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How Real Estate Markets Work

How Real Estate Markets WorkYou do not need a degree in economics to become market-literate, just an understanding of how local real estate economies work, fluency with the terminology and good sources for local data on sales, prices, values, and inventories.  Add your professional expertise and your skilled observations of the latest trends in the charts and numbers and you have a winning formula.

Ideally, real estate markets follow the laws of supply.  If the supply of homes for sale is greater than demand, the market will put pressure on prices to fall until supply and demand come into as because buyers take advantage of bargains and fewer sellers list their homes Home will take longer to sell.  Should the supply of homes for sale be too small to meet demand, homes will sell faster, and prices will tend to rise until more sellers list their homes and buyers wait for better prices.

So the numbers of homes for sale, or inventories, and demand are the two keys to understanding how sales and prices are behaving and will continue to act in the near future.  Demand is driven by changes in local household population; local income and employment levels; interest rates that make mortgages more or less expensive; accessibility of mortgage credit; and local rents.  Supply is created by move-up buyers, who also contribute to demand by buying a new home; by new home construction; by seniors and other owners who sell to become renters; by owners who relocate to another market; and by deaths.

In the real world of real estate, the rules of supply and demand do not always work well.  Sellers sell for many reasons, and most of them do not have much to do with higher prices—relocation, family and financial crises, they owe too much on their existing mortgage, or they need more space or to downsize now no matter what prices are doing.  Buyers often can’t take advantage of lower prices because they do not have the down payment, or they cannot sell their current to move up to a larger one. It is no wonder that the average American family sells a home only once every nine years.

Because of the difficulties buyers and sellers have responding to market opportunities such as rising prices or a plentiful selection of homes for sale, real estate is considered a less “liquid” asset than securities, collectibles, precious metals and most other investment options.

The Fine Points:  Why Real Estate is Different

Illiquidity is just one of several significant ways that make real estate markets work differently than other markets.  Here are some others.

Seasonality. Home sales vary by the season, especially in northern climates where inclement weather makes it difficult to sell a house.  Sales rise in the spring and decline in the fall.  Therefore, comparing sales and prices on a month-to-month basis can be misleading. That is why home sales and prices are either “seasonally adjusted” with mathematical formulas that account for seasonal changes or are compared to a year over year rather than a month over month basis.

The Housing Ladder.  Only in real estate does a sale create a new buyer, as it does with a move up buyers.  Real estate works like a ladder.  As seniors downsize or die, they create new supplies for move-up buyers, who in turn create new supplies for first-time buyers.  That is why first-time buyers are so important; the housing ladder does not work unless first-time buyer demand is high enough to absorb the houses that move up buyers want to sell so that they can then buy a larger home.

Financing.  About half of all homeowners have a mortgage and 86 percent of recent buyers financed their home purchase with a mortgage.  The ability to qualify for a mortgage and the amount a mortgage will cost the borrower have an enormous impact on housing demand.  Factors like interest rates, lending standards that set requirements for income, debt and credit history and the availability of mortgage credit can affect demand for homes by making it easier or harder for buyers to get financing.  Currently, about three-quarters—74.2%—of applications for mortgages to buy a home are approved.

Hyper-locality.  There is no such thing as a national or a state-level real estate market.  Real estate is the most local of investment assets, yet market trends are most often reported and discussed regarding the nation as a whole, states or MSAs.  These are not markets; people buy homes on a house-by-house or neighborhood-by-neighborhood basis.  The numbers you see on the national news are mathematical calculations of millions of homes and thousands of monthly transactions; they are several steps away from what’s going on in a local market.  Local market conditions can vary greatly, even within a metropolitan area.  The factors that impact local values—transportation, retail, schools, taxes, economic conditions, open spaces, location, municipal services, safety, lifestyle—are local, even hyper-local.  A thorough knowledge of hyper-local market trends is one an essential competency that distinguishes top agents and brokers.  However, market level data on a hyper-local level is harder to obtain than so-called “national” data.

Price is Different from Value.  The adage that “something is worth what someone will pay for it” doesn’t apply to real estate.  Instead, a home is worth what an appraiser says it is.  Why? Because nearly nine of ten homes are financed by a mortgage and lenders will lend no more than what an appraiser says a house is worth.  If the contract price is higher than the appraised value, the buyer, and/or seller must figure out how to make up the difference or the deal is dead.  Appraisal issues kill about 11 percent of sales today.  One way to think about the difference between price and value is longevity.  Prices reflect temporary shifts in supply and demand—like tight inventories or heightened demand due to low-interest rates.  Values are more long-term and change slower than prices.  However, price changes DO change values over time because appraisers use prices or sales of comparable homes during the previous six months to make an appraisal.  As more homes in a market are appraised, recent sale prices will change values.

Every house has a unique value and responds differently to market changes.  In today’s market, sellers should price their homes very carefully and research local conditions to avoid overpricing that could lead to an extended time on market in case prices do decline.  Buyers and investors should be careful to avoid buying a home that is on the verge of losing value.  Determining an individual home’s value is difficult.  The “find your home’s value” calculators can be highly inaccurate, and they often mislead buyers and sellers.  New “Big Data” databases with hard sales data from millions of homes are more accurate but like all computerized valuations they may not reflect improvements and condition.

Medians and Averages.  A median is that number where half the numbers are lower, and half the numbers are higher. In the case of real estate, that means that the median is the price where half the homes sold that month was cheaper, and half were more expensive. An average is the total of those numbers divided by the number of items in that set. An “outlier”, or a value much higher or lower than the others in a group, changes the average but not the median.  Medians are preferred in real estate because they give a better idea of where the middle of the market lies.

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