This article was published on 27 March 2004. Some information may be out of date.

QIn all the discussions in your column on investment in residential property, no-one has really assessed the effect of inflation on property prices.

I am in the somewhat unique position to do this, through living in the same house for some 36 years, in what is best described as a ‘leafy outer Auckland suburb’.

I bought the house in 1968 for $19,000 — an apparent bargain when set against today’s values.

But what many don’t realise is that since then inflation has been over 1000 per cent. So when the Consumer Price Index is applied to that $19,000, it translates into about $230,000 in 2004 dollars.

The present value of the house is about $300,000, which means that in real (inflation-adjusted) terms the compound capital gain over the 36 years has been less than 1 per cent per year.

The conclusion is that those now leaping into the housing market expecting massive capital gain are unlikely to get it.

It is true that in inflationary times, borrowing heavily and waiting for inflation to reduce the real cost of debt was a great way to make money. But this doesn’t apply now when low inflation removes that cushioning effect.

Instead, we have a situation where the downside risk can well outweigh the perceived benefits, which are based on a distorted view of the past history of residential property investment.

AWell put — and a really important point.

Since you bought your house, inflation has averaged 7.5 per cent a year.

Given that it’s been much lower than that lately — around 2 or 3 per cent most of the time since the early 1990s — it must have been much higher earlier.

And it was. In the 1970s and 80s, inflation often topped 15 per cent and sometimes approached 20 per cent.

People who owned houses through that period, and saw their values soar, often seem to ignore the fact that high inflation pushed up prices in a way that won’t happen now.

How can I say that, after what’s happened in the last couple of years?

House prices have always gone through cycles, rising fast for a few years, then rising much more slowly or, in recent times, falling for a while.

In the last two years or so, we have been through an upswing. Even so, national average price rises haven’t been nearly as high as in the mid 70s, when they rose 43 per cent in one year, and in the early 80s, when they rose 37 per cent in one year.

And, just as the highs are not as high these days, so are the lows lower. National average prices fell in the early 90s and again in the late 90s, and they could well do so again in the inevitable downswing to come.

The lower highs and lower lows are simply the result of lower inflation.

I should note here that there isn’t a direct link between house prices and the Consumer Price Index (CPI), which measures inflation.

The prices of all but new houses are not included in the CPI. Nor are residential sections, “because the land on which a house stands is not ‘used up’ and is considered to represent the ‘investment component’ of a dwelling purchase”, says Statistics New Zealand.

But changes in the costs of building and buying new houses make up about 10 per cent of the CPI. And history shows that the prices of all houses and the CPI are fairly closely linked.

That means, as you say, that people expecting huge ongoing gains in house prices are almost certainly in for disappointment.

Since 1963, says the Reserve Bank, house prices, on average, have risen 2.2 per cent more than inflation each year.

Our best guess at future growth, then, is an average of around 4 or 5 per cent.

By the way, when I checked on your calculations, I came up with a slightly different answer. I used a rather wonderful CPI Inflation Calculator on the Reserve Bank’s website,

The calculator shows you how inflation has affected values over any period since 1919. It automatically adjusts for the change from pounds to dollars in 1967.

In your case, it says that if your house had grown by inflation only, it would have been worth about $240,000 to $250,000 at the end of last year, when the latest CPI figure was announced. (The variation depends on when you bought it in 1968).

That leaves your gain, over and above inflation, at not much more than 0.5 per cent a year — similar to what you came up with.

Your point in your last two paragraphs is also really important.

When inflation is high, it makes sense to borrow to invest. Now that inflation is low, it’s not nearly as good a proposition.

That’s not to say that most people who borrow to invest — usually in property — will come a cropper, although some undoubtedly will.

But it’s quite feasible that a fair number will end up worse off for borrowing than they would have been if they had invested in property, shares or a share fund without borrowing.

For more on this, see a free small book that I wrote for the Reserve Bank in 1998, called “The REAL Story — Saving and investing now that inflation is under control”.

You can download it from Click on Publications. If you haven’t got access to a computer, write to The Librarian, Reserve Bank of New Zealand, PO Box 2498, Wellington, or phone 04 472 2029 and ask for the librarian.

QIn a recent column you compared the benefits of shares over property. You correctly identified the rich list in the US, where the ownership of a multinational IT company had propelled Bill Gates, Larry Ellison, Paul Allen and friends into the “Most Rich” list.

While every software developer dreams of joining them, the reality is closer to the ground. As a small software company we can only fund our development costs internally, and that has been a brake on our progress.

If I went to the bank to ask for finance for a property asset that would earn $120,000 pa, they could do their sums and estimate what it was worth and lend me some of the “development cost”.

If it is a software asset earning export dollars they won’t be interested. If they can’t see a place they could pin a “Mortgagee Sale” sign on, it’s not a real asset in their view.

In these current times of flood I would suggest an intangible asset like software would be a lot safer than a riverside or cliff top property!

When will the banking industry discover the IT economy? Or am I wrong? I look forward to your comments?

ASorry, but I can understand why banks are wary of software companies, whose assets might end up worth little. You can insure most houses, even by rivers or on clifftops, but not the value of software.

Most would-be Bill Gateses have to go beyond banks to find backers willing to take more risk.

I don’t have any expertise in that area, but I do know there are potential investors in your type of company, including some specialist fund managers.

A friendly stockbroker might be able to steer you towards some. Good luck.

QIn a recent column, the ‘litigious’ correspondent brought to mind an expensive and similar problem I ran into when I last went house hunting.

I had reached the “conditional” stage, and amongst the conditions was the ability to build an extension. The City Council stated that a full land survey with ground stability tests would be a prerequisite.

When pressed very hard they admitted the site had been a rubbish tip (domestic and industrial) prior to 1973. The tip was merely capped with a couple of metres of clay and houses built on concrete rafts for stability.

The LIM report showed nothing of this. The “life” of a tip, during which it effuses nasties is upwards of 60 years, which explains why, 20 years after the houses were built, there were no trees above roof height.

I insisted on a full survey at the vendor’s expense and he withdrew. By almost sheer chance, and at a cost of about $900 in fees for services already carried out, I escaped what would have been a very bad purchase.

AIt sounds as if you wouldn’t have found out about the tip if you hadn’t planned the extension.

Does that mean we should all propose extensions before buying houses? Or at least talk hard to the local City Council?

The truth is that many people don’t do a lot of homework, even when making such a major purchase as a house. That’s one lesson we can learn from you, I guess.

Another lesson — which we get from you and the other recent letters containing horror stories about property — is that there are plenty of risks out there, even with land.

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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to [email protected] or click here. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.