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Real Estate 101 – Market Dynamics

Real estate can be a positive lifelong investment or it can be a financial nightmare, depending on who you talk to.  Often, the difference comes down to a couple of market factors that must be evaluated carefully, before the decision is made to buy.  Thankfully, this is pretty simple stuff, even for first-timers.

This is the second in a series of four posts on real estate.

Real Estate 101 – Renting vs. Owning
Real Estate 101 – Market Dynamics
Real Estate 101 – Purchase and Finance
Real Estate 101 – Investment Property

Disclaimer: I’m not a licensed broker or a real estate professional and laws change and vary by state.  Before making any decision about buying a house, you should be aware of the laws or consult with a licensed professional.

Timing is Everything

Keys Left in the Door

Image by Woodley Wonderworks

Here in California, there are three things you can always count on, sunshine, earthquakes and the real estate market crashing.  It seems to happen about once every decade.  The only difference between this crash and others in the past is the mania spread all over the country.  Some of the markets are even worse off than ours.  People who bought recently in Phoenix and Las Vegas are completely upside-down and their local market probably won’t recover for a decade.  Many have chosen to walk away and rent for a while.

Everyone I know who says real estate is a bad investment bought their house within the past couple of years.  Anyone who bought a house 15 years ago probably thinks it’s the smartest thing they have ever done.  Timing can be one of the biggest factors that determine whether any investment pays off.  And, real estate is an awfully big investment.  So, when it comes to buying a house, you want to be more like Warren Buffet than Nicolas Cage.

What is a House Worth?

So, how do you know if you are getting a good value in a house or you are buying at the top of the market just before the collapse?  It’s really no different that stocks, gold or any other commodity.  There is a fundamental value of housing and that doesn’t change.  Speculation, interest rates, access to credit and many other factors can make housing prices rise and fall.  But, in the long-term, they always return to the mean.

Housing prices are based on income and the ability to qualify for a loan.  Whenever housing prices rise and real incomes don’t there will be a correction.  This is measured by the Median Home Price to Median Family Income Ratio.  Historically, this ratio has been around 2.7.  So, if the median family income in an area is $100K, the median price of a house should be around $270K.  At the peak of the real estate bubble, this ratio had risen to around 4.6, which wasn’t sustainable.  Since the crash, it has settled in around 3.5, which is reasonable, considering the very low interest rates.

Location, Location, Location

Any good real estate agent will tell you location is one of the biggest factors in determining the value of a house.  There are many reasons for this including the crime rate, quality of schools and proximity to jobs, shopping and other resources.  There are desirability factors, such as natural surroundings and the weather.  That is why some areas such as LA, San Diego and Honolulu are consistently low on the affordability index.

Here is another huge factor in a property’s location that agents rarely discuss; the value of properties sold recently affects the value of all properties in the area.  A couple of foreclosures or short sales on a block can devastate the property values and make it very difficult to qualify for a loan.  So, a buyer may have to come up with a bigger down-payment and they would be buying a house for more than its appraised value.  This leads to the common advice, “buy the cheapest house in the best neighborhood you can afford.”

Every Market is Different

Different regions of the country each have their own unique market conditions.  Popular locations in the Sun Belt, such as California, Nevada, Arizona, Texas and Florida have seen very rapid growth.  Unfortunately, this caused the housing prices to skyrocket, which led to more foreclosures and much sharper declines in the prices.  But, they will likely boom again, in the future.  Areas that are losing population, such as some agricultural areas of the Midwest, have seen slow but steady declines in property values.  These markets may never recover, unless new residents move there to create a demand for the housing.  In fact, some municipalities are giving away houses for free, just to keep the schools open.

The biggest regional factor has to do with jobs and opportunity.  Rust Belt cities that once provided hundreds of thousands of jobs during the industrial revolution are now areas of economic stagnation.  States such as Michigan, Ohio, Pennsylvania, West Virginia and Upstate New York are losing population and their median income is dropping.  High crime and urban blight chase away the middle class couples that create a future demand for properties.  If you have a solid job and live in one of these areas, you may be able to get a great deal on a house.  Just don’t expect it to appreciate in value.

The Bottom Line

The bottom line is that buying a house is no longer a sure thing.  Market conditions dictate the future prospects for a property.  So, it’s critical for everyone to understand these factors before they buy.

“Don’t buy the house; buy the neighborhood.”

Russian Proverb

Recommended Reading

Bruce Bucks – Home Buying for Dummies Like Me
Money Reasons – Pros and Cons of Building a House
Watson Inc. – Labeling Debt to Make it More Palatable

This post was featured on the Carnival of Personal Finance over at Yes, I am Cheap.  This is the Greatest Carnival on the Net.  Check it out.

9 comments to Real Estate 101 – Market Dynamics

  • The ratio here in Canada ranges from 4 to 5 and up, depending on which city you’re looking at. Either prices are going to stagnate for a while or there will be a crash, but I’m not betting on prices to continue rising the way they did from 2000 – 2010. Not unless incomes rise even faster.
    Invest It Wisely recently posted..Future Imperfect- How to Prepare for an Uncertain FutureMy Profile

    • Kevin,

      I agree with you and I think the prices will stagnate for a while, here and in Canada. Real wages aren’t rising that quickly. In fact, wages have stagnated for people on the lower end of the scale and I don’t think they are going to rise any time soon. The things that made real estate prices jump in the past were dual incomes, low interest rates and crazy credit. I don’t see any new way to prop up the prices.

      Bret

  • I like what you said about timing being everything. Buying a house needs to be strategic and not based on emotions. We all must consider the neighborhood, the cost of the house, and the timing of our purchase. Thanks for these valuable insights.

    • Matt,

      It’s crazy when you try to buy a house. The agents are all pushing you to “buy now”, no matter if the house is right or if you can even afford it. As soon as you sign an offer, they take over and talk among themselves. You have very little say in the deal after that point.

      The great first-time homeowner loan you were promised by the broker turns into the lousy subprime loan they try to stick you with at the last minute. Even though you were “pre-qualified” all of the sudden you no longer qualify.

      I had to walk away from the first house I wanted and give up my escrow deposit. I told them straight up, “If you can’t deliver the loan you promissed me, the deal’s off.” Then I had to unpack my dishes and put them back in my appartment. It was humbling, but I learned from it.

      When I bought the house I have now, I got my own loan straight from the bank and I bought the house directly from the owner. It was a much more pleasant experience. And, I got a great deal on both the house and the loan.

      Bret

  • Timing is the essence of all things in life. Real estate is close to the top.
    Doable Finance recently posted..Market Moves Affect Your Personal FinancesMy Profile

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