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What Really Drives Real Estate Prices —

The Golden Rule

If we’re going to be talking about the benefits of renting versus buying, we have to talk about why house prices rise and fall. It’s unavoidable! The price of real estate has an impact on the cost of renting, but it has an even larger impact on the cost of home ownership. Even more important, the popularity of home ownership is highly dependent upon the broad-based belief and expectation that house prices will go up.

Before we go any further, let me say that, as a general rule, in this book when I talk about houses and homes, I’m referring to all formats of housing: apartments, townhouses, semi-detached, single-family, and any other iteration of housing out there. All housing is priced based on the same group of factors, as we’re about to explore.

Of course, we all collectively have many discussions about housing, with friends, family, real estate agents, strangers, and co-workers. However, it is remarkable how few of those discussions focus on what makes houses go up or down in value. We have lots of conversations about how much our houses have gone up or down and what that means for our personal wealth, but not why they go up.

These conversations sometimes touch on topics that have some impact. Interest rates affect how much of a mortgage payment you can afford. Income growth is another topic that has something to do with house prices. Sometimes you’ll hear about new highways or new subways nearby that make transit better. That usually helps a house price.

The few conversations we do have about what drives house prices are usually short, at least in part because there are no clear answers and there are many factors at play. Is it population growth that drives house prices? What about inflation? Do houses always only go up in value, like many people say? The truth is that different houses go up and down for different reasons. Some houses go up, some go up a lot, and some go down.

House prices are driven by supply and demand. Everything else you hear about what drives house prices is about something that affects supply or demand.

We’re going to talk about some simple ways to think about houses that will give you a better chance at understanding how house prices will change over time, and also help explain how prices got to where they are today.

The most complete and true statement that anyone can make on the topic is that house prices are driven by supply and demand. Just like everything else in the world, if there are more people who want a product than there are of that product, the price will rise. If there is more of that product than there are people who want that product, then the price will fall. It’s that simple. Everything else you hear about what drives house prices is about something that is affecting either supply or demand for housing.

We’ll cover a number of things that can affect house prices, and every one of them is a factor that affects either supply of housing or demand for housing. We’ll also look at which ones are most important and how to figure out how each looks for a given property. But first, the Golden Rule.

Over the many years I’ve been analyzing real estate, I’ve come up with a simple rule that helps me understand how a given property’s value might change over time. I use it when I analyze office buildings, shopping centres, industrial warehouses, apartment buildings, self-storage properties, houses, and generally any real estate investment a person or company can make. Here goes.

The Golden Rule of Real Estate (Part 1 of 2)

Buildings never go up in value. Ever. Period.

Pretty simple, no?

That statement is true of all types of buildings, including houses. If you can accept that as a universal truth, you’re a lot closer to understanding property value than most people ever get.

But Alex, have Canadian house prices risen at an average of almost 5 percent a year for the last twenty-five years?

Yes, they did. But we didn’t talk about why.

The trick here is that you generally don’t just buy a house — you buy the house and the land that it sits on. The actual house goes down in value in real terms. Always. Without any exceptions.

That’s because, as a house gets older, it wears out. The roof gets older and maybe it starts to leak. The furnace gets older and needs repairs. The kitchen starts to look older, a little bit worn, and maybe the colours go out of style. The counters wear out. The fridge dies. Even the floors eventually weaken and begin to fail. Detached home, townhouse, high-rise — parts of every home wear out over time.

Virtually every element of a house gradually fails. That is why there are maintenance costs. If we do a great job of maintaining a house, by keeping on top of regular maintenance items and servicing all the various elements of a house, we can slow down the pace at which the house goes down in value. But there is a cost to maintaining a house, and those costs don’t increase the value of a house, they maintain it.

If buildings go down in value, how have home prices risen?

The Golden Rule of Real Estate (Part 2 of 2)

Only land can go up in value.

Some land goes up a little, and some goes up a lot. Sometimes the land goes down in value. But the house always goes down in value. Both parts of this rule are important to keep in mind when considering “investing” in a home and when comparing the potential financial benefits of doing so compared to the cost of renting.

This rule I’ve created helps me to gain perspective when I’m trying to value real estate. I created the rule based on a few things I kept noticing as I was making my way into the real estate industry: