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

[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.