Sunday 6 October 2013

Why Rising Home Prices are Bad

There is absolutely nothing good about rising home prices. (Especially if it results in a housing bubble).

That's a pretty strong statement to say so I better back it up.

Real estate appreciation is like increasing the price of gasoline. When the price of oil goes up, oil companies, speculators and oil producing countries benefit. Yet a vast majority of society suffers as they are forced to pay more to fuel their cars.

No one is jumping from happiness at the local gas station when prices go up by 5 cents in a day.

Similarly, when home prices go up, it mostly benefits speculators, banks, and condo developers. While the above three pocket the profits, everyone else ends up paying more of their earnings towards their mortgage and, as a result, become more indebted. No wonder the average mortgage debt in Canada went up from $137,536 in 2006 to $190,213 in 2011.
Yet many Canadians ignore the fact that each year home prices rise, they have to take on more mortgage debt to buy a place than ever before.

Canadians view property as an investment. Real estate prices always go up.

Who cares that I have to take a $200,000 mortgage to buy a shoebox? In a decade I will sell my condo for twice the price to someone who would take a $300,000 mortgage to purchase the same place. In another decade somebody else would take a $400,000 mortgage to buy the same place. And so on.

Let's pretend that Toronto home prices will rise at 7% annual rate for the next decade. That would be a good investment?  Right?

Buy a two bedroom condo for $500,000 and in a decade it would cost almost a million ($983k to be exact).

But who are the buyers of real estate in 10 years?

Yes, some immigrants will be buying property, but for the most part, the future buyers of real estate in Toronto (or Canada) will be our kids - the younger generation.

I think it is safe to assume that if home prices double in a decade, the younger generation will be paying a larger proportion of their income towards owning a home than today.

After all, between 1990 and 2010 earnings grew 0.87% annually. The median household income in Toronto in 1990 was $55,400 and $65,900 in 2010.

This brings me to an important point.

While the older generation will enjoy a nice profit from their property appreciation, the younger generation will be left with the bill.

Rising home prices in the long run are nothing other than a transfer of wealth from younger generations to the older ones. This statement relies on assumption that home prices grow faster than incomes. 

I see nothing good about stealing money from future generations - which is currently happening as a result of home prices growing faster than incomes.

Finally, rising home prices often lead to housing booms which result in huge waste of money. During the boom years a lot of extra capital flows into real estate as more money could be made in the housing industry.

In turn this hurts manufacturing industry and overall competitiveness of the economy as capital chases easy money to be made in the housing sector.

A recent paper by the OECD came to conclusion that rising home prices hurt exports. They examined several countries with rising home prices and found than in every case exports were hurt as a consequence. See graph below:

As usual, in Germany - where real estate prices have been mostly falling since the early nineties - saw a big increase in exports as falling housing prices tend to boost exports.

All in all, rising housing prices and the resulting boom generates short term wealth for the few while hurting the overall economy in the long run. A real estate economy is not sustainable path for growth. Just look south to the US.

Summary of key points:

Rising home prices are bad because:

1. Real estate inflation benefits few people at the top while everyone else becomes enslaved with debt.

2. When home prices outpace income growth over the long run, a transfer of wealth from the younger population to an older one occurs.

3. Rapid property appreciations hurts the overall economy as it reduces exports and hurts manufacturing.




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