blow long run average says something very different story than if prices are increasing at an exceptional rate and already high barely affordable to most.  One is a likely a bubble the other, a recovery.    

@ Ron Thomas

Hi Ron, the way you make money when you buy is to understand the real value of what you are buying. Naturally real cash will be made either by way of rental income or on a sale, but you actually CREATE this environment when you make your decision to buy. You need to know if you are buying an absolute bargain based on comps or you need to know how you are going to add value day one to increase the value of the property in the present market, not relying on the future market, i.e. a reno.

Whilst inflation is a measure of the increase in the cost of living, and you are right in as much as the numbers will no doubt align at some time in the future, because inflation is a measure of what HAS happened in the economy. It is important to understand that inflation is also a measure of an increase in the QUALITY of STANDARD of living that a society is seeking. People want more of something they perceive as being beneficial to them. That is what causes demand to increase along with a shortage of supply.

In regards to,"...shaky appreciation expectations being one of them" it is primarily the fact that most novices do not understand the concept of, "you make your money when you buy". Whilst this may sound odd it simply means buy the right property that you know that in the CURRENT market you could make money on. I do not look to make money in the future market unless I can see that the market is set to rise. An example here might help.

I bought a property that was in need of a renovation in a market where the asking price to income multiplier I mentioned was at 3.7 times. So the price being asked was 3.7 times the area's average household income. On investigation the average price in the current market for similar properties that were in good condition was 4.8 times average household income. However, on further investigation the average price for properties in this area when the market was nearing its high point was 6.1 times average household income. So I could now perform the following calculations.

Purchase price including costs $280,000.00 on a multiple of 3.7 time incomes means incomes for the area is $73,675.00. This is a figure obtained from government records and statistics.

Renovated properties were selling in the current market at a multiple of 4.8 times household income so $75,675.00 x 4.8 = $363,240.00 or thereabouts. This told me that if I renovated this property I could expect a selling price around $363,000.00 on completion of the reno. The reno was costed at $46,000.00 so my investment would be $280,000.00 + $46,000.00 = $326,000.00. Excluding interest costs the potential margin would be $363,000.00 value in current market less costs of $326,000.00 being $37,000.00. This is 10.19% on my investment and it could be turned over in 4 months. This would then be 30.57% per annum rate of interest on my money. Not bad.

In this deal I increased my real value by $37,000.00 when I bought. Now, I mentioned that in good times this market trades at a multiple of 6.1 times household incomes. If household incomes remain the same, which they don't, but let's assume they did and the level of incomes is $75,675.00  on a multiplier of 6.1 times income the potential value this property could reach during the current investment cycle, not counting inflation, would be $75,675.00 x 6.1 = $461,617.50. I checked this against the past high in the last cycle and it was correct. I also checked the previous cycles against their income levels and the model held true. On these figures I can hold this property during the rise in the market knowing I have already locked in a profit in real value of $37,000.00 and could ride this all the way to a potential profit of ($461,000.00 - $326,000.00) $135,000.00.

I held this property for 15 months and sold it in a better market for a profit of $114,000.00 not calculating finance costs.

Understanding the market, and that you make money when you buy not only makes sense, is also makes decision making easier because the evidence is real. I was not hoping to ride the market blindly.

I would assume that you would consider leverage as one of those financing numbers that allows magic to happen.  Any commercial or apartment building is going to use cap rates as a valuation. 

If you leverage your money with an 80% mortgage, your equity will rise much faster as a percentage. If income and expenses go up at 2% per year, your value will rise based on the cap rate.

1,000,000 value

200,000 down

Cap rate 7%

70,000 NOI

2% inflation for NOI over one year is 71,400

NOI * cap rate = value

Value is now 1,020,000 using the cap rate. 

A $20,000 gain is 10% based on the $200,000 down payment.

Now figure out how to make the rents go up faster than inflation using the value-add process or buying at the right time and you have yourself a winner.  It can certainly return you much more than inflation.

@Steve Olafson

Great point about leverage. One only needs to pay attention to how to manage the debt and away control the risk.

Of interest is how many people buy properties that are fully tenanted and in great condition. How on earth are they ever going to increase value when all they can rely on to increase rents is inflation increases. Much better to buy property with a number of vacancies or in need of improvements, based on sound values, and there you have the opportunity to increase values by finding new tenants, and or improving the property. This will increase yields and thus values. It can also increase loan amounts reducing the amount of actual cash one has invested in the deal which magnifies the cash on cash yield. Which is exactly what we should be looking to do to beat inflation and create wealth.

@Ron Thomas Averages matter if you buy the market. When you buy S&P 500, you are buying a good proxy of the market. Then you can expect market average returns. When you buy AAPL, you are buying something totally different. AAPL can grow 1000% in a 5% market. As in investor in AAPL, what do you care more about? At least in stocks, there is a way to buy the market average. There is no such vehicle (to my knowledge) that lets you buy the average RE market, whether it be US, CA, Bay Area, Cupertino or even the average on just one street. Therefore, averages dont mean anything. You are buying a house whose value can differ significantly from the average. Of course entire markets move and affect the value of your property (or stock). Detroit is a clear example of that kind of risk. And yes, certain markets can be overvalued or undervalued at some point in time so that should be a consideration in your buying decisions. But looking at my local market, there is really no 10 year period over which properties lost value or grew slower than inflation. When you have very limited new housing stock and growing population, it makes for high appreciation markets. And this can continue a long time. The median home prices far exceed median income and yet prices still go up. Because only a small percent of the residents can afford to buy but thats still enough buyers for the limited housing stock. And there is little to no new development and people dont sell their house that often because its almost impossible to get back into the market. In the final analysis price is always a simple function of supply and demand. Nothing else.

@David Nolan and @Steve Olafson

Great points you both mention, I agree with pretty much everything you both said. I will say, Dave, I do think its very important to not only track whatever equity you acquire at purchase but also what the asset is likely to do over your intended holding period. You may come across what seems like the best deal in the world but if you dont at least consider what your exit strategy is when your financing comes due, you may be setting yourself up for disaster. If you know, for example, that your likely to earn an IRR of 15% over the next 5 years in your current investments but, regardless of the day 1 equity gains of any other new endeavor, your total actual realized annual return for the entire holding period of this new project is not at least 15%, then I would be critical of making that investment. Clearly, though, you both know more than a little bit about investing.

Somehow the greater point of my article seems to have been missed in most of the subsequent comments though.  My point was that real estate prices, like any other good or service demanded by consumers, cannot consistently occupy a larger portion of expense within everyone's personal budgets.  If they appear to be doing so, buyer (investor) beware.

@Ron Thomas

Hi Ron, I understand that what you are saying is that, as the proportion of the household budget allocated to property purchasing costs, i.e. loan repayments etc, increases too much, then people will reach a point of being unable to afford the property. As I said in my post when the multiplier of household income to property values exceeds 6 times income it becomes unsustainable. This is when we start looking for the bubble to burst. This is a sign of an over heated market. Especially here in Australia where I live. It is sustainable only until the next increase in the cost of living, the cost of money or the reduction in the supply of money. All of which could burst the bubble. 

Is this in line with your thoughts?

Originally posted by @Ron Thomas :

Somehow the greater point of my article seems to have been missed in most of the subsequent comments though.  My point was that real estate prices, like any other good or service demanded by consumers, cannot consistently occupy a larger portion of expense within everyone's personal budgets.  If they appear to be doing so, buyer (investor) beware.

 I understand the point of the article.  You happened to address it to a forum of real estate investors.  It can easily be taken that you are inferring that there is not a lot on money to be made because prices cannot go up above affordability.  That is what I addressed. 

There are affordability indexes out there that can be looked at from various angles.  When the price of homes begins to get out of reach, more people rent.

So you are correct in your basic assumptions.  Some areas will outpace inflation though.  Others will not even keep up with it.

Perhaps you are stating this as a warning to people to be wary of a hot market.

That does not mean that money cannot be made.

The one thing that hasn't been taken into account is the act that someone else is paying off your leverage. While yes my "real estate" might not be able to keep up with inflation or stock market (different debate). No other where can I get into the market for 0 down (VA loan), and have the dividends pay off the what I owe with just sweat equity (my management)

Originally posted by @David Nolan :

@Ron Thomas

... As I said in my post when the multiplier of household income to property values exceeds 6 times income it becomes unsustainable. This is when we start looking for the bubble to burst. This is a sign of an over heated market. Especially here in Australia where I live. It is sustainable only until the next increase in the cost of living, the cost of money or the reduction in the supply of money. All of which could burst the bubble. 

 David:

We are in similar shape in Canada.

The ratio of household income to housing prices has been hovering near 6 in Canada for some time now (the national average was 5.7 2013).   If you exclude the Atlantic provinces (slow economy) and rural parts of the prairies the number is over 6.  In the metropolitan Toronto area the multiplier is over 7.0 and in Vancouver it has exceeded 11.

Many have been waiting for head to come off the market for some time now, but the train keeps flying along with its boiler ready to explode at any point.

@Steve Olafson - I definitely think money can be made in real estate.  You're correct, the last think I was trying to say is that real estate is a lost cause for investing.

@David Nolan - This is exactly in line with my thoughts.  I think this was fresh in my mind, and I wrote the blog post, because of a book I'm reading right now, The Big Short.  A lot of what is in the book reminded me of what I observed when I first became interested in real estate back in the early-mid 2000s, just before the US housing collapse.  I was only 20 or so, and didn't know enough at the time to understand what was wrong (few people did, it turns out), but even then I saw the price growth everyone took for granted as unsustainable.  I decided to wait and eventually began getting involved with real estate in 2010.  One fascinating example from The Big Short is this Mexican immigrant strawberry farmer living in California that was able to get a mortgage on a $750,000 house based on a stated income of around $15,000 annually.  It was a 'pay option, negative amortization' loan, meaning he could pay whatever he felt like paying and if he didn't quite pay enough to cover the interest then the remaining balance would get rolled back in to a larger principal balance due.  Which, in theory, wouldn't be that big of a deal if you knew, for example, your value would increase by 10% per year endlessly.  Your equity gains would eat up any negative amortization, depending on specific loan terms, and even if you paid nothing you may walk away later on with positive sale proceeds.  The problem is, real estate cannot endlessly increase by such absurd amounts.

When I was first getting started and trying to understand the dynamics at work, the basic ways real estate prices interact with people's income and things such as inflation probably would have been helpful information.  Too often it seems like the information given to beginning investors has nothing to do with market basics and has everything to do with no-money down deals, or 'yellow letters', or other stuff that is on the very edges of real estate.  

        

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