Saturday, June 4, 2011

Calgary’s Housing Prices Driven by Oil Prices and Inflation

Dean Baker was quoted in Globe investor as saying that housing prices over the long term (100 years) follow inflation. The Globe called Mr. Baker "The Man Who Called the Last Two Bubbles". If it earns distinction to call right two major bubbles, then I guess us less enlightened souls have no chance to call right a run of the mill recession or market crash. So much for market timing!

Everyday we're hearing that we're living in bubbles and thus that we must live a bubblicious life! But are we in Calgary living in a housing bubble? What is an appropriate price for an average single family dwelling? We discussed already that property pricing lies in the eyes of the beholder and that a real investor looks at pricing quite different than someone who is buying his/her dream home.

But the true value of property prices is ultimately determined by the market. So I pulled out the old graph to see if Dean Baker's observation that long term property values do trace inflation makes sense. The graph is shown below:

Calgary's average single dwelling price versus time. The slope of the blue line represents approximately 4% which is close to Canada's 40 year average inflation rate of 4.6%

Starting in 1973 up to today, a 38 year time range, the average annual price of a single family dwelling in Calgary increased at 7.95% per year. But not at a steady pace! Look at the graph again; you may notice that the price trend can be subdivided into 3 segments:
  • 1973 – 1982
  • 1982 – 2005
  • 2005 – today
If you calculate the average price increase between 1973-1982 and compare it with 1982 (after the crash) to 2005 it can be concluded that they were more or less the same: around 4% (slope of blue line) which is close to Canada's average inflation rate over the past 40 years (4.6%). So what caused the crash in 1982 and the upturn from 2005 to 2007? Duuuh! The oil price! In 1982 the oil price crashed from an all-time high that had been building all through the 1970s.

From 1982 until 2005 were Calgary's 'misery' years when the rest of the world boomed due to falling inflation and low commodity prices, including oil and gas. If you think $4.25 per mcf for gas is low then check natural gas prices in the 1990's when we got excited about $1.50 per mcf!

It looks to me that Calgary is still an oil town and that real estate prices are governed by inflation and that sudden jumps or crashes reflect commodity price trends, in particular those of oil and gas. So provided that commodity prices hold, our real estate prices will likely increase at a rate more or less equalling the inflation rate (long term). With a new long term period of increased inflation likely ahead, real estate investments should provide a good hedge (barring another major oil price crash). I guess if you look at a glass being half full, you may want to say that we may expect a significant bump upwards when gas prices recover
A final lesson to be learned is the notion that if you break even between rental income and operating costs, you'll do OK in real estate. But if you really want to make money you need leverage. The reason is simple high school math. Without leverage your property value increases with inflation, i.e. you don't win nor lose in purchasing power. But assume your $100,000 property increases with inflation of say 4.6%, i.e. by $4600 per year, and you have a mortgage equal to 80% of your property value (Loan to [property] Value = 80%) then your own money invested is only $20,000. A profit of $4,600 would then represent a return of 23%!

Conclusion: in times of inflation leveraged real estate may be hard work but it also will proof to be very profitable.

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