When discussing real estate (generally speaking), all variables grow with inflation over time except the mortgage amount. For example, over time the following will increase roughly 3% per year on average: rent, condo fees, taxes, insurance, maintenance and (most important of all) the home value. Over a 25 year period, your $500k home growing at 3%/yr will produce a much larger gain then your income. Your yearly income probably starts out flat (maybe even slightly negative) and then slowly grows over time as your increased rent (3%/yr) begins to exceed your fixed interest expense. Clearly, $500k growing at 3% will produce a much larger gain then the annual rent of $25k growing at 3%.
My spread sheet model has estimated the capital appreciation component to represent roughly 90% of total gains (and rental income 10%) for the average Toronto property over a 25 year period. Other less desirable cities may not have home values match inflation over time, but they should yield a higher rental income to help compensate, therefore producing a 50%/50% split rather then Toronto’s 90%/10%. The absolute $ gain though will still be much higher in Toronto vs less desirable cities.
In the above example, I’m only assuming Toronto home prices increase with inflation (and no more). If you believe (as I do) that well located central Toronto real estate will actually grow at least 1%-2% above inflation over the next 25 years, the returns will indeed be good. You may disagree and claim that Toronto real estate will not increase more then inflation. Perhaps, but I would counter with two main points. First, the long term fundamentals are just too damn good. Of course the next three years will be slow but let me point out: Toronto is a great city, a financial centre, a medical/research centre, an educational centre, the upcoming demographic shift of baby boomers moving to city centre (and away from suburbia), population increases (2 million +), restricted land use policies, increased transport congestion in suburbs, and continued foreign immigration (to mention but a few). My second main point is that the average GTA property has already increased in value 2.49% above inflation between 1966 and 2008. According to Stats Canada data (source Bloomberg), Canadian CPI has averaged 4.6% over the last 42 years. According to the Toronto Real Estate Board, the average yearly compounded growth of a home in the GTA has been 7.09%. Here’s the raw data:
Average GTA House Price
Year Price % Increase
1966 $21,360 0.00%
1967 $24,078 12.72%
1968 $26,732 11.02%
1969 $28,929 8.22%
1970 $29,492 1.95%
1971 $30,426 3.17%
1972 $32,513 6.86%
1973 $40,605 24.89%
1974 $52,806 30.05%
1975 $57,581 9.04%
1976 $61,389 6.61%
1977 $64,559 5.16%
1978 $67,333 4.30%
1979 $70,830 5.19%
1980 $75,694 6.87%
1981 $90,203 19.17%
1982 $95,496 5.87%
1983 $101,626 6.42%
1984 $102,318 0.68%
1985 $109,094 6.62%
1986 $138,925 27.34% +
1987 $189,105 36.12% +
1988 $229,635 21.43% +
1989 $273,698 19.19% +
1990 $255,020 -6.82% -
1991 $234,313 -8.12% -
1992 $214,971 -8.25% -
1993 $206,490 -3.95% -
1994 $208,921 1.18%
1995 $203,028 -2.82% -
1996 $198,150 -2.40% -
1997 $211,307 6.64%
1998 $216,815 2.61%
1999 $228,372 5.33%
2000 $243,255 6.52%
2001 $251,508 3.39%
2002 $275,231 9.43%
2003 $293,067 6.48%
2004 $315,231 7.56%
2005 $335,907 6.56%
2006 $351,941 4.77%
2007 $376,236 6.90%
2008 $379,347 0.83%
Side note: It’s best to look at the raw “unadjusted†data. Previous posts have included price graphs of Toronto home prices “adjusted†for inflation. This is a pointless (and distorting) exercise. To compare apples with apples, you would also have to adjust the mortgage amount over time to fall 4% a year. Suddenly a flat gain in your home value looks good if the mortgage amount decreases each year (without even making a principle payment!).
Of course, past performs doesn’t guarantee the future, but it helps to form an opinion. Also note the abnormal period between 1986 and 1996 in the above table. You had 4 years of outstanding gains and then 6 years of outstanding losses. But the average annual compounded return over this 10 year period was still +6.2%.
I firmly believe the most important (and least understood) concept pertaining to real estate, is “Compound Interestâ€. You’ve all heard the term but few people actually appreciate how powerful it is over time. As long as you have constant growth every year, you will experience exponential growth which is perhaps the most powerful force in our world. Some might say “well you can’t have continuous growth foreverâ€. Well, few people understand that, in our current financial system, you can. Most central bankers in the world (FOMC, ECB BoC, BoJ, etc…) have explicit (or implicit) goals to maintain inflation between 1% and 3% per year forever. This is easy to do as we now have a “fiat†(paper) monetary system. Most systems withdrew from the gold standard (money supply based on amount of gold in the vault) after Richard Nixon in 1971. It is now extremely easy for central bankers to maintain a positive inflationary environment as they just print more money (or type a few keys on a keyboard). The next few years will prove to be difficult for central bankers (no question) but don’t you worry, central bankers will prevail (I wouldn’t bet against them!). Basically, the way most financial systems work today, inflation acts as a form of stealth tax on the masses. Your living standards are continuously eroded by inflation (a dollar today will be worth about 1 cent next century). The reason governments support this system is that it’s a great way to secretly reduce national debts. These huge gov’t debts continuously decrease in relation to the overall economy, thus becoming more manageable and easier to pay off.
This is the beauty of real estate investment. Provided you invest in the right area at the right price, don’t over leverage (never invest with just 5% down), and are prepared to wait, you will handsomely out perform most any other asset class. You’re basically taking advantage of the system in the same manner as governments. Let it work for you and not against you!
There are three main barriers to entry which explain why most people choose not to invest in real estate:
1) Large lump sum- At least 20%-25% is required to ride out the bumpy years. You can easily lose a lot of money if forced to sell in a down market
2) Time- The two main ingredients to compound interest are growth and time. Growth is easy, you’ll get that from Mark Carney. Time is the tricky one. You need to wait at least 15 years to begin bearing fruit and to fully maximum your investment 40+ years are required. I suspect most people on this board are under 40. You basically have to pre-commit to a long holding period (as long as your life to date) and begin investing as early as possible. This is not easy.
3) Hands-on- Real estate is not something you can just purchase and through in the drawer. It requires continual maintenance and management. Unfortunately, most people do not want this added burden.
One final note on behavioural psychology. When things are going well, we humans assume things will continue in this fashion forever. When things go wrong, again we assume things will continue badly forever. It’s easy to read the papers and follow the heard but miss the broader picture. Nobody said building true wealth was easy.
