Housing is a decent investment. Is that true? Well… I think you have heard just about every argument for and against this, so I won’t bore you with the usual arguments from both sides. I will attempt to show a nuanced reason why I believe housing is a decent investment. And it begins with a 15 page mind-numbing paper from the bank of canada. See link below for BOC’s view of how the shelter component of the CPI is calculated. FYI, CPI stands for consumer price index (fancy word for inflation) which basically measures the cost of a basket of goods. If you want to know how it is calculated, please google the word.
The part of the CPI that I am interested in is the shelter portion. Conventionally, to a normal person, the cost of shelter can come in one of three forms: cost of purchase, cost of rent or cost of maintanence. It should become very obvious to most that depending on which approach we use, this shelter index could vary greatly. For example, if we are to use Vancouver as a simple case, the cost of purchase and recently the cost of rent has increased more than the cost of maintanence. This is because the cost of maintanence which includes such measures as mortgage costs, property taxes, insurance, etc hasn’t exactly gone up to the same extent as market prices or even rents now. This is partly because we are in a low rate environment. As any good real estate investor knows, our biggest cost is usually the interest on that mortgage.
Wait, is that the correct way of calculating the shelter portion (which accounts for a decent percentage of the actual CPI)? It really doesn’t matter what you and I think, it’s more of what does the BOC think? Well, they use a convoluted or what they call truncated version of “user cost approach”, which is closer to option 3, so basically some form of equivalent rent, mortgage cost, insurance, property taxes, etc. It does not actually take into account the cost of buying a home, ie how much you actually pay for the house itself. So if you are wondering why the shelter portion of inflation is relatively low when the real estate prices have skyrocketed, you have your answer here.
Now, why is this relevant? Well.. it’s relevant because central banks use a policy called inflation targeting. See, they try to keep the inflation rate (CPI) at around 2 percent a year (that number seems arbitrary, the best explanation I have gotten is from Ken Rogoff where he thought 2 was sufficiently far away from 0 yet not large enough to cause high inflationary concerns). When it goes above the target, they make money cost more by raising interest rates, and when it goes below, they make money cost less by lowering interest rates. More on this in another post. Those who have followed the equity markets lately would note that the CPI is barely around 2 percent right now and the central banks have had a hard time maintaining that target. That is, except if we changed the way we measure CPI.
See, before 1983, the United States used to calculate CPI using the actual cost of housing. There are some online papers who have suggested that had we continued using this method the CPI would actually be closer to 5 to 6 percent in the United States. Given that the central bank’s lending rate is tied to the CPI growth rate, we should be seeing far higher interest rates than today if we measured it the old fashioned way.
This brings me to my point. Imagine if I gave you a long term investments whereby your return on capital is 5 to 6 percent (CPI rate calculated using the actual housing cost rather than the user cost approach), and then I lent you money at 3 percent (a simple scan on ratehub would show that most major banks 5 year fixed rate for their best borrowers are coming in under 3 percent at the date of this blog post), then I allow you to leverage 80 percent of the total cost of purchase, this in theory should, over long period of time produce decent investment results.
The part that people miss about real estate is that in reality, it is one of the few investment vehicles that we can use to achieve a low cost of capital and decent leverage. If the bank is willing to lend me 5 to 1 leverage and allow me to buy S&P 500 ETF as collateral and hold it for 25 years I would be thrilled (don’t try this yourself, there are a lot of risks with investing in equity markets and this is not an endorsement for that strategy), but the reality is, they don’t do that (I checked, they kind of laughed at me and pointed me to a unsecured line of credit which cost about 8 percent to do that today, yikes). So, one of the key advantages in real estate investment is the low cost of capital. It is one of the few places that we can borrow capital at below 3 percent.
Thus, when you combine this with the CPI calculations above, you can see that real estate is actually a very attractive investment. That is until they decide to revert back to the way we calculated CPI before 1983, then the cost of capital will skyrocket thus making it a terrible investment. This is my two cents. Please do your own research as there are a lot of risks with investing in real estate and the use of leverage.