Friday, June 19, 2009

Inflation and House Prices

Following up on a conversation in the previous post, I thought it would be interesting to look at the correlation between consumer price inflation and house prices. This chart shows YOY BC CPI and the YOY change in Nominal Benchmarked house prices for Greater Vancouver. Click on the chart to make it bigger.

The correlation between the two series is 0.18 - not strong, but positive. I think we need more data than 15 years to prove conclusively that there is a link between inflation and house prices. The fact of the matter is that inflation has been relatively low for a very long period of time and interest rates have fallen dramatically during this low inflation period. We don't really know what much higher inflation will do to real estate values of the short / medium term but we do know that real estate is a very interest rate sensitive asset since most people use borrowed money to buy real estate. If I look back at high inflation periods in the past (the 70s), house prices were a much smaller multiple of personal incomes than they are today and rates were also much higher than they are today which would indicate that affordability is a combination of the interest rate and the price - duh!

If we expect inflation then we should also expect much higher interest rates eventually to bring the inflation down and this would deflate house prices as current house prices with a 10% or 15% mortgage rate would be out of reach for all but the super rich. As we know, the housing market is fundamentally a supply / demand based market and if there is no demand at a given price the price will fall until the price meets someone's ability to pay.


Anonymous said...

This is the exact conversation I had with my father last night. I think inflation will push prices up, while higher interest rates will pull prices down, leading to flat real estate prices in my opinion. The hyperinflation scenario would lead to much higher asset prices, including real estate.

Anonymous said...

This is the exact conversation I had with my father last night. I think inflation will push prices up, while higher interest rates will pull prices down, leading to flat real estate prices in my opinion. The hyperinflation scenario would lead to much higher asset prices, including real estate.

jesse said...

If we go to first principles, assuming future inflation risk is fixed, inflation should not in and of itself change the net asset value of a property. It's when the cost of capital increases, due to uncertainty of future inflation or competition from other investments, that real estate is negatively affected.

mohican said...

When talking about real estate as a 'hedge' against inflation it doesn't matter what you think rates or inflation will do. What needs to be done is analyze whether or not a hedging opportunity exists with real estate versus inflation - the data indicates no opportunity to hedge inflation with real estate.

From Wikipedia: In finance, a hedge is a position established in one market in an attempt to offset exposure to the price risk of an equal but opposite obligation or position in another market — usually, but not always, in the context of one's commercial activity. Hedging is a strategy designed to minimize exposure to such business risks as a sharp contraction in demand for one's inventory, while still allowing the business to profit from producing and maintaining that inventory.

A better hedge would be to purchase ETFs or futures contracts linked to asset prices that you will in fact use over the next 10 to 20 years or whatever hedge period you want to hedge for.

For example:

You could buy gasoline for all of the next 10 years of your personal gas consumption. You could buy all of the grains you will need in your diet for the next 20 years if you wanted. Or electricity, or coffee, or pork bellies, or whatever you like.

Buying real estate on the other hand is not a good hedge against inflation unless all of the below factors apply to your situation:

1) You are able to buy a place to live that will suit you for a long time and are committed to not moving for the entire period
2) You are able to hedge your interest rate risks away

I don't know anyone who 1) applies to and 2) takes significant knowledge and financial resources to do properly.

Anonymous said...

I think things are being over-complicated here. If there is inflation (it is still an assumption) real estate prices will go up. When interest rates rise to tame inflation, it will put a ceiling on real estate leading to most likely flat prices.

Somewhat of an unrelated question here and I hope no one takes this the wrong way as it is not intended to be offensive in any way but have any of you ever been bullish real estate? I have seen so many analyst, pundits or just regular every day people that are perma-bears on an asset class. Real estate, the stock market, Gold etc etc. Even though these perma bears always have valid points, a lot of the time they are just absolutely dead wrong and potentially ignore other valid points from the other side because they are so steadfast in their views.

Anonymous said...


I just saw your post. I am not using real estate as an inflation hedge, I'm using the house I buy to live in. My difficulty here is I don't want to buy if prices are going to go down, but I definitely don't want to rent and buy in a few years at much higher prices if inflation takes real estate prices higher.

mohican said...

chad - no offense taken - the dialogue makes us better so long as it is honest and thoughtful

I am not a real estate 'perma-bear' by any stretch. I happen to think that prices will likely come down to more sustainable / affordable levels in Vancouver over the next 5 years or so.

I purchased my first condo in 2004 for $114,000 in Surrey because it was cheaper than renting. I sold that same condo in 2007 for $200,000 because we outgrew the space and it was in a poor location for us. We did not rebuy immediately because we could rent for cheaper than buying until August last year when I snapped up a townhouse at a deeply discounted price that made it cheaper than renting.

I don't have any problem with people buying real estate for personal use provided it is cheaper than renting an equivalent property. There aren't really any properties in most of greater vancouver that meet that criteria. There may be some.

My main concern is that most people do not have much of a buffer or margin in their personal finances so that if they suffered an illness, disability, job loss, etc they would have limited financial options to help deal with the setback. This is especially true if they have bought real estate with less than 20%-25% downpayment.

Anonymous said...

For example I looked at a condo the other day in a building built in 2005 in the Retro on Hudson street. Selling for $375,000. 2 bedroom, 2 bath, very nice unit. A comparable unit in the building rents for roughly $1600/month. A mortgage with a 10% down payment, 30 year amortization would be about $1200 a month, $250 in condo fees and you're looking at very similar to renting. Furthermore, I'd likely rent out the other room for let's say $600 a month bringing my payments to $900 a month with only a $40,000 down payment. If interest rates look like they will spike dramatically, I will lock in the rates. Again, this is not an attack whatsoever, I'm just curious if there is something very big that I am missing in this equation because like a previous poster said, this is definitely the biggest financial decision I have made in my life to date.

mohican said...

chad - be sure you include property taxes, a contingency for unexpected maintenance items or special assessments, and please, please, please don't use a variable rate mortgage for your assumption.

Even if you decide to go with a variable rate please use a 5 (4.5%) or preferably a 10 (5.45%) year mortgage rate for your assumption because the variable rate, although attractive, is very risky - especially with such a large amount of money.

What if your variable rate goes from 2.7% to 4% or 5% or higher?

My other question would be, how much of your monthly income will be going toward housing costs? If it is more than 25-30%, I'd be looking to reduce that somehow.

Anonymous said...

I'd likely go with a fixed rate just for the safety and peace of mind knowing what I'll be paying. A fixed rate would take it to $1500 a month, $1800 with condo fees.

Mohican, I respect your opinions and analysis in a very big way and the main reason why I'm considering waiting for a year or two to buy and rent instead is because of your very bearish tone and if you think real estate prices are headed potentially 10% lower, then ultimately, I think they are likely headed 10% lower.

Unknown said...

Most people assess Vancouver real estate in terms of its relationship to cash, such as this discussion about inflation.

However, I believe the more important concern for Vancouver real estate is its relationship to other assets; particularly, real estate located in jurisdictions that provide better economic opportunities for educated, mobile, individuals.

If you think that ownership looks attractive compared to rent in Vancouver- what do think it might look in cities that have already collapsed or did not bubble in the first place. For example, the medium house price in the San Francisco Bay area is $377,000 U.S., and its medium income is $65,519 (U.S.). Whereas, the GVRD benchmark is $506,000, and its medium household income is $69,688 (Cdn.). Another 25% depreciation before lower mainland real estate start to look appealing.

Roberto said...

Your (and the government's) definition of inflation needs to be expanded. It is always and everywhere a monetary phenomenon. When the money supply is increasing faster than the GDP, you have inflation.

We have had inflation over the past 15-20 years, and rather high inflation over the past 5. Just because it hasn't been reflected in consumer prices such as eggs and LCD TVs doesn't mean it hasn't been there. The 'extra' money found its way into assets such as stocks and, yes, real estate.

alexcanuck said...

Chad: (From last post)
Canadian real estate historically is a terrific inflation hedge

Vancouver is a very different market than most of Canada. Don't lump them together carelessly.
RE is indeed one of the classic inflation hedges, no argument there.
Only problem is that Vancouver appears to be late in a classic speculative bubble, with the high leverage and marginal players that characterize the late stages of a bubble.
If inflation is the way this bubble is to play out,with the rise in interest rates that accompany inflation, and the economic woes that are virtually guaranteed either way it unwinds, so many players will be forced out that a much better entry point will appear.
If you read Mish's blog among others, (highly recommended to search his blog for "deflation if you don't already know the deflationist case) you will be aware of the possibility for deflation. He makes a compelling case. If so, buying now is a huge mistake. At least you're young, with (presumably) few assets, so walking away in the worst case scenario isn't the disaster it would be to me.
Whatever you decide, think long and hard, and good luck.

Anonymous said...

Thanks Alex. I understand the deflation case and I still think deflation will be the near term problem but long term I think we are in for some hefty inflation. Regardless of any argument made here, the most obvious case to me for Vancouver real estate being overvalued is a simple price chart which has gone parabolic and quite frankly, gravity applies to everything. I'd like to wait to see what happens after this spring bounce and that will obviously be telling to see if we do make new lows.

JimTan said...

Excellent! A careful and civic discussion.

Unknown said...

Mohican, what is the correlation with inflation and income? My guess is pretty high. If inflation goes up, your salary will as well.

Anonymous said...

Does anyone have a chart of Vancouver real estate prices with moving averages on it or possibly a linear regression channel?

Would be very interesting how far off we've really come from normality.

Unknown said...

I believe during stagflation, incomes typically rise much lower than inflation. So, this would be the scenario that chad should most fear, not deflation. Then you're looking at high interest rates and higher payments on basically the same income. I think it's also relatively likely.

Patiently Waiting said...

I think some people are already experiencing stagflation, and sadly those who can afford it least. I really feel badly for those who only earn enough for basic necessities (ie. food). They are suffering right now, I'm sure. :(

Patiently Waiting said...

It appears that part of the inflation right now is declines in both quality and quantity. A box of cereal is the same price but the box is slightly smaller or your socks wear out faster than they used to. Lots of little things chipping away at us.

Chad: What about your job or business? Few are as secure as people think. It's another good reason to wait a year or two.

Check out this story about mid-management types having to dumb down their resumes to get a job that pays half of what they're used to:

I already know people who've sold at a loss after a layoff.

buff_butler said...


You can make one yourself if you'd like. There is a link on the main site "UBC Sauder data". It has prices on a per quarter basis. It also has tons of other data... it really is a cornucopia of stats... :P

mohican said...

chad - wee

we have posted the linear regression here many times and needless to say we are still way above normal.

I will post an update to that chart again soon.

kcf said...

Good post as inflation is going to be a huge issue in the US in approx. 5 years after we discover the effects of Obama's stimulous package. I really think we are going to see high inflation like we haven't seen in a very long time with alot of people really hurting.

patriotz said...

If there is inflation (it is still an assumption) real estate prices will go up.

Wrong, wrong, wrong.

If CPI inflation increases, and interest rates also increase (as would be inevitable), and wages lag inflation (like in a recession you know) what does that mean for house prices? Use your head.

The reason that house prices have tracked CPI inflation over the long run is that wages have tracked CPI inflation over the long run - the effects of interest rate changes average out over cycles. What will happen if wages don't keep up going forward? Or even if they do, looking forward from today's historically low interest rates?

Tony Danza said...

I really think we are going to see high inflation like we haven't seen in a very long time with alot of people really hurting.

kcf can you please explain how you think this will play out? Did you notice the massive inflation in real estate and commodities that took place across the globe since the .com recession bottomed? Have you noticed the deflation since about last spring in wages, real estate (other than Vancouver) and commodities? The stimulus isn't even enough to fill the hole caused by lost homeowner equity in the US over the last year let alone losses in equities, CRE and unemployment.