Real Estate Appreciation

One of the things I find interesting about human cognition is how we handle different intellectual tasks.  Catching a ball is an INCREDIBLY tough task on the surface, the catcher needs to:  estimate the ball’s current location, estimate it’s current direction and speed of travel, apply the force of gravity to it to determine its trajectory, position her hand in the right location and tense the muscles at the moment of impact.  We do this so effortlessly that children can learn to do it after a few attempts.

Compare this to deriving the area of a circle.  The concept is quite simple, but you have to think pretty hard to get your head around it the first time you come across it. Our brains are clearly better optimized for projectile motion than for geometry.

One of the things that throws us is rates of change.  To really bake someone’s noggin get them thinking about non-linear rates of change, such as exponential growth.  We all know compound interest is great for our money, but it’s very easy to make mistakes when we start trying to reason about, and make extrapolations in, such situations.

A number of investing myths are based on such misunderstandings, and one of the most popularly believed is that location inherently affects the appreciation rate of property.  As one real estate software site suggests:

The location of a property can affect how fast it appreciates in value.  Water properties have been increasing in value at a fast pace.  There is a finite amount of water property available in the United States and demand has been increasing.  More and more people are reaching retirement age fueling the demand for recreational property.

Sounds reasonable, a commentor many moons ago made exactly this argument.  Similar arguments are made about different price tiers of real estate and properties in world famous towns appreciating faster than the market as a whole.

John Reed responds to this myth (and, in my opinion neatly demolishes it) with comments such as:

“No price category appreciates faster consistently. It would be mathematically impossible because that category would eventually cost too much for anyone.”

and

“However, I have never bought the notion that high-priced homes appreciate at a higher rate than moderate-priced homes. If it were true, the disparity between the two would grow greater as a percentage year by year. Say that in 2004 the median price of a high home were $400,000 and the median price of a moderate home were $250,000. That means the moderate home is 62.5% of the high one.

Then say the high home appreciates 10% and the moderate, 5%. That gives new prices of $250,000 x 1.05 = $262,500 and $400,000 x 1.10 = $440,000. Now the moderate home is only $262,500 ÷ $440,000 =59.7% of the high. Run those numbers since the beginning of home building and you get something that bears no resemblance to current reality.”

I was convinced the first time I read the first quote.  Mr. Reed only talks about appreciation rates for different categories of the housing market, but to my mind the same logic clearly holds for other situations.

To be clear, I’m *not* saying that all houses in a town have the same value, and I’m *not* saying that housing in all towns have the same value and I’m *not* saying waterfront property has the same value as non-waterfront property and I’m *not* saying that transitional areas can’t appreciate at a different rate during the change.  What I’m saying is that all properties, on average, tend to appreciate at the same rate (so if waterfront property is twice the value of non-waterfront property, it will tend to remain twice the value into the future).

So, say non-waterfront property was worth $100k and a waterfront property was worth $200k.  If the non-waterfront property went up $10K and the waterfront property went up $20K (over some period of time), their appreciation rates are identical (10% in both cases).

While factors exist that may temporarily distort appreciation (often economic issues that lead to more people moving into or out of a community), these WILL be temporary.  If an aging population fuels higher appreciation of waterfront property, then once this population gets to an age they can’t enjoy these properties any more there will be a lower appreciation as these properties flood back onto the market.

Let’s go through an thought exercise for anyone who still doesn’t believe it.  You (the reader) and I are two Roman siblings who move to Egypt in 10 AD (or, in 10 CE for people who are morons).  I buy a nice little villa in the heart of Alexandria for 10,000 denarii and you buy a similar villa (on the water) for 20,000 dinarii.  We each marry locals and have many children – our Greek slaves shout opa! – who each remain in these ancestral homes, maintaining them, updating them, dealing with political turmoil, and living their lives.  The properties get passed down through the next 2000 years at which point our descendants get together to compare the values of the identical modern houses they’ve each had recently built on our respective plots of land…

Say we accept that there’s a higher appreciation rate for waterfront property, and let’s make it TINY (a 1% difference).  Proponents of faster appreciation claim MUCH higher rates than this.  Currently, in Alexandria, your property is valued at LE 800000.00 (or $147,378.16 Canadian), quite reasonable for what looks like a beautiful place to live.

Given a 1% difference in appreciation, this would mean my comparable, inland property would be worth LE 0.0018 (800 000 / (1.01)^2000)).  This would be 0.03 CENTS Canadian.

As Mr. Reed eloquently puts it, “you get something that bears no resemblance to current reality.”