Understanding Real Estate Prices
A prerequisite to understanding real estate prices (specifically, their year-over-year movements) starts with a solid understanding of nominal vs. real prices. Nominal prices ignore inflation, whereas real prices (quite appropriately named) consider and adjust for the rate of inflation.
Inflation can be described as the wasting away of our money due to governments adding to the money supply. Inflation is a bad thing. It makes us need to keep working and making more money. It forces us to participate in financial markets by way of investing because if you simply leave your hard-earned cash in a piggy bank or under a mattress, you will one day have next-to-nothing. It’s a form of government and corporate control; reach really took off once we dropped the gold standard. But that’s another topic…
So, why does the Toronto Real Estate Board (TREB) post their real estate figures using nominal prices? Simple, it influences you, and everyone else, to think that real estate is a better investment than what it really is. A little bit of self-serving statistical storytelling, if you will. They pufferize the stats; as my lawyer friend, Joe, would often say. Think: puffer fish.
Look at the overall annual gains the Toronto Real Estate Board (TREB) has posted for the following years of sale prices: 4.3% in 2009; 9.1% in 2010; 7.8% in 2011; 6.9% in 2012; and 5.2% in 2013. Compounded annually (most everything in life is compounded), that equates to a whopping 38% nominal rate of return over five years!
But wait – you want to know what the real rate of return was, don’t you? After all, it is real estate and you are a real person, not a nominal person (does that even make sense?). Anyway, in order to calculate the real rate of return, we must adjust for the level of inflation.
I can write another twenty pages about inflation but I won’t, at least not here. Suffice it to say that I don’t believe the government has a vested interest in overstating the rate of inflation, seeing how they’d quickly plow through their budgets and end up having to not grow as fast as they’re already growing.
So, for argument’s sake, let’s say that inflation averaged 2.5% every year over the past five years. With that, TREB would have to post the following: 1.7% in 2009; 6.9% in 2010; 5.2% in 2011; 4.3% in 2012; and 2.6% in 2013. Compounded annually, that equates to a much more (actually, 100% more) realistic real rate of return of 22% over the same five years. That’s more like it!
Tell me the truth, Agent Gus!