House prices historically have outpaced inflation by 0.7% nationally. In a normal market, this is the only appreciation homeowners obtain. This appreciation is caused by wage inflation translating into higher housing payments and the ability of borrowers to obtain larger loan amounts to bid up prices. In some areas where wage growth has outpaced the general rate of inflation, the fundamental valuation of houses has increased faster than inflation.
Of course, inflation also erodes the buying power of money, so properties that only appreciate at the rate of inflation do not see any real benefit. The property sells for a profit later, but the buying power of the money received is no greater than the buying power of the money put in to the deal. With no real benefit, inflation equity serves merely to preserve capital. It does not contribute to wealth generation.
People who purchase real estate use the phrase "building equity" to describe the overall increase in equity over time. However, it is important to look at the factors which either create or destroy equity to see how market conditions and financing terms impact this all-important feature of real estate.
In simple accounting terms, equity is the difference between how much something is worth and how much money is owed on it (Equity = Assets, Liabilities). For purposes of illustration, equity can be broken down into several component parts:
The related benefit to home ownership obtained through utilizing a fixed-rate, conventionally-amortizing mortgage is mortgage payments are frozen and the cost of housing does not increase with inflation. Renters must contend with ever-increasing rents while homeowners with the proper financing do not face escalating housing costs. Over the short term this is not significant, but over the long term, the monthly savings accruing to owners can be very sizable, and if the owner owns long enough or downsizes later in life, housing costs can be nearly eliminated when a mortgage is paid off (except for taxes, insurance and upkeep).
Although this inflation benefit is attractive, it is not worth paying much of a premium to obtain. The long-term benefit is quickly negated if there is a short-term additional cost associated with obtaining it. For instance, if a property can be rented for a certain amount today, and this amount will increase by 3% over 30 years, the total cost of ownership, even when fixed, cannot exceed this figure by more than 10% to break even over 30 years. The shorter the holding time, the less this premium is worth. In short, capturing the benefit of inflation equity requires a long holding period and a minimal ownership premium.
The Great Housing Bubble was a period of low inflation and quickly appreciating house prices. Few people concerned themselves with the inflation premium when there was so much speculative equity to be gained. However, the inflation premium can be substantial when the ownership period is long, and in the aftermath of the Great Housing Bubble, inflation may be the only source of appreciation for some time to come.
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