Topic 15.2: Economic Characteristics of Real Estate

Learning Objective

After successfully completing this topic, you will be able to describe the economic characteristics of real estate.

Government Regulations Influence the Market

Government actions and controls such as zoning, building codes, and tax policies have a major influence on the value of a parcel of land. 

Relationship Between Supply, Demand and Price

Supply and demand affect real estate values. Changes in either the supply or demand for real estate will affect its price.

For example,
Assume that builders in a particular city overestimate the demand for houses and overbuild in the area. Because of the oversupply of homes, homeowners who need to sell may need to lower their prices. Alternatively, imagine an area with few homes. If a large company builds a factory nearby, there will be lots of demand by new workers, but low supply. Prices will go up.  

Slow to respond to change in supply and demand

Overbuilding will take many years to get back in balance as new residents in the area buy and bring down the supply.

The example of a new factory will result in builders rushing to meet the increased demand. However, the builders will have to purchase land, get permits for development, prepare the site for roads and utilities, get building permits and construct the homes. It can take up to a year before the first houses are ready to occupy.    

Demand factors

Factors that influence demand for real estate include the
• price of real estate (inverse),
• population and household composition (direct),
• income of consumers (direct),
• availability of mortgage credit (direct), and
• consumer tastes and preferences (varies).

The price of real estate affects the demand for a parcel. Suppose a prospective buyer is interested in a certain neighborhood. If there are two houses that are similar in location, size, and style, the customer will normally select the home with the lower price. The price affected the demand. The same is true for investment property. There is an inverse relationship between demand and price. When prices increase, the demand will tend to decrease.

Population and household composition 

Increased population results in increased demand.

Demand for real estate is directly related to the population and the number of persons in a household. If one assumes that population in an area is expected to be 250,000 at the end of ten years, and the expected number of persons in a household is 2.5 people, the area will need approximately 100,000 homes (250,000 ÷ 2.5). If a study shows there are currently 88,000 homes, builders should expect to see demand for 12,000 additional homes during the next 10 years.

About 100 years ago, the number of persons in a household was about 5. Just the reduced number of people in a household would result in more than double the number of houses needed. With fewer occupants, the size of the homes tends to be smaller.

Income of consumers

Most consumers make buying decisions based on their incomes and the likelihood of continued employment. Demand is directly related to the income of consumers. In times of recession when consumers lose their jobs, the demand for real estate is adversely affected.

Availability of mortgage credit

Demand is directly related to the availability of mortgage credit. Most buyers need to finance the purchase of their homes. If financing is not available, or if lending standards have become very strict, demand for housing will decline.

The cost of the credit is also important to demand. If interest rates rise, fewer buyers can qualify to purchase property. Assume a customer wants to purchase a home when interest rates are at 4% annually. For a 30-year $200,000 mortgage, the monthly payment of principal and interest would be $955. At 6% the same mortgage would have a payment of 1,199.

Consumer tastes and preferences

Consumer tastes affect demand, either directly or inversely. In many areas, buyers mostly favor traditional home designs. The prices of non-traditionally designed houses may be lower.

As incomes have risen over the past few years, many families have purchased vacation homes and timeshares. The values of these vacation properties are directly affected by this demand, but are the first to decline in times of recession as families cut back. 

Empty nesters tend to move to the southern areas of the country in their retirement years causing an increase in demand for condominiums and smaller homes in those areas.

Supply Factors

Factors that affect the supply of real estate include
• availability of skilled labor,
• availability of construction loans and financing,
• availability of land, and
• availability of materials.

Availability of skilled labor

Availability of labor is a supply factor.

In 2019, before Covid 19, the overall unemployment rate averaged about 3.5 percent. That is effectively full employment. New workers are hard to find during times of full employment, and builders have to offer higher hourly pay with benefits to attract the workers they need to continue building. As payrolls increase, the builders pass on those increases to buyers in the form of higher prices. Remember that price is a demand variable; when prices rise, demand falls. 

Availability of construction loans and financing

In 2020, the market remained strong and construction loan interest rates remained low. This may change if inflation becomes a factor, and builders will have to factor in higher costs of borrowing. 

Availability of land

Land is readily available, but finding sites ready for building is sometimes a problem for builders. It takes time for permitting and land development. And as we know, the demand for the best areas increases the cost of buildable land, making the housing more expensive.

Availability of materials

In 2018, the tariffs placed on lumber from Canada caused a 6% increase in housing costs. It demonstrates the effect that a shortage or cost increase in materials can have on house prices.

Interpreting Market Conditions

Price levels

When houses are scarce, prices increase.

Price is based on supply and demand. If economic activity declines in an area, some workers will have to find work elsewhere, and put their homes on the market. With more homes available than buyers to buy them, prices will tend to fall. It then becomes a buyer’s market (the buyers have the advantage).

If the supply of houses in a desirable area is scarce, prices will tend to increase. Because sellers have the advantage, the area becomes a seller’s market.

Vacancy rates

Assume a small city has 100,000 houses. If 93,000 of the houses are occupied, the occupancy rate in the area is 93% (93,000 ÷ 100,000). 7,000 of the homes are vacant, so the vacancy rate is 7% (7,000 ÷ 100,000).

Ordinarily, a 95% occupancy rate is a balanced housing market. As the occupancy rate increases (and the vacancy rate declines), prices will tend to increase.

The same principle applies to apartment properties. If vacancy rates are 20% or higher, it becomes a buyers’ market, and landlords will begin to offer many incentives to obtain new tenants. When vacancy rates approach 5%, prices will increase until new apartments are brought to market.

Sales volume

Brokers and sales associates must keep up with market trends to help buyers and sellers understand the market. MLS data lets licensees find trends in the market place, including the most popular areas, most active price ranges, and the average times on the market. The sales volume also helps brokers check to see that their market share is steady or increasing.

For Example
If the MLS shows that 3,000 homes were sold in the market last year, and the broker’s office made 450 sales, the brokerage firm had a 15% market share (450 ÷ 3,000).  If the broker checks sales volume, which was $7,000,000 and the broker’s sales volume was $1,000,000, the broker’s market share based on volume is 14.3%

Area preference−Situs 

Real estate is fixed as to location. Location is a parcel’s situs. Because certain areas are preferred by buyers, the market value tends to be higher for the comparable homes in those areas. For example, if the situs of a home is on the waterfront, that house will usually have greater market value than a house across the street that is not on the water.

Market Adjustment

Because of the differences in the situs of property, appraisers usually make an adjustment to the sale price of comparable properties with a different situs. 

Buyer’s market

A buyer’s market occurs when buyers have an advantage over the sellers in a market that has an oversupply. Prices tend to decline.

Seller’s market

A seller’s market occurs when the sellers have an advantage over buyers. If the inventory of available houses is in short supply, buyers are forced to pay higher prices demanded by sellers.