Inflation and Housing Markets

My good buddy Nate is fixin to be released form purgatory and is moving. The move is job related. They are going from one town to a better job and a better place to live. Back in 2001 they bought the house that they now live in and just sold. Purchase price $118,500 in 2001, sales price in 2006, $192,000, it would look like they made a profit of $73,500. Nice chunk of cash right?

Not so fast. I know everyone’s talking about the great housing bubble and how house prices are through the roof. Like most things there is a reason for what we are seeing across America. The reason is inflation.

With the exception of areas that are high demand real estate locations, the home bubble is in part a reflection of inflationary pricing.

If we use Nate’s house sale as an example we see that $192,000 adjusted to 2001 dollars equals $169,250. In terms of what he paid for the house in 2001 he made a gross profit of:

$169,250
$118,500
$ 50,750

Pretty good just for 5 years of living in a house, but over $22,000 of his nominal profit was just the difference in how much the fed devalued the dollar. Considering that the ole boy made a return of about 8.5% per year on the place, I’d say he did ok.

Before you rush out and sell off the homestead to cash out and move to greener pastures you need to check the actual economic profit, not the nominal one.

First take what you think you could get for the house today and cost effect it to figure out the inflation. I can give you the formula, or you can use this.

Second subtract the cost of selling the house, real estate commissions etc.

Third, did you have a mortgage? If so subtract the interest you paid on the mortgage from the adjusted profit.

Forth, did you make any home improvements? Subtract that from the total. The amount left is what you actually have received in terms of real economic profit on the property.

Another example:
Year house bought 2000
Price paid $125,000
Value today $200,000
Value improvements $12,000
Closing costs @ 7% = $14,000
Mortgage interest on $100,000 at 6.5% = $31,500

Economic profit adjusted for inflation is:

$170,500
$125,000
$ 45,500
$ 14,000 less closing costs
$ 12,000 less home improvements
$ 31,500 less interest expense
$ -12,000 LOSS

Even if you had no closing costs or home improvement expenses you still would have only made $14,000 or 2.25% rate of return on the house.

I wish Nate’s clan all the best with the move and the new job. I know that they’d gladly bale out of where they are to go just about anyplace, regardless of profit or loss. Before you sell your place to take advantage of supposed high house prices, remember to look at how much of your house price is the result of inflation. You’ll often do better by paying off the mortgage than by cashing out and moving.