Real Estate - A Nice "Commodity" Play

I found this to be a very interesting and "out-of-the-box" view concerning the current economy and real estate. You won't be sorry you've read this! -Ross

The following article was written by Lawrence Yun, NAR Chief Economist

We are all well aware of high commodity prices in today’s market. Most tangible raw materials are commanding sky high prices. Oil, diesel, copper, steel, cement, and other construction-related costs (except lumber) are all up substantially. Some have even brought back the Malthusian theory of too many people on earth outstripping available resources.

We can see the effect in inflation figures. In the past five years the consumer price index has risen 18 percent; the producer price index for construction has increased 39 percent during the same period.

In light of the resource price boom, one interesting angle that has not been delved into deeply is that real estate could be a nice commodity play. Real estate -- with all its tangible and concrete solid qualities (unlike paper financial assets) -- has historically been a good hedge against inflation. High commodity prices -- and high inflation rates in the late 1970s and early 1980s -- led to double-digit gains in home prices. So why hasn’t that happened this time?

One reason goes back to supply and demand. Right now there are too many home sellers (some of whom are trying to sell one of several properties they own) in relation to home buyers. The short-term dynamics of high home inventory (of both new and existing homes) will require some time to work off. However, once inventory reaches a manageable level, does it then mean that real estate prices will “catch-up” to reflect high commodity costs and the high costs of construction?

Think about two different households (one owner, one buyer) interested in homes situated where land is cheap and plentiful. How much are those homes worth? If a household desires to build a (new) home there, then the real price of that home will be the cost of construction.

But let’s assume that the home owner wanted to charge a much higher price (i.e., more than the cost of construction) to sell that home to a buyer. The buyer would do well by simply building a new home at the cost of construction rather than paying the higher asking price. So the long-term home price equilibrium can be viewed simply as the cost of production. If the cost rises, then so will the home price. In areas of the country where developable land is relatively widely available, the rising cost of construction will surely then lead to proportionately higher home prices.

Of course, where land is not cheap and/or plentiful, then real estate prices will not only reflect the cost of construction, but also the shortage (in supply) and the premium value of the land. New York, San Francisco, and the Washington D.C. areas, for example, will always command high home prices because of the very limited land supply that is close to downtown job centers.

Inflation has been – and always will be -- a big headache for the country, our economy and consumers. One way for consumers to assuage the pain of inflation, however, is to own commodities. A simple, good way is to own real estate. If commodity prices further accelerate for some reason, you will automatically be in the game.