The Real Estate Market

The real estate market, like all markets, is influenced by the forces of both supply and demand upon price. Both supply and demand can fluctuate, although supply tends to be more fixed in the short term and demand is certainly more stable than we see with most goods.

The demand for real estate exists to a certain degree regardless of market conditions, as people always need a place to live and businesses always need a place to do business. It’s the quality and not the quantity of real estate that fluctuates, as people for instance become more or less affluent and demand more or less expensive real estate.

The Real Estate MarketThere is no competing good for real estate itself, with the only real alternative being either living homeless or going out of business with commercial or industrial real estate. Within the real estate market though, demand for various types and grades of real estate does fluctuate of course, and if you are in the business of real estate, these factors do need to be paid attention to rather closely.

In China, entire cities have been built that remain virtually uninhabited, where the goal was to populate them but for whatever reason this did not come to pass as expected. This is what can happen when central planning drives things more than market conditions, although we do see this to a lesser scale in the West at times, where failed real estate developments are certainly not unheard of.

There is usually a considerable lag in the real estate market due to the length of time it takes to ramp up supply to meet increasing demand. This lag can exist in large degree for many years, especially in markets where it can be more difficult to expand the supply such as in very populated areas where land within the market area is in short supply.

The real estate market is for the most part fixed, much like the gold market, where additions in supply only comprise a small portion of the overall market year over year. This is the case with real estate as well, and while each year sees new developments, this only consists of a small percentage of the overall market.

It is estimated that only about 2% of the real estate market consists of new supply. This does serve to limit the effect of increases in supply, although it does serve to make the market more stable as well.

Changes in Real Estate Supply and Demand

Both supply and demand tend to change quite slowly compared to typical markets, although this condition does add a lot of stability to real estate markets. Under normal circumstances, you don’t see wide fluctuations, leading to less risk involved for the participants.

Under situations such as a lot of mortgage defaults that we saw during the recent housing crisis, this can affect the market quite a bit in the near term at least, where the market may be flooded with properties and this can well exceed any changes in demand.

During these times of economic upheaval, demand tends to contract while supply expands, and this can result in prices being significantly depressed during these environments. Eventually things do tend to stabilize though and the real estate market is such that you can’t keep it down for long, unless the overall economy becomes really depressed, for instance during the Great Depression where demand was kept down for many years.

As a testimony to how durable the real estate market is, even during the Great Depression, we didn’t really see a big pullback in real estate prices, it was more like the market was flat for a very long time.

In fact, for the first half of the 19th century, we didn’t really see all that much movement in the market, although that did change during the second half of the century as the index moved from single digits in the 1940’s in the United States to around 100 at the turn of the century and all the way up to 180 at the peak of the real estate bubble in 2007.

The issue with the housing bubble is that many people were brought into the market that had no business being in there, due to very lax standards, poor lending strategies, securitization of debt which served to disconnect lender and borrower to some degree, and even misrepresentation of borrower’s ability to service housing debt.

When the sustainability of growth depends upon growth itself, with significant rises in prices necessary to fuel the growth, when these prices stop going up, this can and did lead to quite a crash. Demand for real estate does not normally drop like this, but it certainly can, as we saw with this recent big pullback.

Main Drivers of the Real Estate Market

Modern economies are so driven by credit that anytime credit shrinks, like it did during the Great Recession, this in itself is going to fuel market pullbacks. It’s not hard to imagine how this affects the real estate market directly, as real estate is almost always financed by credit, but the effects go deeper than that, as credit determines money supply itself, and changes in credit will expand or contract the entire economy in a direct way.

As the credit market expands, this will lead to an increase in both the supply and demand of real estate. Developers can borrow more readily and more cheaply to build more projects, increasing the supply. People can also borrow more readily and more cheaply, the end users of real estate, and this drives up demand for real estate.

The real estate market isn’t really that cyclical like most markets tend to be, and part of the reason is that when growth is slowed, interest rates go down, which makes real estate more accessible. In inflationary times, when interest rates rise, income rises as well, so while it costs more to borrow, people have more means to borrow as well.

Real estate ownership also remains a primary goal of most people regardless of where we are in the business cycle. People are therefore usually willing to make sacrifices with housing costs that they would not normally entertain with other goods.

This has allowed for prices in some areas, like in many major cities, to expand well beyond what we would normally think as reasonable, as people become willing to dedicate more than the normal allotment of their income to housing costs, when the supply cannot keep up with the demand.

Lenders are supposed to keep things in check, and they do to a certain degree, but often they are willing to be more liberal with the ratio of housing costs to income provided that the market in general appears willing to dedicate more of their income to housing and become comfortable enough with doing that.

The Effect of Location with Real Estate

In the long run, as we move towards more decentralization and in particular having more and more people work from remote locations, where location becomes less of an issue or perhaps much less, we will see this reflected in the real estate market.

It’s fair to say that our business culture has not kept up with the technology, as there are a lot of roles that could be performed more efficiently from remote locations, anywhere with a high- speed data connection really, but it may take many years before we see this even approach its potential.

Real estate agents speak of location a lot, and location is certainly the main driver of the value of real estate. A parcel of land in Manhattan is going to be worth orders of magnitude more than a similar parcel in a rural area for instance.

The value of real estate depends in large part upon the value of the land involved, as land is the resource that is scarce here, not the buildings. Buildings are quite durable and can last decades, but land is the ultimate durable good, it lasts forever.

The value of land does depend on a number of factors and location is certainly the main one. It’s not so much the location of the land that matters, although in some cases, like with a beachfront property or one with a great view, it can, but this has more to do with its relative location, what is nearby.

We should trend away from this as the world gets smaller so to speak, where you can now work at certain things from anywhere, and we may expect this to expand in the coming years. When you add in the ability to do so many other things online, this will all serve to mute the effects of location in the future.

Location will still remain a primary driver of the value of real estate though, as there’s only so many things you can do with technology to narrow the gap between prime and non-prime locations, and there’s still going to be areas where people prefer to live in over others, for a number of reasons.

It does certainly cost more to live in some areas rather than others, and a lot of people don’t give enough consideration to the ultimate costs of living in one area over another. If you’re making more money at a certain job in a certain city, but your housing costs leave you with less money, this is something that’s at least deserving of some careful thought and analysis, rather than just taking or remaining at a job and not thinking about these things too much.

All personal financial decisions are ultimately about value, and value starts with an assessment of what one’s values truly are, and it’s only when we take these values into account that we can correctly determine whether a certain purchase provides enough value to us.

The real estate market is certainly a vibrant one and also one that is remarkably durable and stable, and people invest in real estate in several forms with the expectation that these investments will do well in preserving their value over time. This, for the most part, is an expectation that tends to be well fulfilled over the long term.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: [email protected]

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