February 8, 2011

About Real Estate Prices Part 2

by Michael Manley

In yesterday’s post, the 8 basic components which call the rise and fall of real estate values were introduced. We looked at how the land and structure and the laws of real estate may or may not be directly related to real estate prices at any moment in time and how each one can dictate where prices are now and where they will be in the future. Today we finish this two part series by looking at the how the state of the economy directly drives prices.

The Economy

Real Estate, in general, is mightily affected by the economy. When the economy is good earnings increase, jobs are more plentiful, most feel positive about the future and there is more money around especially when interest rates are low to stimulate economic activity. In good times lenders will give almost anyone money to buy property. When the economy is good demand for property increases, prices go up. Governments, at least government created organizations like the Bank of Canada and the US Federal Reserve use interest rates to try to influence economic activity one way or the other, to increase it or decrease it. Real estate is affected by the increase and decrease in rates, but is more affected by the attitude towards the economic future than the rates themselves. There have been times in the past that rates went up substantially and had no effect on real estate prices because the economy was still going strong. But when the economy turned down and the rates were still high, what a headache. People’s perception of their economic future is the most important economic factor in their deciding whether to buy or sell.

Economic Value

Every piece of real estate has economic value; this value can be the amount of consideration that is received at a moment in time for your ownership – a sale. Or it can be consideration to give up certain rights over a period of time to someone else – a lease, rental, option or the like. Every property can be either leased or sold to release its economic value. The two values are somewhat related in that the more you can get for rent the more someone will pay for the right to own that property, but the driving forces behind the rental market and the ownership market aren’t always in sync. During an economic downturn the demand for ownership drops and the demand for rentals increase. The opposite is true in an economic up-period, the value of ownership increases as more people move out of rentals.

Fear and Greed: Two Sides of the Same Coin

When the economic outlook is good and especially when interest rates are low renters, actually anyone who is interested in buying property, or more property, fear that if they don’t buy soon they will lose out. Demand increases. Speculative sellers, or anyone who has a reason to sell, feel that if they sell to soon they will lose out, so they don’t put there properties on the market restricting supply, sometimes dramatically. Where new construction (supply) is not available, supply doesn’t increase to meet demand and the supply/demand ratio tilts in favor of sellers and prices go up.

When the economy starts to turn down speculators, actually anyone who has a reason to sell, fear losing out and put their properties on the market to capture as much current value as they can, increasing supply. Renters, actually most buyers, fear that they may not have a stable economic future and may be buying as prices decline so they exit the market decreasing demand. Those who trade properties don’t feel the urgency to move anymore fearing unsettled economic times and declining prices. The supply demand ratio turns to the favour of buyers causing prices to decline. Everyone is in a bad mood except renters with jobs. An interesting aside; all owners of property have a vested interest in seeing property values rise. All renters have a vested interest in seeing values drop, but the second a renter becomes an owner their vested interest becomes to see property values rise.

Greed fuels demand and lower inventory increasing prices, while fear decreases demand and increases inventory pushing prices lower.

Big increases in economic activity can cause prices to rise quite quickly. Big declines in economic activity can cause prices to decline sometimes quickly too. An economy that continues on at a reasonably positive level over time can lead to a more balanced market where the top of the pyramid continues to see high demand but as the increase in number of new buyers decline the middle range inventory increases and demand slows stabilizing prices. At the low end of the pyramid where most first time buyers buy, supply of new construction can increase dramatically in relation to demand keeping prices in check or even putting them into decline until the supply demand ratio levels out.

The economy and economic outlook are the most important factors affecting overall prices in a market. Fear and greed are to a large part an offspring of the economy but can also influence pricing (supply/demand) when laws change or are about to change.

Contracts, local laws, location, structures and economic value will always affect a specific properties value in a very individual way, in addition to fear and greed and the effects of the economy and its future outlook.

Originally published from The Home Renovation Guide.