The Money Illusion

February 05

In the last month, for various reasons, I have been spending a fair amount of time with economists and hedge-fund types. It has long been my view that getting a wide range of viewpoints on investment is helpful, and that experience and understanding from another area of the market can illuminate our understanding of how we profit in property.

The Money Illusion is something that these professional investors assume, sometimes correctly, that we property investors do not understand. For those who have not come across the term, let me start with a definition (from www.amosweb.com). Again, to explain the terms, a nominal price is the price measured in pounds. A real price is the price that you get if you take into account inflation, and the fact that a pound today buys less than it did a while ago.

The erroneous perception that a change in nominal wages or income [or, house prices - yourpropertyexpert.com] results in an equal change in real wages or income. Money illusion occurs due to a difference between the actual prices and perceived prices. In particular, people usually have better information about nominal wages or income received than the prices paid for goods and services. For example, a worker might receive a 10 percent increase in nominal wages view this as a 10 percent increase in real wages (and living standard) by failing to recognize that the price level in the economy has also increased by 10 percent.

Now, how does this pertain to house prices, and in particular, how can we use this information to make money?

It is my belief, based on past evidence, that in the long term, house prices go up in line with average earnings. Which is to say that, in real terms, house prices do not actually go up. However, overlaid on this general increase is a very wide curve that goes up and down wildly with very little predictability. However, putting aside questions of timing, over the long term, house prices stay constant in real terms. Scarey stuff.

Suppose I buy a flat for 100,000. At the time, a washing machine costs 200. This means that a flat is worth 500 washing machines. Let us now wait a few years... I am not attempting to predict how many... but at some time in the future the same flat will be worth 200,000, a doubling in price. What we would expect, however, is that the washing machine now cost 400. So the flat is still only worth 500 washing machines, despite the fact that in nominal terms, it has doubled in value.

Now, it may be that washing machines are a bad example, since it may be that some technological innovation means that they come down in price. However, I find that it's easier to pick a concrete example of something that has a price, rather than use a waffly term about broad baskets of goods. Maybe a better example would be a Mars bar. At 50p, a 100,000 flat buys 200,000 of them. In the future it is easy to believe that Mars bars will be a pound - it does not seem so long ago that they were 10p, not 50p.

Armed with this set of expectations, we can now proceed to make (real) money, but using leverage. (And I will stick with washing machines.)

Suppose that, in order to buy the 100,000 flat, I put in down a deposit of 20,000 (which is to say, 100 washing machines). Thus the lender has advanced me 80,000 (which is to say, 400 washing machines) - at the 200 per washing machine price.

Roll forward in time again, so that the flat is now selling for 200,000, and washing machines are selling for 400.

The assumption that many investors fall into is thinking that their stake has gone up from 20,000 to 120,000 (ie - the 200k that the flat is now worth, minus the 80k they still owe the bank), and thus believe that they have multiplied their wealth six-fold.

In fact, that 120,000 is only worth half what it used to be - that 120,000 will only buy 300 washing machines. Which is to say that their wealth has gone up three-fold, not six-fold.

Two lessons to learn from all this:

• be careful when looking at how much money has supposedly been made. Particularly in periods of high inflation, the gains may not be as great as the raw numbers might make you think.
• even despite this stuff about money illusions, the long-term investor still makes money PROVIDED that the rent in the mean time has covered the rent and other expenses.

Even better, what all this ignores is that, provided a property is just cashflow-positive, or even cashflow neutral at time of purchase, then inflation will gradually increase the rent income, without increasing the interest payments. So after this time, the property can be generating substantial cashflow to the investor as well as being a capital asset. The stock market types tend to forget how much higher the cash yields of rent are compared to the paltry dividends that most stock investments gain.

This is just the feature article from the February 05 newsletter. Subscribe for market comment, forthcoming events, and more.

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