What drives home prices?

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The coronavirus pandemic has most people wondering what will happen to home prices this year. While demand currently is stable, the big risk is employment. If the employment rate does not come back to pre-covid-19 levels, unemployed homeowners will have no option but to sell their house.

That increase in supply, combined with a high unemployment rate, plus a huge number of companies shutting down, could set the stage for home prices to drop this year.

I often hear people say that because interest rates are low, home prices will go up; or, they find one reason to justify their thinking of what will happen in the real estate market. That is like saying that tomorrow will be sunny because it rained today.

The reality is home prices are driven by many factors including the following:

  1. Cost and accessibility of mortgages
  2. The velocity of money
  3. Local employment rate and productivity growth
  4. Supply and demand for housing
house prices plan

However, if you ask a real estate agent whether home prices will increase or decrease, chances are you’ll get a favorable view as it relates to future home prices.

The truth is that there are a lot of factors that are converging right now as a result of the Covid-19 pandemic. This has created the perfect storm, which could result in home prices decreasing by 15% or more.

That means a first-time homebuyer entering the market could see losses of over $75,000 on a home priced at $500,000. However, we could still see prices go up instead of down. What happens over the next six to nine months will determine the side of the pendulum home prices start moving towards.

So, should home buyers and sellers out there buy, sell, or wait?

Why do home prices go up?

Let’s picture this, you’re back in high school and want to sell the bicycle you’ve used for the last two years. It’s a nice bike, so your friend Julio just made an offer for $50.

You like the offer, but you want to enjoy your bicycle for the weekend, so you asked Julio to wait for Monday to close the transaction. When Monday arrives, word has gone out, and you now have five other school friends interested in buying your bike for $50.

What do you do? If you’re like most people, now you want more than $50, right? You’ll likely accept the highest offer you can get. What if a rich kid comes and offers you $100? Is your bicycle all of a sudden worth $100??

It works the same way in real estate; when there are more buyers in the market willing to buy homes, home prices increase.

You might wonder, why would there be a bunch of kids with so much cash all willing to buy your bike, and where did all that money come from. Their parents must have good jobs and lots of disposable income, right?

This is referred to as market liquidity; when it comes to real estate, this liquidity is provided by lenders in the form of access to mortgages for homebuyers.

The more money there is flowing in the economy, the higher home prices are going to be.

Home prices also rise for the following reasons:

  • When people can borrow money to buy houses.
  • House prices rise when people expect to get richer in the future.
  • Home prices also rise when fewer new homes are built.
  • If there is a consistent increase in population growth

Cost and accessibility of mortgages

Over the last 15 years, we have seen unprecedented amounts of money being flashed into the economy at interest rates near zero. Thus, getting a mortgage became easier and cheaper. This gave home buyers the confidence to rush in and realize their homeownership dream causing home prices to push higher.

That sounds like our earlier example of expecting more money when six kids were waiving $50 dollar bills at you to buy your bicycle, right?

A good amount of money flow in the economy is good because it signals that people have money to buy things, companies are selling their products and employing more people, who then use the cash they make to buy more things, and money keeps changing hands.

The issue comes when people have to spend so much of their income to pay bigger mortgages, which means less money available for other things like buying a car or good food.

The drop in local spending then results in lower profits for companies, which then have to lay off employees who can’t afford basic things, let alone buying expensive homes.

Eventually, the flow of money slows. 

How does the velocity of money work?

First, what is the velocity of money? No, it’s not money on wheels, although that’d be fun. The velocity of money is the speed at which cash exchanges hands.

Without money velocity, there may not be inflation, which may cause home prices to fall. For example, a home that takes six months to sell would sell for a lower price than a similar home that took one month to sell.

The biggest threat to our economy right now is not the millions of unemployed workers; it is not even the trillions of dollars we have in national debt. Well, if it’s not that, could it be the thousands of companies that are filing for bankruptcy as a result of the Covid-19 pandemic? No, it’s not that either.

The greatest threat to our economy right now is that people are saving money like never before. Wait, why is that a threat exactly? The thing is, consumer spending accounts for 70% of our total economic activity.

If people aren’t spending enough money, it means companies have fewer customers, which results in having to lay off employees, which then circles back to wages going down, and before you know it, we are in a recession.

Even though governments keep printing money and interest rates are low, this cheap money has little effect on the real economy.

We could soon see home prices decline as a result of money a lower velocity of money.

Local employment rate and purchasing power

Homeowners spend over a quarter of their income to pay for housing expenses; some spend more, and others spend less depending on demographics and age. However, in every region, housing remains one of the most significant sources of economic activity and employment.

A key factor that affects home prices is the health in the economy; this is generally measured by employment levels, GDP growth, manufacturing activity, and the inflation rate. When these economic indicators drop, so does real estate.

For example, the higher the rate of unemployment, the fewer people can afford to buy homes, and that causes home prices to drop. Then, as demographics change and people’s income increases, demand for homes goes up, which results in a long-term positive effect on home prices.

Conversely, when real estate prices become too expensive, land prices go up, forcing companies to relocate to suburbs and move employment growth from cities to other areas.

In short, if housing is less affordable in the city, employment growth is slow. This happens because land supply in unaffordable cities is inelastic; if a company wants to move into the area, the demand is likely absorbed by nearby cities driving workers to cities with lower rent or land prices.

Real estate market cycles and their effects on home prices

It’s no secret that the real estate market moves in cycles. If you’re planning to sell or buy a home, step number 1 is to understand what type of market you’re in. You can summarize every real estate market in the world into three types of markets; these are:

  1. Cyclical market
  2. Linear market
  3. Hybrid market

Cyclical markets are real estate markets that tend to have large price moves over the years. You can think of it as a roller coaster ride; home prices go up to exciting highs but eventually come crashing down. These are the markets that get the most media attention.

The length of a cycle in a cyclical market typically lasts between 5 to 10 years, but this can change from region to region because real estate is local.

Good examples of cyclical markets right now are cities like San Francisco, Seattle, Denver, or other cities where median household income is high and supply for new housing is low.

Another good example of cyclical markets is cities where many households work in cyclical industries such as the energy industry. When those jobs decline, the area becomes ground zero for falling home prices.

Real estate investors hoping to make money in a cyclical market are really gamblers and speculators.

The key to making money in real estate is buying low and selling high, not buy high a selling higher. Many people fall into the trap of buying high and pray that prices keep going up so that they can sell higher.

To do well, you have to have the luck to time the market well so that you buy when prices are going up and sell before prices begin to decline.

The problem with cyclical markets is that if home prices decline, you could end up with a home that is worth less than what you bought the home for; then, it might take a few years before you can recover that loss, and then prices may fall again.

Linear markets are areas where home prices increase consistently over time with little room for price drops. The big advantage of linear markets is that there is much less downside price risk because the increase in home prices is highly correlated to local steady economic growth.

Cities with a finite supply of land but with consistent demand for housing, such as NY, are good examples of real estate linear markets.

However, keep in mind that some linear real estate markets could become cyclical markets if prices are pushed to unaffordable levels.

When home prices get to unaffordable levels, few people can afford to buy those homes. At that point, buyers dry up, the equilibrium is lost, and home prices come crashing down since there are more homes for sale than buyers.

Hybrid markets, as its name implies, are neither linear nor cyclical but right in between.  Home prices in hybrid markets have more price movement than in linear markets, but the ups and downs are not the boom and busts seen with cyclical markets. They are right in between.

If you are thinking of buying a home, I highly recommend you check out our Home Buyer’s online course. You will learn the entire home buying process step-by-step.

Click Here: Home Buyer’s online course

Why are homes so expensive?

Home prices have little to do with the costs that it takes to build the property and more to do with the value of the land.

The first time I bought a home and called to get the property insured, I was surprised to find out the insurance company would only insure the property for the replacement value, which was a fraction of what I had paid for the home.

While I had paid $400,000 for the home, the insurance company insured the property for $180,000. Why? Because if there was a fire and the property got destroyed, it would take $180,000 to rebuild the same home.

When you buy a home, the difference between the replacement cost and market value of the property is the value of the land.

This bears the question, why does the land cost so much?

One reason is that while demand for new housing keeps growing, the supply of new homes does not increase at the same rate. Also, the number of people living in one household is getting smaller; some people choose to live alone, so the demand for homes keeps growing all the time.

The issue with high home prices is low supply. Politicians know this but homeowner voters have a vested interest in seeing home prices increase. So instead of building new homes, policymakers lower interest rates to make it cheaper to borrow.

Unfortunately, though, creating easy credit does not make homes more affordable. When you ease credit without increasing the supply of new homes, you’re just be making homes more expensive, which is precisely what has happened.

You might be able to borrow more, but so can other people. The result is you’ll have more people chasing a low number of homes and bidding against each other while pushing home prices higher and higher.

Could home prices decrease?

You bet! Home prices can and do decrease; it’s a matter of when and by how much home prices will decrease, but they will; that’s why it’s important to understand at what stage of the market cycle you’re in when you buy. Are you buying at the peak, at the bottom, or in the middle of a market cycle?

What can cause home prices to decline?

First is unemployment; if people aren’t working, they won’t be able to pay their mortgage. A rise in unemployment is often followed by more strict mortgage approval standards, which means fewer people will qualify to buy homes.

When there are fewer buyers out there looking to buy properties,  home prices decline.

  • An increase in interest rates can render some hopeful homebuyers unable to afford a mortgage.

  • An economic recession could lead to a drop in disposable income, high unemployment, and lower demand for housing.

  • An unbalance equilibrium between current home prices and what homebuyers can afford.

Are home prices going to increase in 2020?

Look at the fundamentals. What are the things that could drive prices higher?

Are interest rates going to go down a lot? Probably not – they are now very close to zero. Are we going to see huge wage growth that will improve purchasing power? Probably not right now – businesses are laying off people at record rates, and it’s really uncertain the economy will recover to full speed anytime soon.

Supply and Demand for housing

Competition drives prices. When the market has more buyers than sellers, prices go up because a higher number of buyers chase a limited number of homes available for sale.

So, when demand is higher than supply, property prices rise. This is often referred to as a seller’s market.

The reverse happens when the opposite is true; when there are more sellers than buyers, home prices drop because sellers get desperate and reduce their prices to catch buyers’ attention.

Hence, when supply is higher than demand, property prices drop. This is often referred to as a buyer’s market.

Various factors can influence a rise in demand in a particular neighborhood vs. another. These include:

  • New shops, cafes, recreation facilities, and shopping centers

  • New infrastructure projects such as highways, roads, public transport routes.

  • Reputable companies relocating to nearby

  • How well-maintained properties are in the area

If you want to learn more about what drives home prices including how to buy the right home, for the right price, on your terms, you should check out our New Home Buyers Online Course.

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