What is the velocity of money and why does it affect home prices?

By Holger Reinel | Updated on June 10, 2020


What-is-the-velocity-of-money-and-why-does-it-affect-home-prices

The velocity of money is the rate at which people spend money; it is an important indicator of economic activity because it measures the relationship between money and spending. Thus, if the velocity of money falls, it means people aren’t spending money as fast as they did before.

Why does that matter? It matters because money is a medium of exchange for transactions, including real estate transactions. Thus, the velocity of money is an indicator of people’s willingness to buy things.

Real estate spending accounts for a huge portion of our economic activity. According to the National Association of Home Builders, consumption spending on housing accounts for 12-13% of annual GDP.

When people earn money, they eventually spend it to purchase a product or a service; then whoever got that money later also spends it, and so on. Consider this example:

  • You won $1,000 in the lottery.

  • You used the $1,000 to buy a computer

  • The computer store uses the $1,000 to pay their vendors.

  • The vendors use the $1,000 to pay their employees.

In this example, the initial $1,000 created $4,000 worth of transactions, and the process will continue until one person stops spending. That increase in economic activity results in prices rising. The same happens in real estate.

When more buyers are willing to go out and buy homes, property prices rise because of the increase in demand.

The velocity of money typically rises during good economic times, and it drops during a recession.

Why?

Prices = Quantity of Money × Velocity of Money / Real GDP

Thus, when homebuyers have the confidence to go out to buy homes it results in more confidence in the market, which opens the door for home prices to increase.

For more information about how home prices change, check out this article.

What drives home prices?

Is a declining velocity of money good or bad?

A decrease in the velocity of money can result in deflationary pressure; that’s a fancy word that means prices go down. When people make fewer transactions, companies’ sales decrease, prices decrease, and the economy is likely to shrink.

If everyone stays at home and does not spend any money, the velocity of money is zero. Thus, if a property goes in the market but it does not sell, it doesn’t take long before the sellers drop the price so that buyers have better incentive to make offers.

As you can see, a lower velocity of money equals falling home prices. That’s bad for the economy as a whole.

You might wonder, why would people decide not to spend money all of a sudden? Here are a few reasons:

  • A recession, or economic uncertainty.

  • An increase in interest rates resulting in borrowers spending more to pay off debt, including mortgage debt.

  • Higher systemic risk in the market

  • Unaffordable prices in hard assets such as real estate

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What is the relationship between the velocity of money and home prices?

The real estate market is closely tied to how well the economy performs. When house prices go up, homeowners feel more confident so they tend to buy new furniture, renovate their homes, and increase their discretionary spending.

There is a whole industry that benefits every time someone buys a home. From the real estate agent, mortgage brokers, furniture stores, painters, renovation contractors, and local shops, a large number of related businesses benefit whenever homebuyers purchase a property.

Speed matters too, particularly if you’re buying a home as an investment; the faster money turns over, the quicker it will get back to you, with profits.  

So, if you can buy a property and sell it in six months vs. a year or longer, you’ll be realizing those profits quicker; you can then turn it around to do it all over again, which means higher returns on your money.

For everyone thinking to buy a home, ask yourself, what’s the velocity of money right now? Are people spending money confidently right now, or is a recession coming?

The answer to those questions can determine whether home prices will increase or decline as a result of how quick money is changing hands.

Lastly, if you’re planning to buy a home we highly recommend you check out our Home Buyers Online Course. This is a great resource with step-by-step instructions where you will learn everything you need to become a savvy home buyer.

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