Nov. 21, 2016
This is the second instalment in a series of lessons on basic economics and how they relate to the real estate market. Please click here to view all available lessons.
Money and capital are two independent concepts that are often treated as interchangeable when they are not. In essence capital is real wealth whereas money is simply a way of measuring wealth.
Pieces of paper printed by a governing body. While money is affected by supply and demand - if you print a whole bunch of money the supply will increase which will decrease the value of money (known as inflation) - it is not capital because it has no intrinsic value or use. If a country devoted all of its production to printing piles of money its only real capital would be the machinery and resources used in the production of the money. Money, by itself, can not increase employment or standard of living as it can not feed you, clothe you, shelter you, or entertain you.
This also means that the purchasing power of money is not fixed and future money is typically worth less than present money. In this way inflation favors debtors and not lenders.
Anything of value that is not money can be thought of as capital. For example, every item in your home can be thought of as capital. While most of it is worth little to nothing - 2nd hand cloths, old books, old furniture - some of it has value - the house, the land, your car. Most of these items will depreciate in value from either obsolescence or wear and tear and will be worth substantially less than the original purchase price. However, a few of these items may appreciate in value - a classic car, an original work of art, land value - from either a decrease in the supply (they don't make '69 Mustangs anymore), an increase in demand (population growth in a given neighbourhood/city), or a combination of the two (classic road bicycles have grown in popularity with "hipsters"and are no longer produced).
Another example, which has become increasingly valuable in today's economy, is intellectual property and digital rights. These are the rights of use to ideas, franchises, apps and websites. The value of this less tangible capital is based less on supply (the supply of an idea or app is infinite) and more on demand, popularity, overall use, and market share.
Q: Who is worth more? Person A with $25,000 sitting in an RBC savings account getting 0.5% interest or Person B with $0.00 in their savings account who put $25,000 down on a $450,000 investment property where the rent is covering the mortgage?
A: The forecasted rate of inflation for 2017 is 2% meaning that Person A, while gaining money (.05%), is actually losing capital as the real value of their money decreases. Person B has not only been adding to the equity of their initial down payment, solely from rental income, but the value of their property is likely to have gone up, at the very least, proportional to the rate of inflation. It is also likely that they are getting an extra couple hundred dollars a month from the rent after mortgage payments. Person B has increased their money and their capital. Person B may be in debt but their debt is for money and not capital so while the value of their property (capital) increases the value of their debt (money) will decrease.
"If you owe the bank $100 that is your problem. If you owe the bank $100 million that's the bank's problem"
-J. Paul Getty