February 7, 2011

About Real Estate Prices Part 1

by Michael Manley

There are 8 different components worth thinking about when trying to figure out why real estate prices are where they are today and where they are likely to go in the future.

* Physical factors, land and structure

* Legal factors, laws and contracts

* Economic factors, the economies performance and economic value

* Psychological factors, fear and greed

Real estate values rise and fall due to the interaction of these 8 basic components. Each component lives somewhat in its own environment and may or may not be directly related to real estate prices at any moment in time but each one can and all together do dictate where prices are now and where they will be in the future.

The simple all encompassing concept behind real estate prices is supply and demand. The ratio of the number of buyers and sellers at any given time in a free and open market dictates market price. More buyers or less sellers = higher prices. Less buyers or more sellers = lower prices. Supply/demand ratio = price. Each of the 8 factors either affects supply or demand, one way or another.

We’ve been taught to believe that real estate is one of the freest and most open markets in North America, but how free and open is it and how are prices affected by restrictions?

Today, let’s look at the first pair of these factors.

Physical Factors, Land and Structure

Real Estate technically is just the land. Any structures that are permanently situated on or in the land are considered to be separate from the land and rightly so. Land value itself is influenced by a different set of factors than structures. Structures are more or less valuable depending on the cost to replace or bring a structure up to current standards. Land is more strictly influenced by pure supply and demand.

The two can run together, both increasing and decreasing with similar demand, but there are specific instances when they don’t coincide. After a recession construction costs tend to be at their low, along with real estate prices. As the economy increases, spurred on by low interest rates housing demand increases faster than construction costs, pushing up the land value. Latter on in an economic up period, construction costs increase, sometimes dramatically. This can increases the value of renovated and newly constructed structures, faster than the land value itself.

Land’s value as a function of location is strictly dictated by supply and demand. Think of locations as being part of a pyramid structure. The most desirable at the very top and the least desirable at the bottom. Few at the top, many more towards the middle and the bottom. As the money supply increases (lowering of interest rates) demand increases overall but supply is most limited towards the top, this pushes prices higher faster the closer you get to the top of a pyramid. I believe that every market and all local markets have this pyramidal type structure.

Laws

There are very few restrictions on who can own, but there are some barriers. Financing a purchase in Canada, by a foreign resident is much harder than for those who live here. Governments dictate who can own and how they can own. Governments routinely change land use classifications, zoning by-laws and building codes which are all restrictions to a free and open market. Governments, at rare times, have restricted price increases and or the ability to buy or sell to meet government objectives.

One real estate market segment that governments seem to be more interested in restricting is the rental market. Here some governments have created a multitude of restrictions and inducements to influence the market to attempt to meet government social policy. Another arena of market restriction to meet social policy is land designations, such as green belt, wetlands and brown-lands.

At least compared to the health market, real estate is reasonably open and free. Baring new major government intervention, causing a slap to the side of the head, knock out punch, or jackpot win, the other 7 factors basically set prices with some proviso for the rental market.

Being so, this leaves the other seven components to be the major influences of the demand for – and the supply of real estate – most of the time.

Contracts

Any contract that encumbers the property, rental or otherwise, which adds restrictions to the use or sale of a property influences the market value. This includes lease or rental contracts, easements, right of ways etc. If you have your property leased for a long time to a class A tenant who is paying a lot of rent, then your property is worth much more than next door which is leased for a long term to a no-class tenant at low rent. If you lease your garage in a high garage demand area to your brother for a long time for brotherly rent, then you may have affected the value of your property downwards.

Tomorrow I’ll continue to discuss the remaining pair of factors, which contribute to how real estate prices change.