Real Estate Appreciation – It Can’t Beat Income Growth

A Guest Post from Paul Gabrail –

I have family/friends in many “hot spots” for real estate in this country: California, Florida, Arizona, Massachusetts, etc…They think that prices will go back to a stable growth rate.  When I inquire about what they think a normal stable growth rate would be, I have heard 6-7% and I am floored.  Granted, not everyone says that.  Most of them say “I don’t know” and they just leave it at that, which is probably a better answer than 6-7%.

I know that many in this country are used to the 2000s where rates of growth were in the double digits in many markets across the country. Most would think that 6-7% would be very reasonable compared to double digit growth rates, which is something I can understand.  But just like the stock market and other investments, just comparing to boom times and bubbles is going to cost someone in the long run.

Do you want to know how much real estate in your area will go up?  Well, there are two major factors: Supply and Demand. Just like everything in life, supply and demand is key. I have a previous post titled Real Estate – Supply vs Demand…which is more important? in which I discuss the supply side in great detail, but from the demand side, there is one major factor that matters: Income growth.  For the long run (20+ years), and keeping supply issues (population growth and land availability) constant, real estate values cannot grow at a pace that exceeds the income growth in that particular area.  Does it sound complicated?  I hope not. But if it does, here is the logic behind it…

Let’s say that someone who makes $50,000 per year can afford to buy a $100,000 house.  Nothing crazy.  So let’s say in 20 years, their income has gone up 5% per year and they are now making $132,000 per year.  It is logical for someone to say that since their purchasing power has increased by 165%, they should be willing to pay 165% more for that $100,000 house.  That is not an unreasonable hope/expectation.  So their $100,000 house has gone up to $265,000 in value and that makes sense.  Now, just extrapolate that out as 1,000,000 people in an area who have an average income of $50,000. They should all be willing to buy 1,000,000 houses worth $100,000 each.  The percentages are the exact same, but the amount of dollars is much higher, but it’s all the same math.

So now let’s look at what my friends/family are saying and let’s look at some historical data from certain areas.  They believe that in these major markets they should be able to see 6-7% appreciate per year over the long run.  Let’s pick one spot: California.  Very nice climate.  People are moving there.  Business is moving there, so it’s a happening state. The supply side of the equation is definitely HELPING real estate values.  Back in 1970, the population of California was 19,950,000 and now it’s over 37,000,000! That is a large increase for such a large state as it is.  So clearly there was increasing demand in real estate as their population went up almost 90% in 40 years! Compare that to my home state of Ohio which has only gone from 10,600,000 people to 11,500,000 people in 40 years.  A mere gain of 8.5%!

Since 1970, the average home in California has gone from $25,000 per house to $160,000 per house which is an annualized increase of 4.4%.  Still VERY respectable and a nice appreciation rate. Yes, they have seen the brunt of the drop in the last few years, but they also saw the large increase in the late 1990s as techs were booming and in the early to late 2000s as interest rates were low and real estate values were skyrocketing.  Meanwhile, the average per capita GDP in California was $4810 per person to $53,000 per person, which is an annualized increase of 5.75%!

So, as I said above, real estate values will most likely  NOT grow at a pace faster than the increase in income, so even with a state like California who has doubled its population in 40 years and has seen growth each year and has experienced the highs and lows of real estate…they still haven’t seen massive price appreciation above regular income.

Now compare it to Ohio. Like I said…barely any increase in the population.  Let’s compare income to real estate values.  In 1970, the average house in Ohio was selling for $17,600 and today, the average home is selling for $151,320, which is an annualized increase of 5.57%! So in a time where Ohio only gained 8.5% appreciation while California almost doubled, we outpaced them in appreciation as a state.  Let’s look at income: In 1970, the average Ohioan made $4086 per year and now they make $42,083, which is an annualized increase of 5.57%!  Again, in a very consistent population growth state, we didn’t even see real estate values beat the growth of income.

If all this data was a lot to grasp, look at the chart below to see the recap:

As you can see above, income grew at a rate 30% higher than real estate values per year in California over the 42 year period and 9.2% higher in Ohio per year over the same period.

So going back to our example above of the person making $50,000 per year and buying a $100,000 house, if their income increases by 5% per year, in 20 years, they will have the $132,000 in income, but if the real estate values go up by 7% per year, a mere 2 % difference, instead of having a house at $265,000 to purchase, their house is now $386,000! Quite the difference and on income of $132,000, that may be a bit harder.  Go 20 more years, and the 5% increase in income goes to $350,000, but now their house at 7% is now having to be purchased for $1.497Million! Clearly, the same house with the same wage earners cannot grow that much higher than income levels over the long haul.  It has to be like the situation above where income outpaces real estate values and, at worst, they grow at the same rate.

As you can see from this chart, the same house went from 2X the income of the individual to almost 5 times the income! Any mortgage banker will tell you that a house cannot be bought for $1.5MM on income of $350,000 per year! Granted, it took 40 years, but even after year 20, it was almost triple the income.  It’s just a matter of time before things have to settle back to normal.

Unfortunately, as our economy matures more and more, I don’t think the rate of income over the last 40 years will be the same for the following 40 years.  Our economy is too mature and strong to have the large growth rates that we had experienced in the past. if the last 40 years didn’t beat 6-7%, why would we expect the next 40 years to do the same?

About the Author: Paul Gabrail is a partner at Select Investment Group, a real estate investment firm, and a blogger at thecapitalistmanifesto.com. For more articles and thoughts like this, follow Paul on Twitter @capmanifesto, subscribe to his RSS feed or visit his blog thecapitalistmanifesto.com.