2 Apr 2015

The Rich Get Richer Thanks to Real Estate

The Rich Get Richer Thanks to Real Estate

The Rich Get Richer Thanks to Real EstateMuch has been made about the rise in residential real estate values in major cities around the world. For years, many have pondered the surge in prices in Vancouver and Toronto, as well as New York, San Francisco and LA. To be sure, there have been bumps in the road—the U.S. subprime meltdown was important, but relatively short-lived in the largest business and financial centers. As of the most recent data, despite the U.S. housing collapse, home prices in San Francisco are up 96 percent since 2000. They have more than doubled in Washington, D.C. and have risen more than 75 percent in New York City. The Canadian experience has been far more dramatic as Canada did not suffer a housing collapse because of far more prudent lending practices. Since the beginning of 2000, Vancouver house prices have risen 280 percent, while Toronto has boasted a nearly 235 percent rise.

This enormous rise in home values is relevant to the discussion of income and wealth inequality, which has become a significant political hot button. In his remarkably popular book, Capital in the Twenty-First Century, celebrity French economist Thomas Piketty, argued that inequality was the result of the rapid growth in capital gains relative to the economy as a whole. Labor’s share of the economic pie has declined sharply. Wages and salaries have stagnated as corporate profits and returns on capital have surged.

It is Piketty’s contention that the rich will stalwartly get richer and wealth inequality will continue to widen, which ultimately leads to political unrest if not outright revolution. Much has been made of the dwindling middle class as high-paying jobs for relatively uneducated people are disappearing.

So what accounts for the high rate of return on capital relative to labor? Economists combine a number of different categories into their definition of “capital,” such as machinery, computers, software, buildings and land, as well as financial assets like stocks and bonds. Computers, software and other high-tech products have become an increasingly important component of capital. These products obsolesce very quickly, so business leaders, in an effort to remain competitive and profitable, must spend more money replacing these short-lived assets. Indeed, innovation must be ongoing or companies that were once at the leading edge find themselves well behind (think Blackberry).

Piketty doesn’t take depreciation into account. Physical capital must be serviced and replaced. Office buildings, factories, trucks and other hard assets must be upgraded and maintained and the cost of upkeep has been increasing so higher profits might well be siphoned by future maintenance bills.

The growth in returns on financial assets may also be limited in the future. Stock prices have increased sharply in recent decades, hitting new highs. But much of that rise has reflected an increase in price-earnings multiples. The rise in book value (the total net value of the assets owned by companies) has been much more modest and, arguably, multiple expansion may be near its limit, refuting the notion of a permanent explosion in the wealth of shareholders. Interest rates are at record lows, so bond prices, in time, will trend downward, generating capital losses not gains.

Inflation is low and technical innovation suggests that price pressures will remain low, keeping a lid on commodity prices and the wealth garnered from resource sectors.

Almost all the rise in the value of capital over the past century has come fromland instead of other forms of capital. This was recently pointed out by Matt Rognlie, an economics doctoral student at MIT. According to Rognlie, “it’s landlords, not corporate overlords, who are sucking up the wealth in the economy”.

This is not so surprising. Urban economists have long pointed out that as density increases, productivity increases. Agglomeration economies describe the benefits that firms garner by locating near each other. Clusters of businesses in the same sectors—think Hollywood, Silicon Valley, Wall Street or Bay Street—experience the benefits of an experienced labor force, shared infrastructure, innovation and best practices, competing multiple suppliers and greater numbers of demanding customers. Cities grow and prosper to exploit these economies of agglomeration. Moreover, talented workers want to live where opportunities are the greatest, driving up house and land prices.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres
416-722-8771
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Dave Teixeira

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