Updated 4/22/2022 | For as long as I’ve been in the real estate finance industry (and that’s a long time) friends and family have asked me about real estate values – Are they going up?  Are they going down?  Are we nearing the peak?  Are we close to the bottom?  Over time the question changes, but the question is there.  All you need to do is remember one thing: It’s all about supply and demand.

Anyone who has taken economics 1A has seen the supply / demand curve

The problem is that most people only understand the curve as a static representation of how markets price goods or services.  In reality, the curves move as the factors that drive the motivation of buyers or sellers change.  For instance, as incomes rise, demand for goods and services rise.  The demand curve then shifts, moving the equilibrium price with it.  As production costs fall, the supply curve shifts downward, as producers can now sell their goods at a lower cost and still make a profit.

This is important, because we can examine these phenomena to (sort of) predict what will happen with housing prices in the future.

The demand side of supply and demand

What is demand?  Demand is a function of two factors: the desire for a particular good or service, and the ability to pay for it.  The higher either one of these factors goes, the greater the demand for the good or service.

How does this work in regards to real estate?

Desire

You’ve heard that owning a home has always been the American Dream.  But has it?  There have been times in history when people were so insecure about their ability to continue earning income that the desire to own a home declined measurably.  After the Great Depression and again after the Great Recession polls showed that fewer people – for a while – thought that owning your own home was a good thing to do.

Most of the time, however, our culture drives the perception that we “should” own our own home, and that home ownership is the American Dream.  While there may be some financial benefits to home ownership in the long run, the emotional belief in home ownership tends to be a stronger factor in driving desire.

Related – Own vs Rent – the financial analysis

But the financial component should not be ignored.  Given enough time, owning a home leaves you better off financially than renting.  Over a really long period of time, it leaves you much better off.  Few people do the math well, but home ownership is a smart financial move – as long as you hold on to it long enough.

To be meaningful, in this discussion let us remember the old adage that “all real estate is local.”  In addition to this general emotional attachment to home ownership in America, desire for real estate can change over time based on where people want to live.  Think of failing industrial towns.  People leave those town for better opportunities and values decline, even if the rest of the country is doing well.

On the flip side, areas with high immigration – like Silicon Valley – have become the “least affordable place to live in America” because of two factors: great weather, and a strong job market with eye-popping salaries.

The point is that when desire for homeownership increases, the demand curve shifts to the right as more people are willing to buy at any given price, or the same number of folks are willing to pay more for the same property.  (Either view is an accurate depiction.)

Ability to Pay

We’ve only covered the desire factor, and the demand curve is equally influenced by the aggregate ability to pay for real estate.  The ability to pay for real estate is driven by three factors: Assets (what you have for a down payment), Income (how much you can afford to pay each month), and the availability and cost of financing.

In this light, the financial crisis of 2008 begins to makes sense.  The rapid rise in housing prices leading up to the crisis dramatically outpaced earnings growth, but interest rates were moving down and – more importantly – financing became far more available to anyone, with programs offering stated income, stated asset, low (or no) down payment and looser credit standards.  The Option ARMs (negative amortization loans) made the monthly payments much more affordable, at least initially, by allowing a minimum payment that was actually lower than the interest that was accruing.

The loose availability of credit meant that more home buyers were able to pay more money for homes.  As the demand curve pushed way off to the right, prices rose more rapidly than housing inventory could rise, since it takes a while to bring new homes to market.

This is a very negative example of how ability to pay can move the demand curve, but it isn’t always negative.  In Silicon Valley we have essentially zero unemployment at this writing, and average salaries that are as high as or higher than anywhere else in the nation.  Moreover, many Silicon Valley folks get stock options, stock grants and bonuses (and thus have a lot of cash available for large down payments.) Finally, add in the fact that we are very close to historically low interest rates, and – all things being equal – the typical home buyer in Silicon Valley has the ability to pay far more than their counterpart elsewhere.

(We could also add in the effect of foreign money pouring in buying up real estate; that is certainly affecting most metropolitan areas in the western U.S.)

While these factors explain the wild rise in Silicon Valley home prices, there is always a flip side to this.  Things change.  If there is a serious stock market correction, the liquid cash available for down payments could drop far enough to affect demand.  If there is a high-tech recession, layoffs could impact the ability to carry the monthly cost of ownership.  If interest rates rise, that could affect the monthly cost of ownership too.

Demand changes over time

The message here is that demand for goods or services changes over time; demand for real estate is no different.  When demand increases, prices increase until supply can catch up with the demand.  When the demand decreases, prices decrease until supply decreases accordingly.

The supply side of supply and demand

Supply doesn’t exist in a vacuum.  Producers respond to demand.  (Business don’t spend money to produce widgets or offer services unless there is clear demand – a market for them.)  Some businesses invent new products, of course, for which there is no current demand, but they then spend massive amounts of money creating demand through advertising and promotion.  Some succeed, some fail.  If a new product succeeds, other businesses arise to meet the demand – showing how producers respond to demand over time.

So what makes up supply?  Like demand, when it comes to real estate supply is not driven only by financial considerations.  We could think of it as desire, too, but it makes more sense to me to think of it as motivation.  If one seller is more motivated to sell than another, then all things being equal they will accept a lower price.  The converse is also true – an unmotivated seller may hold out for a higher price, or may not sell at all.

This also helps explain the financial crisis, as homeowners who found themselves unable to make their payments suddenly became highly motivated to sell even if they would have to sell for a loss, and banks that suddenly had large inventories of foreclosed homes were similarly motivated.  With fewer buyers being able to qualify because of the collapse of the sub-prime / stupid lending market, values were bound to go down and the number of available homes on the market was bound to go up.

The lesson is that the motivation of sellers of real estate can change very quickly, and brings about rapid changes in market conditions.

In the long run, however, financial considerations are a larger factor, because in the long run supply is increased only by building more homes, and developers tend to want to make a profit.  The higher the cost of raw materials and labor to build a home, the higher the price will be.  The greater the perceived risk in being able to sell a home, the higher the potential profit margin the developer will demand before making the commitment.

What happens when the supply increases too rapidly?  We’ll see more homes sold, but lower prices.  In this example, the higher prices induce builders to build more homes, but if they build too many and over-run supply (S2 in the chart to the right) prices can decrease. (P3)

Intuitive supply and demand

If you want to reason out whether prices are likely to go up or down, therefore, you simply have to ask the following questions:

Is there any factor present which is changing the demand for real estate by the typical buyer?

Is there any factor present which could influence the ability of the typical buyer to pay for real estate?  (Think down payment, and monthly expenses and the cost and availability of financing.)

Is there anything about how or why individual home sellers are motivated to sell which might change?

Are developers willing and able to bring new homes on the market to satisfy growing demand for housing?

The housing market is complex, but at its core, it is still driven by supply and demand.

Casey Fleming, Mortgage Advisor and Author of The Loan Guide: How to Get the Best Possible Mortgage