“Back When I was a kid…"
This is something that you may have heard quite a bit growing up. Heck, you may have used this line yourself 😉 When we typically hear this line it is followed immediately by something like, “I walked barefoot to school, in the snow...uphill....both ways.”
Apart from those always interesting moments of reminiscing, I often hear this same sentiment spoken about with regards to the price of real estate and goods. In particular, I hear people say, "Homes [or fill in the commodity] were so much cheaper when I was growing up than they are now." Which prompts me to ask, "Where things really cheaper back then?"
I know that prices of real estate today are higher in most of the country than they were 10, 15, 20+ years ago. This applies to real estate and almost all goods and services. However, while prices might be higher, that does not necessarily mean that real estate was "cheaper" back then compared to today. The change in price is not a true measure for what is the true "cost" of the property. When I say "cost," I mean people's ability to actually buy the item at the time.
There are many factors that influence the true "cost" of goods, like salary, unemployment rate, availability of credit, etc. However, the factor that we will examine here is inflation. Inflation is simply the buying power of money weakening while the price of goods are rising.
Because of inflation (not to mention, our friend time value of money), it makes it impossible to compare the cost of property from two time frames by simply comparing the price. Rather, to compare property prices from different time frames, we are going to evaluate prices relative to historical rates of inflation to see how the price of property moved relative to the buying power of the dollar. While this is not the only metric to measure whether properties were "cheap" or "expensive," it is a good place to start.
Let’s see how his plays out. I recently found a 3 bedroom, 2 bathroom home in Los Angeles that just sold for approximately $430,000. Back in 1993, this same home sold for approximately $130,000. At first glance, that seems like a huge price increase that definitely supports the “when i was a kid” argument. The question is, was the price in 1993 that much cheaper relative to today? I mean, did the price of the home increase faster than inflation/the buying power of the dollar? Let’s find out.
To determine this, we have to see how much $130,000 in 1993 would be equivalent to in today's dollars. In this example, we will assume an average historical rate of inflation of 3.2% (this is a common historical average that I see for this time period, but if you have a different number, feel free to use that). To determine the value of $130,000 in today's dollars, we need our trusted financial calculator. If you don’t have a financial calculator, no problem, simply follow along and everything will be explained.
Answer: (input the following into your HP10bii Financial Calculator)
N (number of months) = 288 (24 years x 12 months/year)
I/YR (interest rate/year) = 3.2 (we are assuming an average rate of inflation during those 24 years of 3.2%)
PV (present value) = (130,000) (this is the value of the home in 1993, notice you must enter this as a negative into the calculator.)
PMT (monthly payments) = 0 (there are no monthly payments here)
FV (future value) = ???? (this is what the value should be today if it appreciated at 3.2%)
After entering this information above, the answer comes out to be $279,922.36. Meaning, that if the property above simply followed the average rate of inflation of 3.2%, today it should sell for approximately $280,000 today, not $430,000. So, this property beat the rate of inflation, resulting in an increased value of $150,000 more than it would be if it followed the "normal" path. For this property, the "when I was a kid" line actually works.
Now, the question becomes, how much did that property actually appreciate? In other words, by how much did it beat inflation? To figure this out, we will go back to our financial calculator.
Answer: (input the following information into your HP10bii Financial Calculator)
N (number of months) = 288 (24 years x 12 months)
I/YR (interest rate) = ??? (this is what we are solving. We are working to determine at what interest rate the property appreciated)
PV (present value) = (130,000) (this is the price at which the property sold 24 years ago, once again, when you enter this into your calculator it is a negative)
PMT (monthly payments) = 0 (there are no monthly payments)
FV (future value) = 430,000 (this is the value that the property sold for present day.)
After entering the information above, the answer comes out to 4.99%. This means that the rate of appreciation for this property was actually 4.99% over the last 24 years, or 1.8% more than the historical rate of inflation.
One interesting part of this analysis is the huge difference that a small change in interest can have. There is only a difference of 1.8% between the two situations. However, that small change in interest resulted in a price difference of over $150,000 between the two options. Definitely food for thought on your next negotiation....
OK, now I understand that not every part of the country appreciates like Los Angeles. Some areas are better for appreciation, while others are better for cash flow. So, we will examine another home in another area to see whether the "when I was a kid" line works there when looking at prices. The second home that we will examine is near where I grew up, just outside of Atlantic City, NJ.
This home is a 3 bedroom, 2 bathroom home that sold in 1993 for approximately $115,000. It recently sold for approximately $210,000. Let's see if this property followed the historical rate of inflation.
Answer: (input the following into your HP10bii Financial Calculator)
N (number of months) = 288 (24 years x 12 months/year)
I/YR (interest rate/year) = 3.2 (we are assuming an average rate of inflation during those 24 years of 3.2%)
PV (present value) = (115,000) (this is the value of the home in 1993, notice you must enter this as a negative into the calculator.)
PMT (monthly payments) = 0 (there are no monthly payments here)
FV (future value) = ???? (this is what the value should be today if it appreciated at 3.2%)
After entering the information above, the answer is $247,623,62. Meaning that if the property followed the historical rate of inflation that it actually should have sold for approximately $250,000, rather than $210,000. So, while the price of the property today is much more than it was back in 1993, it is actually "cheaper" today than it was in 2017 as the buying power of the dollar relative to the price is better today than it was in 1993.
So, at what rate did this property appreciate? Let's find out.
Answer: (input the following into your HP10bii Financial Calculator)
N (number of months) = 288 (24 years x 12 months/year)
I/YR (interest rate/year) = ??? (this is what we are solving)
PV (present value) = (115,000) (this is the value of the home in 1993, notice you must enter this as a negative into the calculator.)
PMT (monthly payments) = 0 (there are no monthly payments here)
FV (future value) = 210,000 (this is what the home sold for recently)
The answer is 2.51%. So, the property appreciated at a rate of 2.51%, or .7% under the historical rate of inflation of 3.2% and half of the rate of appreciation compared to the Los Angeles home. This ultimately means that the value of the property, even though it is nearly double what it was in 1993, is really "cheaper" today than it was in 1993, as it increased at a rate lower than inflation. Thereby, hurting the favorite "when I was a kid" story for this particular home.
In closing, while prices might be higher today than they were in the past, that does not mean things are necessarily "cheaper" today than they were back in the day. To determine whether something was truly cheaper, there are a number of factors to consider, the most important is how does the increased price compare to the rate of inflation. The inflation rate gives people the ability to compare prices of properties/goods across time periods. So, next time someone starts to reminisce about the "good ol' days" and how things were so much more affordable than they were today, make sure that you have your financial calculator handy.
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Thanks, Buddy Broome, for thoroughly explaining real estate appreciation as separate from inflation. Can you go a little further and compare the two houses from this example, by comparing all the expenses, such as real estate commission, sales tax, annual taxes-real estate, school, county, municipal, tax breaks on income property, repairs on a house and other expenses, plus rental income? I would like to know if there is really any substantial profit in buying a home or rental house, and is it better to buy in somewhere like LA where the appreciation is better, but which said appreciation profit could be eaten up possibly by taxes? Many thanks.
Hi Margaret, thank you very much for reading my blog, I am really glad that you got so much out of it. You also put out some very good questions, and I will do my best to answer them. With regards to expenses for properties, I think a good starting point is 50% of gross income. Meaning, if you buy a residential property and it has a monthly rent of $1,000, then typically 50% of $1,000 (or $500 in this instance) will go towards property taxes, insurance, repairs, utilities, vacancy, etc. This does not include the mortgage payments. Mind you, this is not a set a stone number, but it is a good starting point to figure out what the net rental income would be. I find that in reality, this is pretty close to what the expenses will be, but ultimately each property is different so you have to do this on a case by cash basis.
With regards to the commissions and sales taxes, that only happens when you sell. Typically realtor commissions are around 6% and tack on maybe an extra percentage for closing costs. “Sales tax” depends on is a rental property sale, a personal residence, or a flip? As each has different standards and rules. You have to sit down with your tax professional to guide you through this. However, one of the awesome things about rental real estate (as opposed to other investment vehicles) are that you can defer the taxes from a sale of a rental property (not a flip), so long as you perform a tax deferred 1031 exchange (that is the Internal Revenue Code number) and follow all of the rules. That requires a 1031 accommodator to assist with this process. It is an extremely powerful tool in real estate that is not available in other types of investments. However, there are some instances when you cannot perform a 1031 exchange depending on the situation, so please consult with your tax professional before relying on any tax advice here.
With regards to whether real estate is a good investment, I believe it is awesome. It gives you cash flow from the rents, appreciation, amortization of the loan, and tax benefits not available in any other investment vehicle. Additionally, an important thing to consider is that real estate allows one to use “leverage”, which ultimately means that while a property may appreciate at 4%, the investors returns can be much higher because of leverage. To see a brief explanation of how leverage works, check out my blog on this subject: https://www.buddybroome.com/give-me-a-lever/ An important note, while leverage can super charge an investment, it can also be very dangerous if used incorrectly, as people found out in the last down turn (myself included). So, any property that you buy, make sure that it is positively cash flowing, so that the rents more than cover the mortgage and all of the expenses of the property. This will help to prevent you from getting into any problems.
With regards to area, it all depends. For me, I like to manage my properties myself, so I prefer to purchase close to me. However, some people do not mind being long distance landlords. Also, each area is different in terms of appreciation and cash flow, so it all comes down to personal preference and what you are looking for. If you are interested, I created a “Comprehensive Guide to Evaluating Rental Properties & Introduction to Seller Finance” which you can get for free by signing up for my newsletter. This Guide answers a lot of the questions that you have in greater depth than I can here. If you simply want the Guide, and don’t want to be on the newsletter, you can unsubscribe anytime that you like.
I hope that this helps, Margaret. Once again, thanks for reading the blog and for the great question. Have a great day and please follow up if anything I said is not completely clear or if you have anymore questions. Good luck!!