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Understanding Inflation vs Appreciation

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pexels-photo-164656In 2002, my wife and I bought our first home. We paid around $190,000 for it, and by about 2005, it had ‘appreciated’ to closer to $275,000.  Why? We had done some cosmetic work to it, and the neighborhood we bought in improved quite a bit; but most importantly, the economy had simply strengthened a lot after the dot com crash. So we took out a home equity line of credit on that house and used the proceeds to fund the downpayment on a triplex–our first rental property.

In many ways, I credit the ‘appreciation’ of that first house for launching my real estate investing career.

In real estate, one of our favorite words is ‘appreciation.’ After all, we love it when the value of our properties goes up over time! We use the word ‘appreciation’ very broadly to describe any situation where the ‘value’ of a property has gone up.  To put it in more economic terms, we use the word ‘appreciation’ as a catch-all term to describe:

Any situation where the number of dollars increases, that one must exchange in order to purchase our property

There are really two ways that ‘appreciation’ happens to our properties:

  1. We Make It Happen (Forced Appreciation)–We do this through developing a property, improving it, expanding, etc.  In other words, we make it more useful and valuable by changing the property for the better.
  2. The Market Appreciates–In this case, regardless of what we do, we see the ‘value’ of the property go up along with the other properties in the market.

The former we have control over; the latter we do not…but we’re still excited when it happens!

Market ‘appreciation’ may not be exactly as it seems, though. Let’s take a moment and look at an important concept:  ‘appreciation’ contrasted with ‘inflation.’

Appreciation vs. Inflation

Appreciation is when the true intrinsic value of something increases.   Notice I didn’t say when the “price” or “cost” of it increases; rather the value increases.  Appreciation is when something becomes more valuable, more desirable, more useful.  Here are a few examples of how your property could truly appreciate:

  • You live in a town that is immensely more desirable than it was when you bought the property, and many people are moving to town (increased demand for the same supply)
  • You struck oil in your backyard
  • A major employer announced it was building a facility two miles from your house, that will employ 5,000 people (who will need a nearby house to live in)

In these cases, regardless of what the market or greater economy is doing, your property is now in higher demand than it used to be–making it appreciate. Appreciation is a reflection of a change in the actual asset itself.  

Inflation, on the other hand, can look a lot like appreciation…while not being true appreciation. Inflation is when the number of dollars one has to exchange in order to buy your property goes up. Sounds like ‘appreciation,’ right? But it’s not.  You see, inflation is NOT a reflection of a change in the asset itself; rather, inflation is a reflection of the decreasing purchasing power of the currency you exchange for that asset.  In other words, the asset isn’t necessarily worth more; it’s just that the dollars you have don’t have as much purchasing power as they used to, so you have to give up more of them if you want to trade for something.

Price vs. Value

A related concept we should briefly mention is the distinction between ‘price’ and ‘value.’  Again, we use the word “value” as a catch-all term to broadly describe any time it takes more dollars to buy something.  But is it really ‘value’?

Value is like ‘appreciation’–it’s reflection on the usefulness and demand for a property itself.  If you make a property better and more useful, you’ve truly made it more valuable.  Price, on the other hand, is a reflection of the number of dollars it takes to buy something. In other words, price is more like the concept of inflation.

Why Is This Distinction Important?

So, why is it important to understand the difference between appreciation and inflation?  Are we overthinking this?  At the end of the day, if the dollars one must trade to get my property increases, isn’t this a good thing?!

In my own personal opinion…yes, it’s a good thing. But I personally don’t ever want to be confused or deluded about the appreciation in my portfolio, vs the inflation.  Here are a couple reasons why:

  1. I don’t want to convince myself I’m an investing genius just because my property ‘appreciated,’ if the credit really belongs to inflation instead.  Now, if I did something meaningful to make my property more useful, and thus it’s now truly worth more, then good on me.  But I don’t want to be one of those people who thinks that just because my name is on the title of a property and it now costs more than when I bought it, that I’m brilliant.
  2. I don’t want to trick myself into thinking that any increase in the price of my real estate is somehow isolated to my assets. In other words, if my real estate is inflating in price, that probably means my other expenses (utility costs, food costs, fuel, etc.) are inflating in price as well. That means I’m not really making any headway…everything is just requiring more dollars. Think about your grandparents; they lived in a house that cost $5,000, and you live in a house that cost $300,000. Are you 60 times richer than they were? No. They also lived in a time when a good hamburger cost $0.50, and you’re paying $10.00.  This fallacy can make you feel richer because you see your property price increasing, but you’re not actually getting richer.

So, Did My First House Really Appreciate?

As I look back on that period of 2002-2005, in which my first house ‘appreciated’ so much, the question is obvious:  Did it really appreciate, or did it just inflate?

While the question is obvious, the answer is not as simple.  In reality it was almost certainly a combination of both factors; we’ll never know exactly how much of each.  All I know is that today, when I tell that story, I’m careful to say “my first home increased in price,” rather than “my first home appreciated in value.”  Am I happy the number of dollars for that house went from $190,000 to $275,000?  Yes! Do I know how much it truly appreciated vs inflated? Nope.

But is it important to understand this distinction as a real estate investor? You better believe it.

 

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