Supply and Demand Flashcards
As you might imagine, supply and demand play a big role in how property is valued and priced. It’s a relatively simple concept, but what really drives demand in the real estate market? If demand were simply a measurement of how many people would like to own property, demand would be a much higher number — who likes paying rent? Instead, demand is determined by the number of people who want to own property and can afford to buy it.
Demand tells us how many consumers are willing and able to afford property.
Supply is determined by looking at the number of properties that are available for sale or rent.
Supply and Demand Factors
Supply and demand are both affected by many factors, such as employment rates, wages, interest rates, and more. Characteristics of the population, the social attitudes prevalent at the time, and the legal and tax structure of the economy also shape the demand for and supply of real estate.
Property values can change often. These changes are mostly driven by good ol’ supply and demand.
The Relationship Between Supply, Demand, and Price
As the demand for real estate rises, supply will decrease. When demand is high and supply is low, property becomes more valuable and prices rise.
On the other hand, if the demand for real estate falls, supply will increase. When demand is low and supply is high, prices fall.
The Makeup of a Market
Supply and demand are the basic forces that control all markets. But what’s a market? A nice place where you can stroll around and pick up some seasonal vegetables? 🍅
Yes, but for our purposes a market is a theoretical construct that isolates the selling and purchasing of any one particular commodity from the economy as a whole.
Levels of supply and demand differ between different areas and markets. A market can be as small as a neighborhood or as large as a city, state, or country.
Supply and Demand
The impact of supply and demand differs when applied to value and the market, respectively. If the supply of real estate and the demand for it are proportional, values will remain stable. If there is an under-supply, prices will increase. If there is an over-supply, prices will decrease. So, supply and price move in opposite directions.
Demand and price move in the same direction.
As demand increases, the prices increase, and as demand decreases, the prices decrease.
A large number of people walking by a house for sale.
How Supply and Demand Affect Price
The state of the economy has a strong impact on the real estate market.
If the economy is strong, first-time buyers will be buying homes and current homeowners will be wanting to upgrade or upsize to a new home.
If the economy is weak (or consumers are feeling unsure), more homeowners will stay with their homes and fewer people will be interested in buying.
You may not have control over the health of the United States economy, but you can at least stay on top of economic news. I’m not saying you have to read the whole Wall Street Journal every morning, but it’s not a bad idea to try and follow economic news and trends through the medium that suits you best.A toppling stack of newspapers.
The Real Estate Market
For real estate finance, more than for any other type of real estate studies, it is necessary to know the basic workings of the market and, most especially, the impact of supply and demand.
For instance, the sale of residential property constitutes a specific real estate market with its own trends and rules. Similarly, the sale of loan products by lenders constitutes another, different market. If you want to be really successful in your market, you have to get to know it first.
Impact of the Economy
As I mentioned earlier, demand can be defined as a consumer’s ability and willingness to buy a good or service at a certain price. Though the demand for real estate is affected by several factors, price is the clearest example. When real estate costs more, fewer people are willing to buy.
The price of a particular piece of real estate is also influenced by many factors. Prices can increase because of increases in construction costs, the cost of financing, and property values.
Additionally, the price of purchasing real estate can be affected by the prices of other commodities. For instance, if the cost of leasing an apartment is low, the cost of purchasing a house might also decrease to attract more buyers.
Income
The second factor affecting real estate demand is personal income.
If the average salary goes down or the unemployment rate goes up, the demand for certain types of housing is likely to decrease.
If the average salary goes up or the unemployment rate goes down, the demand for certain types of housing is likely to increase.
Employers
Cities experience significant changes in supply and demand when a major employer sets up shop or closes down.
A new major employer can stimulate the local economy and lead to an increase in population. This will result in lower supply and higher prices.
If a major employer closes or moves away, the local economy takes a hit. People move away or take lower-paying jobs, resulting in more supply and lower prices.
Expectations
Finally, a buyer’s expectations of their future financial situation, and of the economy as a whole, will affect the demand for real estate. Consumers are less likely to buy a home if any of the following situations apply:
They expect their income will decrease in the near future.
They expect the price of housing will decrease in the near future.
They expect the price of housing will decrease at the time they expect to sell their current house.
Demand Factors: Price, Income, and Employers
Next up: supply. Supply is an economic term for the available amount of something. In real estate, it’s based on the willingness and ability of sellers in a given market to sell their property.
Several factors affect supply:
Selling price: As the price of housing increases, owners become more willing to sell.
Loan price: As the price of a loan increases — that is, as the interest rate goes up — lenders become more willing to lend and buyers become less willing to take out loans.
Price
Price plays an important role in the supply of real estate (high prices entice owners to sell and builders to build), but there’s a limit to its influence.
For example, consider the leasing side of the real estate market. Apartment complex managers are always willing to rent, whether the price of apartments increases or decreases, because renters = income. If landlords can command higher rent during a certain period (if apartment prices are increasing), they may be more interested in offering long-term leases, but there is always an incentive to fill units.
A modern apartment complex.
Cost of Production
The supply of real estate is also affected by the cost of its production.
If construction costs go down, it is cheaper to build houses, apartments, and office buildings, so more of them will appear on the market.
If the cost of construction goes up, there is a greater expense to builders and new housing becomes scarcer.
An increase or decrease in the price of raw land has a similar effect. However, because real estate is a long-lasting commodity, there is usually an existing supply (on the market) of houses that have already been built.
Expectations
Finally, expectations affect supply as much as they affect demand. If sellers expect the price of real estate will go up in the near future, they will be less likely to sell right now. If sellers expect the price to go down soon, they will be more likely to sell right away.
The case is similar for lenders when an interest rate is expected to increase or decrease. However, lenders are much like apartment managers: They cannot afford not to receive interest for any significant period of time. Similarly, market expectations only sway sellers if they have the luxury of a flexible schedule.
Supply
The demand for any commodity, such as real estate, can be illustrated using a demand curve. You will notice that as price increases (vertically), the amount of real estate that buyers are willing to purchase (horizontally) decreases. The opposite is also true: As price decreases, the quantity demanded increases.
Demand for real estate and average price correlate, although there are other factors that keep this from being a perfect 1:1 relationship.
A chart showing how supply and demand move in opposite directions of each other and the equilibrium point.
Equilibrium
Together, the two forces of supply and demand help determine the actual price, and quantity of, real estate on the market. The law of supply and demand states that the forces of supply and demand push the market price of any commodity to one particular point, the market equilibrium. This equilibrium is the point at which the supply and demand curves cross. (Remember this graph? There’s the equilibrium in the center.)
The Demand Curve
Most experienced real estate agents will tell you that the industry is rarely in a “normal market.”
Rather, most will say that we are either in, or moving towards, either a buyer’s market (where it’s good to be a buyer) or a seller’s market (where it’s good to be a seller).
Whether the market is advantageous for buyers or sellers is closely related to the greater economy (nationally and locally) and where we are in the real estate cycle.
Yes, just like the moon, the real estate market waxes and wanes in cycles. The real estate market’s phases include:
Recession 🌘
Recovery 🌗
Expansion 🌖
Hyper supply 🌕
Recovery
Ok, so imagine that a recession (a period in which economic activity drastically declines and stays declined for more than six months) just happened. Recovery is the phase that follows a recession. In a recovery, conditions stabilize and the outlook for the market is just starting to look brighter.
Distinguishing characteristics of a recovery phase include:
High unemployment (but it’s not getting any worse)
Lots of home foreclosures
People have seen the damage caused by recession and are afraid to buy homes (even though it’s arguably a good time to “buy low”)
Government lowers interest rates to encourage investments
Expansion
During the next phase, called expansion, market activity really picks up. Businesses are hiring more, and people tend to view real estate as a good investment again. There is a general sense of being “out of the woods” and recovered from the last recession. Signs of expansion include:
Most available properties have been bought or rented, driving vacancy rates down
Rent and home prices are rising
Construction for new homes and commercial buildings starts
At the end of the expansion phase, people may pay more for real estate than it’s worth, because they are anticipating future increases in value.
Hyper Supply
The real estate industry has been booming, new properties are popping up left and right… what could possibly go wrong? Well, Anthony, this is about the time when the market enters the hyper supply phase, in which supply catches up with (and eventually surpasses) demand.
The first warning sign is an increase in vacant or unsold property. And yet, investors can’t just stop building after all the work they’ve put into their projects up until this point. They’re on the hook to finish projects and pay back the loans they took out. And so we enter the hyper supply phase, also called the “boom.”
Hyper supply is marked by:
Inflated prices
Lots of building projects going on
Vacancies start to rise
Recession
The final phase in the real estate cycle, recession, starts when occupancy falls below average (specifically, the long term average that evens out cycle changes). Homes sit on the market, unsold. Prices are driven down. Foreclosures increase, especially when the real estate recession is coupled with an economic recession that leaves homeowners unemployed and unable to pay their overly high mortgages.
Classic symptoms of recession include:
High unemployment
Decreased spending by consumers and businesses
Less investment in new buildings, factories, and equipment
Land prices are at their lowest
Decreased interest rates
The Cause of Recession
Now that you know where it fits into the real estate cycle, I want to go a little deeper into the topic of recession. To be specific, a recession is a period in which economic activity and gross domestic product drastically decline and stay that way for at least six months. People spend less money on goods and services, and companies lay off employees.
Recession is often caused by an economic shock, like the bursting of an economic bubble. A bubble forms when the value of something (typically real estate or stocks) grows so much that its market value is higher than its actual value. When the “burst” happens, the price for the overvalued item drops.
Circular chart summarizing the real estate cycle, which include, expansion, hyper supply, recession, and recovery.
Image description
Buyer’s and Seller’s Markets
A seller’s market is a market condition in which the number of properties for sale does not meet the demand (number of people looking to buy). The pricing and negotiations of a transaction are typically in favor of the seller (hence the name) – though this is not a hard and fast rule.
If there is high demand for a certain area and relatively few homes on the market, the seller probably will not have to lower their asking price or give concessions to a buyer. Yay seller!
Buyer’s Market
A buyer’s market is the condition of having fewer buyers than the supply of homes for sale in an area. In a buyer’s market, there is relatively low demand for real estate.
Prices and negotiations in a buyer’s market will tend to be more in favor of the buyer. It may be easier for a buyer to negotiate a lower price or even get the seller to pay the buyer’s closing costs. Yay buyer!
Summing it up: A license holder should always know what type of market they are in so they are ready to properly negotiate for their client.
One Market Creates the Other
Part of the market cycle of real estate is that one market creates the other. How does that work? Let’s walk through an example.
The Fishtown neighborhood is currently a buyer’s market. There are many properties for sale, and few interested buyers. This oversupply causes prices to fall and fall.
Seeing that the market stinks in Fishtown, many property owners will choose to stay in their current homes, knowing they’re not going to get a very good price for their property. Still, there will always be people who have to sell, and so the housing stock that is available will be available cheap.
It’s possible the market will stagnate, but if Fishtown is a neighborhood in a growing city, soon buyers priced out of other, more desirable neighborhoods will look at the stone cold deals in Fishtown and start buying properties there.
Often, an influx of buyers can cause a first wave of gentrification, bringing in restaurants, coffee shops, and other businesses looking for cheap rent and a young customer base (think about it — buyers looking for deals are likely to be first-time homebuyers, and first-time homebuyers are likely to be young-ish).
As more people purchase in Fishtown, and especially if it gets a reputation for being hip or up-and-coming, more and more buyers will arrive. Prices go up as supply goes down.
Homeowners who were waiting to sell until the market picked up may now be willing to list their properties. Speculators, investors, and developers who see prices continuing to rise in Fishtown may snap up some of these properties, flip them or tear down old buildings and build something new on them, driving prices even higher.
Eventually, supply will start to dwindle, pushing prices even higher as Fishtown becomes desirable in and of itself, full of recent remodels, new condos, and cool restaurants. Hey, look at that! It’s a seller’s market now!
Buyers who once considered Fishtown for its affordable real estate will have to look somewhere else. As prices climb, you get what’s often referred to as a “bubble”: at some point, prices will go too high, buyers will lose interest, and prices will start to fall again.
After all, once you get above a certain price point, in most cities, your pool of qualified buyers shrinks. If a buyer sees they can get a better deal in another neighborhood, especially a more traditionally established one, Fishtown will start to lose buyers.
As the bubble pops, property values will readjust downward. There will be more stock for sale, and it can become more of a buyer’s market again. Depending on the city and the economy as a whole, prices might find an equilibrium below the high water mark, but above where things started. This is part of the cycle of gentrification (which is rarely considered a good thing, but that’s a conversation for another day).
As you can see, the extreme point of each market pushes it in the other direction. It’s sort of like how the real estate cycle works, except that here we’re talking about specific markets, instead of the larger economic cycle. Real estate markets are best thought of as a pendulum, swinging between buyer’s markets and seller’s markets.
Just try not to get swept up in the hype and buy at the top of the market!
Seller’s Market vs. Buyer’s Market
In addition to buyer’s markets and seller’s markets, there are broad markets and thin markets.
A broad market is one with many people wanting to buy and sell property. A thin market is the opposite: one with few buyers and sellers.
There isn’t necessarily a correlation between the breadth of a market and whether it favors buyers or sellers. Remember, if a market is thin on just one kind of person (not a lot of buyers, say), then you’re just talking about a buyer’s market.
Broad and thin are more generally about the amount of activity happening at any given time. Often, markets go through broad and thin cycles seasonally.
Broad and Thin Market Examples
For example, in cold places, winter tends to be a lot slower. Fewer people want to move when there’s snow on the ground.
An igloo surrounded by snow with no neighbors.
Every Market Is Different
Every market has a different cycle, depending on the weather, the main industry of the area, and the demographics of the typical buyer (parents with young kids? seniors? single tech bros?). Paying attention to these seasonal cycles will give you an advantage in your career if you’re selling residential real estate.
It’s not that you never want to advise a client to try and sell during a thin market: There are fewer buyers, but also less competition. It’s just something to be aware of. Tailor your marketing strategy accordingly.
Broad Markets and Thin Markets
