The median folly

Hypothetical scenario: the newspapers report that median house prices rose 10% in your suburb last year. 

As a property investor or home owner, do you celebrate the fact that you’re sitting on a 10% profit?  As a renter, do you lament the fact that you’ve missed out?

Before you answer, the issue I’d like to address in this post is whether it is reasonable to assume that property investors and home owners in the above scenario are in fact (on average) sitting on a 10% profit.  In other words, can we assume that a 10% increase in the median house price means a 10% average return?

Let’s work through a very simple example. We’ll put aside the issue of dodgy stats provided by vested interests, and assume that the stats are 100% accurate.  OK, here goes:

There are three properties for sale in your suburb.  This is what they sell for in Year 1:

Property A: $500,000

Property B: $635,000

Property C: $700,000

The median (which is the preferred measure) is the middle number in the list when placed in order.  Therefore, the sale of Property B gives the suburb a median price in Year 1 of $635,000.

Now, for simplicity, let’s assume that the exact same three houses are sold again one year later.  Let’s also assume that house prices remain flat over that year.  Before selling, the owner of Property A knocked down his dump and re-built a brand new home. He spent $300,000 which, let’s assume for simplicity, added exactly $300,000 to the value of the property. 

Therefore, in Year 2, the three houses sold for:

Property A: $800,000 ($500,000+$300,000)

Property B: $635,000

Property C: $700,000

If we were to re-order the above list, we’d find that the middle value is now Property C at $700,000. Therefore, the median house prices has “soared” from $635,000 to $700,000 – a 10% increase in just one year and everyone in that suburb thinks they’re now sitting on a gold mine.  Of course, in actual fact, no one made a paper or real profit – all three property owners above actually broke even.

The point is that all the millions of dollars spend on renovating, maintaining and re-building property artificially inflates the index.  In the above example, even if property prices had fallen slightly over that year, the index would still have shown a gain.

The same principal applies to an individual property.  You often hear people saying “I bought a property 10 years ago for x amount and sold it for x (higher) amount”.  Of course, that’s only half the story.  Then again, it wouldn’t sound as impressive if they said “I bought a property for x amount, spend x on stamp duty and other costs, spent x on repairs and renovations, then sold it for x (slightly higher) amount.

Interestingly, the same issue doesn’t apply to share indices, which is an important point for those comparing the performance of house prices to shares.  With shares, investors cannot tip extra money into a company and inflate its share price.  When a company asks shareholders for more cash, they want something in return – more shares, which dilutes the value of existing shares, lowering the average price.

So next time you hear that house prices rose by a certain percentage, don’t assume that the increase in median sales price is the same thing as profit. There’s that pesky detail of expenses that should also be factored into the equation.

Although I suspect that property investors suddenly remember this fact come tax time.

Comments welcome.

Cheers,

Andy.