By Harvey Sax
I was having a discussion with a hedge fund manager friend of mine about what determines house values and it dawned on me, this is really a complex question. Having been a stock trader for so long, I was quick to jump to the conclusion that a house is worth what someone would be willing to pay for it in a reasonable period of time. I’m not sure what reasonable means but perhaps a sixty to ninety day auction process would determine the real value. Of course there are the various real estate appraisal methods of valuation but that doesn’t really interest me. Instead what creates the value?
There is replacement cost value. How much it costs to replicate your house for example if you were fortunate enough for it to burn down and be fully insured. I don’t know how you would measure replacement cost any other way since in many areas of the country you can buy used houses far below the replacement cost of your own.
Assuming everything new costs more than something old;ie new shoes, new car, new bike all cost more than their depreciated equivalents. A new house should cost more than an old house. Then there is no impetus to build new houses until you can sell them for more than used ones or more importantly someone is willing to pay more for a new one than a used one.
Supply demand theory then comes into play. If you can buy cheaper than you can build, then no one builds. Unless you can’t buy exactly what you want to build. So in part it’s an emotional decision and not necessarily an economic decision.
Is it a necessity buy? You have to have some place to live, right? So is this an economic decision- buy versus rent? Or is it a quality of life and again an emotional decision? If that’s the case the general economy has a huge role in the purchase decision. When economic times are good, people feel better about trading up.
Since you can always rent out a house for some price, there is a revenue stream associated with a house. You could apply a commonly recognized discounted cash flow analysis and come up with some value.
Government policy may be a determining factor. You may have to factor in tax savings into that equation as owning a house is a very significant taxable income deduction.
But that begets an even bigger economic question, what’s the definition of good times? Inflation eats away at purchasing power but probably is one of the biggest factors in house appreciation.
Ugh, I don’t seem to be getting anywhere in this analysis. No wonder I’m sticking to stocks. At least I can sell it tomorrow if I can’t tell what it’s worth.
Recommended reading: Bubble Meter blog
This was a timely chart by Robert Shiller presaging the house price collapse in 2006. Click on it twice to get the ful size chart
By Harvey Sax
Your post intrigues me Harvey, and you raise some good points.
Having been in around the real estate business my entire life, I have to add one factor, which is LOCATION, LOCATION, LOCATION. You could definitely tie supply and demand to my aforementioned factor, but even in a down economy, if you have an area that is still highly desirable, buyers are still buying.
I have sold real estate in major metropolitan markets, but now proudly sell in Park City, Utah. What is interesting about our market is that we have two kinds of buyers. Lets call them Type 1 and Type 2.
Type 1 realizes that we are a small town of about 7000 people with three ski resorts within 5 minutes of each other, and a major airport hub 30 minutes away. (Guess I should mention the other 10 ski resorts within an hour away too!) They also learn that we are the largest per capita purchasers of land to be deeded as open space in the country, thus creating more scarcity of quality product. Type 1 also realizes that foreclosures have been in steady decline in the past year, and that distressed sellers are now much fewer and further between. MOST IMPORTANTLY, Type 1 realizes that prices are an average of 30% off the highs of 2004-2006. Bottom line for Type 1 buyers is that they are the ones getting the great deals.
Now we have Type 2 buyers. A Type 2 buyer is one that no matter what the price is, regardless of how much lower it is from the peak of real estate, (a FALSE peak In my opinion), they try to lowball anything that looks appealing, and the sellers do not give them the time of day. I do not know a performing realtor in town that will even waste their time dealing with a Type 2 anymore. Type 2 buyers sit on the sidelines and watch life pass them by, only to maybe buy at the top again, or at least 20% off the bottom. Type 2 fixates on the property, and not the big picture, which goes back to my first paragraph.
Type 2 wants cheap real estate, and they have plenty of cheap real estate in Detroit.
LOCATION, LOCATION, LOCATION. I know I live in an insulated world, where we have a finite amount of property, and do not have huge developments with hundreds of cookie cutter homes that all look the same.
I agree with your comments about buying vs. building, it is certainly much less expensive. In April 2011, there where $5.7 Million Dollars of building permits issued in Park City, of which $5.1 Million where for alterations. Cheaper to buy and remodel than to build new. to see more of this go to http://www.ScottMaizlish.com and click on BLOG.
SO how do I tie all of this together? I guess I would say desirable locations will always weather the economic storms better than less desirable locations. I would also tie our real estate uptick to the return of the financial markets. Many of my clients stated that they would like to own a TANGIBLE asset rather than a piece of paper with a bunch of numbers on it.
After all, a home in one of the worlds most desirable WInter and Summer destination is much more exciting than logging into your stock portfolio every day!
Keep up the great writing Harvey!
while i cannot speak to the park city market in the way that an expert like scott can, the national market seems to be showing no real recovery in terms of distressed assets.
http://calculatedriskimages.blogspot.com/2011/05/distressed-home-sales-and-first-time.html
47.7% of sales last month were distressed, very similar to levels seen over the last 6 months.
worryingly, the % of sales to first time buyers continues to drop.
investors were 23% of the market driving a near record 31% of transactions for cash.
investment in real estate seems comparatively attractive right now as bond yields are paltry and inflation is likely much higher than reported in the cpi. (this is driving some hedge fund managers that i know to accumulate big tracts of farmland as well)
it seem to me that the tricky issue in real estate right now is lending. rates are extremely low. i borrowed on my house in the 3’s. but, i only borrowed a conforming amount which was a small % of the home’s value.
what astounded me was how difficult it still was to get the loan. i borrowed less than one year of income and less that1/3 of the appraised value of the house, and could still barely get the loan. (though, admittedly, having no W-2 income is a complication)
i think this is leading to real trouble in the market. the current loan rates are like an incredible drink special in the VIP room. fantastic if you are on the A list, but useless to everyone else.
leverage is the key to real estate prices. look at any market where mortgages first become available (russia, lebanon, etc) you’ll see a 400% spike in 3-5 years.
this makes perfect sense as prices quickly get bid up to where your whole cash payment from before is now 20% down.
we saw the same thing in the US. with 0 down, prices went parabolic.
those days are gone and not coming back anytime soon.
the national housing market looks to be a real muddle for some time.
in a form of viscous circle, this is likely keeping the unemployment rate high as well. if you are underwater in a house, you may not be able to afford to move and take a job.
labor mobility has been one of the reasons the US economy has been so much better and adjusting to new circumstances than sclerotic europe.
disrupting that will undermine recovery.
i have not seen stats on labor mobility correlated to the drop in housing price in a region, but i think it would be a very interesting analysis to do if you could find the data.