Raising Your Real Estate IQ
At present, most of the nation’s local real estate markets are strong buyer’s markets. That is, the number of buyers placing bids and purchasing homes is significantly less than the number of homes available for sale and in inventory (listed). Sellers are forced to bring prices down to meet buyers’ demands. This state of affairs is expected to continue until the inventory of homes becomes more in balance with the demand for homes. The nation’s month’s supply has been hovering between a relatively high 9 and 10 months during the past 6 months. Some local markets’ months supply exceeds 10 months, while other local markets months supply falls below 10 months.
Anatomy of a Real Estate Market
Depending on the market’s current condition (i.e., the balance between demand and supply), property values are either headed upward, going downward, or staying flat. From a buyer’s perspective, you are negotiating for a property from either a position of strength, weakness, or somewhere in between. Moreover, local property markets are always changing. What may be balanced today might be a seller’s market tomorrow, and a buyer’s market a year from now.
When the demand for homes in a particular area increases, there is upward pressure on market prices. In other words, when demand is more robust than supply, prices increase. But often the supply of available homes does not immediately change in response to increased demand. This is due either to time lags between a change in price and an increase in the supply of new properties becoming available (builders cannot react instantaneously), or to homeowners delaying putting their properties on the market. When demand increases and supply has not had time to respond, the resulting excess demand exerts upward pressure on home values. As inventories increase over time-from the construction of new homes and homeowners putting their homes on the market-one can expect to see downward pressure on prices.
A Balanced Market
In the ideal local real estate market, there should be a balance between the demand for homes and the supply of homes available for sale. Although there is no exact benchmark to measure balance, there are ways of knowing if a local market is close to being a balanced one.
A local market has an adequate supply of homes for sale if houses on the market sell within five to seven months (some locations may be on the low end of this range and others on the high end). This means that at the current sales pace, the entire inventory of homes would be sold within five to seven months.
Of course, demand for home buying depends on a variety of factors, including local job growth, income growth, mortgage rates, and net migration. In a balanced market, neither the buyer nor the seller has the upper hand in negotiations. Current examples of local markets that are near balance include Charlotte, North Carolina and Houston, Texas. Neither area participated in the real estate boom, but neither stagnated either. A well balanced local market is a more sustainable market.
It is difficult to determine the exact amount of housing demand and housing supply that creates a balanced local marketplace. That is because each local market is unique. One practical way to identify a balanced market is to look for home values that produce a 3 to 5 percent price appreciation (difficult to do in today’s real estate recession). The goal of any housing market should be to generate healthy and sustainable price appreciation.
A Seller’s Market
When the market demand for homes in a particular area is high and there is a shortage of homes available for sale, the balance of power in the market shifts toward the seller. With excess demand in the market for homes, sellers can wait for offers on their property to reach (or exceed) their minimum selling price.
We were in an extreme seller’s market throughout the 2003 to 2005 real estate boom in most of our nation’s housing markets. Housing was “hot,” particularly in ocean resort towns. This prolonged excess demand for properties exerted substantial upward pressure on prices.
A Buyer’s Market
When demand for new and existing homes is weak and there is a glut of properties available on the market, the upper hand in negotiations switches to buyers. Buyers now have a much wider choice of properties from which to choose and are often able to negotiate a price that is lower than the listed price. This is obviously the case in many of our nation’s local market today. Aside from today’s market, the most recent buyer’s market was during the 1983 to 1992 period, where the average supply of homes available for sale registered a lengthy 9.2 months supply. There was an excess supply of homes in the nation at large, and housing demand fell due to a slowdown in the U.S. economy and double-digit mortgage rates. One local market that was particularly hard hit during this period was Boston. The months supply of homes in Boston rose to an unthinkable 16 months. At the same time, the local Boston economy experienced a sharp recession and lost 15 percent of its jobs. That created a serious imbalance between weak housing demand and excess supply. Predictably, home values plummeted, creating a buyer’s market in Boston during the 1990s. Sellers did all they could do to sell their homes-even offering to pay some of the upfront costs of the buyers, reducing the listing price and offering other incentives to attract buyers. Of course, sellers are again offering price and non price incentives in today’s extreme buyer’s market.
Many times, local markets are in transition-switching over from a seller’s market to a buyer’s market, or vice versa. In transitioning markets, the balance of (negotiating) power is in flux. This transition is what occurred in many of our nation’s previously hot local markets when the real estate boom slowed in late 2005 and then cooled in 2006. Both buyers and sellers need to beware when negotiating in a transitioning market. The key in today’s market is to today’s buyer’s market is knowing when each local market is transitioning to a more balanced market.
Usually in the early stages of a market transitioning from a seller’s to a buyer’s market, sellers remain stubborn and continue to list their properties at high prices. At the same time, buyers have lost their appetite to bid at such lofty prices. If you are a seller, you need to carefully read the market. Listen to your Realtor-that is what he or she is there for. To sell more quickly, list your home at a more reasonable price that reflects current market conditions. If you list your house at a price that reflects last year’s market, your property will remain on the market longer, costing you lost opportunity money. Most real estate agents will tell you that in a softening market, you need to present a reasonable listing price in order to sell the property. Usually, most serious interest from buyers is generated in the first few weeks a property is listed. If the listing price is too high, the property will sit, lose its luster, and force you to lower the price even more to attract potential buyers.
If you are a seller, the lesson you should learn from a market that is transitioning from seller to buyer is to forget about the “good ole days” of high-price growth. You are no longer going to get top dollar. Price your property correctly. In fact, during market transitions, your real estate professional will likely recommend staging-where you “window dress” your home to attract prospective buyers to want to live there. You will find many ways to spruce up your home on the HGTV cable channel: eliminating clutter, removing some furniture to create a spacious appearance, repainting rooms in neutral tones, eliminating personal items like family photos, and so on. Curb appeal-such as landscaping-is equally important.
If you are a buyer, you need to be more sensitive to your strengthening negotiating position. If days-on-market time lengthens for the seller (your Realtor can tell you this), you are in a better position to make demands. For example, you can bid a lower price, ask the seller to pay points, and negotiate the timing of the transaction, to name a few options. If you are bidding on a new home, the builder may be willing to make concessions. While the builder may not reduce price because he does not want to anger recent buyers, he may be willing to add upgrades to the deal. The list of possible upgrades can include landscaping, free washers and dryers, crown molding, upgraded window treatments, paying down the mortgage rate, or paying the first six months of mortgage payments.
When the market is transitioning in the opposite direction-from a buyer’s to a seller’s market-the roles are reversed. If you are the seller, you will be calling the shots. There will be less need for staging and you will probably not have to offer buyer incentives. If you are a buyer in a seller’s market, flexibility is a key in negotiations. You may need to bid higher than the listing price, depending on the number of bids and interest. You may also need to bid quickly-you may not have the luxury to think about the offer. You may also have to be more flexible in the timing of the transaction.
Demand for Property
Whether you are a first-time buyer, a trade-up or trade-down buyer, a second home buyer, or a real estate investor, there are a variety of reasons why and where you purchase property. Put all these households and factors in a mixing bowl, stir them up, and you have the local demand for property. Demand for real estate influences the willingness and ability of households to make home purchases. All factors influencing demand can be grouped into four categories: population factors, home buyer wherewithal factors, investment factors, and purchase-cost factors.
Population growth is the primary fuel behind home buying. The more people (households) living in a neighborhood or city, the greater the demand for homes. The operative adage is that high population-growth rates are good for housing, while low population-growth rates are not. The population of a local market influences property values through:
- Internal population growth
- Household formation
- Net migration
- Demographic trends
Internal population growth: is the difference between birth rates and mortality rates in a local market. Young metropolitan areas (those with a low average age for its total population) are likely to have high internal population-growth rates compared with older metropolitan areas (those with a high average age). This is because a young community with , let’s say, a median age of 32 years is more likely to have children and so increase the internal population of that community than an older community where the median age is 55. Thus, without any other influences on the population, a younger metropolitan area should experience a more robust demand for housing (trade-up buying) vis a vis an older one.
Household formation: Households range from a single person living by him-or herself, to a married couple, to a mother and/or father living with children. A married couple is considered one household because they live in a home together. Change in the trend of household formation impacts the demand for housing. When a couple divorces, for instance, they are now considered two households, because they will be living separately. Thus, divorce rates influence household formation and housing demand increases: the higher the divorce rate, the greater the number of households looking to purchase a home.
Net migration: Migration is the term for people moving from one location to another. In-migration represents the number of people moving into an area; out-migration is the number of people moving out of an area. The difference is the net migration. If more people move into that out of a metro area, you have a positive net migration.
Demographics: are perhaps the best-known influences on the demand for home buying. The largest demographic player right now is the baby boomer population group. We saw their impact on the housing market in the 1990s, when boomers entered their peak earning years and home sales exploded. There are about 78 million boomers, and they fueled the purchase of larger homes (trade up buying), second homes (vacation buying and/or investment), and condominiums (downsizing). Because analyzing demographic trends is crucial in understanding future home values by location, following the behavior of the boomers will help identify the robust and down markets during the next 5 to 10 years. Further, focusing on the life cycle trends of all major demographic groups - retirees, boomers, the baby bust, immigrants and echo boomers-will allow us to better anticipate future real estate values.
Homebuyer Wherewithal Factors
Homebuyer wherewithal means having the necessary income and savings to purchase property you wish to buy. If you have never owned a home before but you have saved a sufficient amount of money to purchase a home, you will likely do so. If you are a current homeowner and want to purchase a larger home and you have the funds to do so, you will likely purchase a trade-up home. The greater a household’s financial wherewithal, the greater the demand for home buying.
There are many ways to raise your financial wherewithal through income growth, favorable employment opportunities, consumer confidence and stored wealth. As a household’s income rises, so does its demand for housing. Similarly increased income raises the demand for more expensive properties as people enter the trade-up market. The typical homeowner spends about 20 to 30 percent of disposable income on housing (mortgage payments and housing-related goods and services- e.g. furniture, landscaping). The greater your income, the more likely you can purchase the property you desire.
It follows that local markets with relatively high average or median household income levels may experience healthier real estate markets than do those local markets with low household income. It is also true that markets with higher median home prices relative to median incomes may have lower homeownership rates than do more affordable markets. In addition, local markets with high unemployment rates will inhibit property purchasing, while markets with low unemployment rates and job creation are likely to promote home sales, exerting upward pressure on property values.
Confidence is more vital in the purchase of property than almost any other good or service sold. This is because purchasing a home is probably the biggest financial transaction most of us will ever make. If people see their local economy deteriorating, they may become less optimistic about their own financial circumstances. A drop in their confidence may end their search for a new home or delay entry into the existing home marketplace.
In addition to income, people store or accumulate wealth through savings, inheritance, existing home equity, investments, or gifts. Obviously, the greater your wealth, the greater your demand for home buying.
Property owners expect the value of their property to rise over time; that is what is referred to as price expectations. The fact is, real estate is America’s number one vehicle for building wealth. The majority of wealth for almost 80 percent of all households is derived from the real estate market, not from stocks and bonds. For many, real estate equity is the only way to build a nest egg for retirement.
Of course, if price expectations are unreasonable, the price we pay for property may also be unreasonable. For instance, during the height of the real estate boom, in many of our nation’s hot housing markets, home buyers and property investors were willing to pay unreasonably high prices for rental property. Investors hoped that eventually future price gains would outweigh the negative annual cash flow generated by the mismatch of low rental income and high expenses (including the mortgage).
What is an unreasonable price? A price is unreasonable when demand is so great for a property that the buyer abandons the fundamentals of the transaction to make the purchase. One way to determine when prices are unreasonable is to look at the ratio of the home-price growth to income growth. When home prices grow too quickly relative to household incomes, homes become unaffordable. During the real estate boom, households had to stretch their incomes by using interest only mortgage loans to keep monthly costs down in order to purchase properties at lofty prices. A better more reliable measure of unreasonable pricing is the mortgage debt service/income ratio. If prices are out of line with reality, households and investors have to stretch their financial capacity to purchase the property. Their hope is that as demand for housing increases-from renters, homeowners, and investors-the equity in their homes will also increase.
The speculative element in real estate purchasing arises when households (mostly investors) believe that future capital gains will be high and will be able to be realized in a short period of time. A rise in the expectations of future short-term capital gains attracts speculators to the real estate market. This in turn, raises the demand for home buying. The 2001- 2005 real estate boom attracted thousands of speculators to the real estate markets, pushing home values even higher. Such speculative activities included property flipping, preconstruction purchases, and condo-conversion purchases.
In general, if the cost of purchasing a property rises, demand will fall-and vice versa. There are four major factors that influence the costs of property ownership: mortgage rates, settlement costs, mortgage product offerings, and tax/government subsidies.
Property is still the most interest-sensitive purchase in our economy. This is because the majority of property purchases are financed with a mortgage, and so those mortgage rates matter. A rise in borrowing costs can make the transaction cost-prohibitive. Although the level of mortgage rates may differ slightly across regions of the country, by and large, mortgage rates are homogeneous across the nation. If they rise by 1 percent in New York, they rise by 1 percent in California. Changes in mortgage rates directly influence the demand for housing.
That said, a 1 percent rise in mortgage rates in San Diego will impact local housing demand in San Diego quite differently that it impacts demand in Buffalo, New York. The demand for home buying in San Diego is more sensitive to interest rate changes than the demand for home buying in Buffalo. Why? The median-priced home in Buffalo is a bit under $100,000, while the median priced home in San Diego is a bit over $600,000. Households in San Diego are already stretching their incomes by taking out adjustable-rate mortgages to be able to afford and qualify for homes that are vastly more expensive than similar homes in Buffalo. As a result, a 1 percent rise in mortgage rates results in a much higher per month payment in San Diego than in Buffalo (1 percent of $600,000 is six times more than 1 percent of $100,000).
Settlement Costs include title insurance, appraisal, mortgage insurance, credit-report fees, escrow fees, homeowner’s insurance and loan origination fees. These are payable at a property closing. They assure the lender that the property transfer is in order and that the lender can use the property as collateral if you default on the mortgage loan. Most of the time, your real estate agent or lender will recommend settlement service providers, but you can find service providers on your own as well. Either way, settlement costs can be quite substantial (1 to 4 percent of the loan balance). A rise in settlement costs, too, can inhibit home buying, especially among first-time buyers; conversely, a drop in settlement costs can motivate home buying. Settlement costs can vary across states because of different state and local requirements and pricing for settlement service providers.
Although there are less mortgage product offerings today than during the boom years, there still remains and long and varied menu of financing options for home buyers. Here are just a few mortgage loans currently available in the marketplace: thirty-year and fifteen-year fixed-rate mortgage loans; interest only loans, cash flow option adjustable-rate mortgage loans; FHA loans; VA loans; Fannie Mae and Freddie Mac loans; jumbo loans; one, three, and five-year adjustable rate mortgage loans; rural housing loans, reverse mortgages…and so on.
The availability of mortgage credit is one of the most influential factors that affect demand for home purchases. This was never more evident than during the 2007 - 2008 mortgage credit crunch, when home sales plummeted by more than 25 percent The greater the number of available mortgage loan products, the easier it will be for households to find a mortgage loan that works for them.
Tax and Government Benefits
No other sector of the economy receives more of the attention and generosity of federal, state and local governments than real estate. On a national level, the Department of Housing and Urban Development (HUD), the Federal Housing Administration (FHA), the Veterans Administration (VA), Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System are dedicated to promoting housing and assisting low and moderate income and minority households. This is true on the state and local levels as well. The more government assists the housing sector, the greater the demand for home buying.
For most households, the largest deduction on their tax returns is the mortgage interest deduction. Other important tax benefits include the deduction of property taxes, home purchases deductions and capital gains exemption from a home sale. The interest you pay on a mortgage loan of up to $1 million for your primary residence is tax deductible on your tax return. You may also deduct the interest paid up to $100,000 on a second home and/or home equity loan (although the total loan amount on a primary and second g home cannot exceed $1 million). Property taxes are completely deductible on all real estate owned. A home buyer may also deduct closing costs with a real estate purchase on his or her personal income tax in the year of the purchase. These items include origination fees and loan discounts, transfer taxes, recording fees, and title insurance that serve to increase the basis (the original cost of the property). Finally, there is a generous tax exemption on the capital gains from the sale of a home. The current exclusion is $250,000 for individuals and $500,000 for married couples filing jointly. The only requirement for this capital gains exclusion is that the seller lives in the home for at least two of the previous five years. The capital gains exemption plus all the other deductions provide a distinct advantage for the purchasing and selling of real estate over other assets. If and when the real estate tax rules change, so does the demand for property purchases.
Supply of Property
Housing supply depends on a number of factors including construction costs, local growth restrictions, and homeowners’ and builders’ responses to demand conditions. If five of your neighbors decide to sell their homes just as you are ready to put your home on the market, now may not be the best time to add to the housing supply.
The various materials that go into building a residential property influence its cost and thus the number of homes that are built, as well as the price for each home. Take for example lumber. The United States imports a great deal of lumber from Canada. The tariffs and quotas between the two nations may influences the price of lumber imports and the amount of lumber imported. A more restricted supply of lumber will affect both the price and the supply of homes. In recent year, the prices of steel, copper, and other materials have risen significantly, contributing to price appreciation.
Labor costs and other nonmaterial builder costs also influence the supply of homes. I fhte local housing market is hot, a general contractor will have a difficult time holding down costs from subcontractors (such as electrical work, framing and so on). In some local areas, subcontractors are busy, limiting the total number of homes that can be constructed in that area and increasing costs.
The cost of construction-or even the ability to build-is very much dependent on the local political climate and relationships that builders develop with local policy makers. Local growth restrictions rein in the number of homes available for sale by limited their construction. For those homes that are being built, getting site permits, building permits, and so forth adds to the cost of construction. Smart-growth policies, as they are called, have become more common throughout the nation. The notion behind “smart growth” is that as our population grows, we must use land more efficiently and plan for growth. Comprehensive planning, innovative land use techniques, well planned infrastructure, and urban revitalization are universally recognized smart growth strategies. On the other hand, urban growth boundaries and development regulations disrupt markets and driveup the price of housing.
Like any business, builder will increase or decrease the inventories of their products with changing market conditions. A high growth rate in housing starts (construction projects) reflects builders’ response to healthy housing conditions; a slowing in the growth of housing starts reflects builders’ lack of confidence in the housing markets. By tracking starts and housing permits (such information about the local markets you are interested in can be provided by your real estate agent), you can get a sense of how builders are responding to market conditions. If builders are producing too many homes, an excess inventory of properties can result and home values could soften. Conversely, if builders are not building enough homes, you may find a lean supply of homes and home values could rise.
Since existing homes comprises about 85 percent of all homes available for sale versus 15 percent for new homes, it is property owners, not builders, who control the majority of homes for sale in any local market. Understanding why and when current homeowners put their properties on the market is important in determining property value and sales trends. A local market dominated by young households would have a higher frequency of home listings than a local area dominated by established households. That is because young households, on average, are more likely to eventually trade up to larger homes because they have children or relocated because of job advancement. There are many other reasons why homeowners list their home: expected price gains; an inprovemenet in the local economy (creating a more favorable selling environment), the construction of a new highway through a particular location (motivating homeowners to move away from a transportation-dominated area), and so on.
Tools to Monitor Demand and Supply
Here are some housing measures that will help you evaluate the magnitude of demand and supply in your local market. There are three measures on the demand side (population, jobs and investor share) and two measures on the supply side (housing starts and month’s supply).
Population. Compare population growth rates across local real estate markets. Net migration (how many additional households are moving into the local market) is a good proxy for this. This information is easily obtainable from your real estate agent. The higher the net migration number, the healthier are the prospects for local real estate activity.
Jobs. Positive job growth is essential for the long term viability of a healthy real estate market. Again this information is available from your real estate agent. Every country and city in the nation makes job gains/losses information available to the public. Robust job markets are an excellent indicator of an active real estate market.
Investor Share. Before committing to a property purchase, estimate how many investors are involved in the local market. Investors add some degree of risk to a local markeat because they area the first to pull out of the market if the good times turn to bad-as we painfully discovered during the 2006- 2008 real estate bust. Investor flight exerts downward pressure on prices. Obtaining investor share information is difficult, but y our local real estate agent should have a good “gut” feel for investor share percentages.
Months’ Supply. It is essential that you know the inventory of properties available for sale in a local market before committing to a purchase. Months’ supply is the most reliable indicator of inventory and is easily accessible from your real estate agent.
Housing Starts. Even if the demand for home buying is healthy, it is possible that local home builders overbuilt in the local market, creating excess housing inventories that eventually could exert downward pressure on property values. Housing starts (new residential construction) and housing permits are good indicators of how many properties builders are planning on constructing. This information is easily obtainable from the Department of Commerce or just ask you real estate agent.