There are many complicated ways to analyze the market conditions in your local area, enough to confuse and boggle the novice investor’s mind. However, you can keep things simple by using our “MAD” method. This means paying attention to three important factors and noting whether they’re going up or down:
M — Median housing prices
A — Active listings on the market
D — Days on the market
By paying attention to these three simple factors, you’ll get a good snapshot of the state of your local market.
Median housing prices
The median home price is the exact middle of the scale, meaning that half the houses sold for less and half sold for more. Compare this with the mean or average, which takes the total number of dollar sales and divides it by the number of homes sold.
If median house prices in your area are rising, this can be a good indicator that your market is on the way up. If prices are rising, you can ride the appreciation of the properties. In this kind of market, you won’t have to buy houses as cheaply, depending on your exit strategy. However, if they have been rising for several years and the rise in price is slowing, it can be a sign that your market is flattening or getting ready for a fall. That requires you to be more defensive in your buying—that is, you would buy properties at a lower price and assume no market appreciation (or possibly anticipate falling prices in the short term). Also, keep in mind that many areas are seasonal, so housing prices may be higher in the spring and summer than in winter (or vice versa in ski resort areas, for example).
It’s important to keep in mind that even if a real estate market is reaching a peak in prices within a particular area, this doesn’t necessarily mean it will collapse. The fact that real estate values in a specific city may climb at twice the rate of inflation one year and only half the rate of inflation the next year doesn’t mean the bottom is falling out because markets inevitably rise and fall in price.
A temporary excess of demand over supply causes a rise in prices, but supply almost always catches up. When it does, prices level off; sometimes they drop for a period and then rise again, with the next peak being higher than the last peak due to inflation. However, just because a boom in housing prices exists, a bust doesn’t necessarily follow. A likely scenario may be a “cooling off” where prices remain flat, appreciating just above average inflation. Keep in mind that just because your city’s average real estate values or home sales may have declined, it doesn’t mean this was true for the entire city. Unfortunately, people see headlines like “Median Real Estate Prices Falling” and they panic. You need to look specifically in the price range and location of houses you’re buying. For example, the mass overbuilding of new $750,000 homes in your market may not affect the older $200,000 homes that you’re buying. On the other hand, it’s certainly possible that a particular development or sector within a market (such as high-priced condominiums) could fall in a market in which median prices are otherwise stable or rising. In short, know your market on multiple levels — national, local, and micro-local (i.e. neighborhoods).
Housing prices alone may not be an accurate indicator of the local market. Sellers often give buyers concessions at closing rather than drop the price, which can skew the math. For example, a concession may include paying some of the buyer’s loan fees or allowing a credit for items that are in need of repair. In the case of new homes, housing prices don’t always reflect builder concessions, such as favorable financing or upgrades.
In addition, housing prices don’t reflect the amount of money sellers spend to renovate the property before the sale. In a seller’s market, homes will sell quickly regardless of their condition. In a buyer’s market, sellers may spend as much as 10 percent of the price of the home doing renovations before placing it on the market. Thus, for example, if the price of a house rose 5 percent in the last year, it’s really a net loss of 5 percent for that area. You need to look not only at numbers, but also at the houses for sale. Go to open houses, or call and talk with real estate brokers in a particular area to get a reality check of what’s going on.
Active listings on the market.
This is the second factor to track in our MAD method of determining the state of your local market. The changes in the number of properties available for sale provide a good sign of the state of the local market. The basic economics of supply and demand determine whether the local housing market is rising or falling. When demand exceeds supply, prices rise — and the real estate market is said to be rising. When supply exceeds demand, prices fall — and the real estate market is said to be falling.
Most residential properties for sale are listed on the Multiple Listing Service (MLS). The number of active listings on the MLS today compared to six or 12 months ago (adjusting for seasonal changes) can tell you if the market in your area is rising or falling. A good real estate broker or market specialist can provide you with the numbers for listings by searching the local MLS.
In addition, you can check your local building department for the number of permits for new buildings to see if more development is coming. Being active in local politics can give you the inside track on upcoming projects that builders are involved in to get housing developments approved. Also, it never hurts to make friends with people who are in ancillary businesses such as the subcontractors who supply goods and services to home builders. They often can provide prospective and “inside” information that the statistics won’t show.
Days on the market.
This is the third factor to track in the MAD method. It will help you determine the state of your local market, after median housing prices and active listings on the market. This factor is the average number of days it takes to sell a house in the relevant price range. For example, a market in which a house sells for $250,000 in three weeks is quite different from a market in which the same house sells in six months (the latter is known as a soft market). In a soft market, sellers can drop prices, give concessions, or wait longer for their houses to sell. The vast majority of homes are owner-occupied, so there’s generally not a negative impact to sellers who can’t sell their houses because they can continue to live in them unless sellers are in dire need to move because of a foreclosure, job transfer, or other firm deadline they’re likely to hold out for more time to get their prices. If sellers have enough equity in their homes, they can refinance their loans and take their homes off the market.
You can find the average days on market for a particular-priced home by asking a real estate broker to search through the MLS. Make sure you’re comparing apples to apples — that is, the average days on the market for houses in the same area and in the same price range. If the broker has access to the right information on the MLS, you can compare renovated versus non-renovated homes to get a more detailed analysis.
The more information you have, the more accurate your assumptions about the market, and the more solid your resulting investing plan will be.