The demand for real estate remains to some extent irrespective of market conditions, as people always require a place to reside, and businesses need space to operate. However, the quantity and type of real estate demanded may fluctuate based on factors like changes in people’s affluence, leading to shifts in preferences for more or less expensive properties.
Real estate itself lacks direct substitutes, with the only practical alternatives being homelessness or abandoning commercial and industrial properties. Nevertheless, within the real estate market, the demand for different types and grades of properties does fluctuate. This aspect requires careful attention for those involved in the real estate business.
Some instances in certain regions, like in China, have seen the construction of entire cities with sparse occupancy due to central planning influencing decisions more than market conditions. While to a lesser degree, such failed real estate developments can also occur in the Western markets.
The real estate market is characterized by a considerable lag in response to changes in demand, primarily due to the time it takes to increase supply to meet the rising demand. This lag can persist for many years, particularly in markets where expanding supply is challenging, such as densely populated areas where available land is limited.
Similar to the gold market, the real estate market is relatively inflexible, with new supply additions forming only a small fraction of the overall market on a yearly basis. Although new developments occur annually, they represent a small percentage of the entire market.
Approximately 2% of the real estate market constitutes new supply. This limited increase in supply helps to mitigate the impact of supply changes, contributing to greater market stability.
Changes in Real Estate Supply and Demand
The real estate market is known for its slow-changing nature when compared to typical markets. However, this characteristic contributes to the market’s stability and reduces the level of risk for its participants under normal circumstances. Wide fluctuations in prices are uncommon during such times.
Yet, during economic upheavals, such as the recent housing crisis marked by a surge in mortgage defaults, the market can be significantly affected in the short term. In such situations, an abundance of properties may flood the market, surpassing changes in demand. This can lead to a considerable decline in prices.
During economic downturns, demand tends to contract while supply expands, creating an environment of price depression. However, the real estate market tends to eventually stabilize, as it possesses a certain resilience. Unless the overall economy experiences prolonged depression, like during the Great Depression, the real estate market typically bounces back.
An intriguing aspect of the real estate market is its durability, even during challenging times. During the Great Depression, real estate prices didn’t experience a major pullback but rather remained relatively flat for an extended period.
Historically, in the first half of the 19th century, the real estate market didn’t witness significant fluctuations. However, the second half of the century saw more movement, leading to considerable growth in the United States, with the real estate index rising from single digits in the 1940s to around 100 at the turn of the century, eventually reaching 180 at the peak of the real estate bubble in 2007.
The housing bubble was a result of various factors, such as relaxed lending standards, poor lending practices, securitization of debt that disconnected lenders and borrowers to some extent, and even misrepresentation of borrowers’ ability to service housing debt. When the sustainability of growth depends solely on rising prices and those price increases come to a halt, it can lead to a severe crash in the market. While demand for real estate typically remains steady, it can experience significant drops during exceptional circumstances, as observed during the recent housing crisis.
Main Drivers of the Real Estate Market
Modern economies heavily rely on credit, and any contraction in credit availability, as seen during the Great Recession, can lead to market pullbacks. This credit-driven nature significantly affects the real estate market, as real estate transactions are commonly financed through credit. Moreover, credit plays a crucial role in determining the overall money supply, thereby directly influencing the expansion or contraction of the entire economy.
When the credit market expands, both the supply and demand for real estate tend to increase. Developers can access loans more easily and at lower costs, leading to more construction projects and an augmented supply of real estate. Similarly, prospective buyers find it easier and more affordable to borrow money, driving up the demand for real estate.
Unlike many other markets, the real estate market isn’t as cyclical. One reason for this is that during periods of economic slowdown, interest rates typically decrease, making real estate more accessible. In times of inflation, interest rates may rise, but income also increases, offsetting the higher borrowing costs to some extent, and people still have the means to borrow.
Owning real estate remains a primary aspiration for most individuals, regardless of where the economy stands in the business cycle. People are generally willing to make sacrifices when it comes to housing costs, which they might not consider for other goods.
This willingness to dedicate a significant portion of income to housing costs has led to real estate prices soaring in some areas, particularly major cities, well beyond what might be considered reasonable. When demand outpaces supply, people become willing to spend more on housing, and this trend can drive prices higher.
While lenders are tasked with maintaining a balance, they sometimes become more lenient in terms of the housing cost to income ratio. This occurs when the general market sentiment indicates a willingness to allocate more of their income to housing expenses and when borrowers appear comfortable with such arrangements.
The Effect of Location with Real Estate
As our world moves towards greater decentralization and an increasing number of people working remotely, the real estate market will likely be influenced by these shifts. Technology has advanced rapidly, enabling many roles to be performed efficiently from remote locations, as long as there is a high-speed data connection. However, the adoption of remote work and the transformation of business culture may take several years to fully realize their potential.
Real estate agents often emphasize the importance of location, and indeed, it remains a significant factor driving the value of real estate. The value of a property is largely determined by the value of the land it occupies, as land is the limited resource, not the buildings. While buildings can be durable and last for decades, land is the ultimate durable good, lasting indefinitely.
Location’s impact on the value of land is influenced by various factors, and while proximity to desirable features like beaches or scenic views can matter, the relative location and nearby amenities play a crucial role.
As technology continues to bridge geographical gaps and remote work becomes more prevalent, the effects of location may diminish somewhat. People will have the flexibility to work from anywhere, and the ability to conduct many other activities online will also reduce the significance of location.
However, despite these trends, location will likely remain a primary driver of real estate value. There will always be areas that people prefer to live in due to various reasons, and certain locations may offer unique benefits that cannot be replicated elsewhere.
Cost of living is an important consideration when choosing a location, as it can significantly impact one’s financial situation. Making more money in a specific job or city might not be advantageous if housing costs eat into the overall income. Therefore, it’s crucial to carefully analyze the long-term financial implications of living in a particular area.
Ultimately, all personal financial decisions, including real estate investments, are about value. It starts with assessing one’s values and determining whether a purchase aligns with those values and provides sufficient value in return.
The real estate market is dynamic, vibrant, and remarkably stable. People invest in real estate with the expectation that it will preserve its value over time, and for the most part, this expectation tends to be fulfilled in the long term. As the world evolves and embraces new ways of working and living, the real estate market will likely adapt to these changes while still holding location as a critical factor in determining value.
