Who Determines What a House is Worth?

We?ve all experience the long term trend of rising real estate values, most typically in the price of our homes. And while there are some notable exceptions, we?ve come to expect that the value of a home will continue to rise. In some years the rate of increase is well into double digits. In other years, prices rise only slightly. And of course in some unusual but significant years, prices have declined.

Why is that? What is it that determines what a house is worth?

It?s all about the economic fundamentals: supply and demand

Real estate articles often attribute price trends to any number of causes: wages, the cost of materials or labor, interest rates, the health of the national economy, a local market that gets ?hot?, etc.. But ultimately those things are better understood as simply affecting either the demand for housing or the supply of houses. The rate of appreciation is strictly a function of how much supply and how much demand a given market has.
image of houses with graph growing

Take interest rates as an example. Low interest rates put upward pressure on prices by increasing demand. As buyers discover they can afford the payments for larger loans, they are inclined to borrow and spend more on a house (an increase in demand). Ironically, those same lower payments can incentivise investors to put more properties on the rental market, which can reduce rents (an increase in supply of rentals).

This is exactly what the Phoenix housing market experienced from 2001-2005 during the runup to the market crash. The consistent lowering of interest rates over that period simultaneously put steady upward pressure on sales prices and downward pressure on rental rates. Home prices skyrocketed and rents fell sharply.

Similarly, rising or falling wages and the overall health of the economy directly impact housing demand, while the cost of materials and building restrictions impact the supply of houses.

Ultimately it?s the balance between supply and demand that determines the price (value) of a home.

Housing price volatility

So what causes prices to suddenly spike or fall? The answer is necessarily a sudden change in the supply and demand balance. In the case of a fall in values it has to be either an increase in the supply of homes or a decrease in the demand for homes.

A fairly sudden increase in supply is something we experience regularly in greater Phoenix housing. When the building cycle is good, builders get optimistic and make plans for building lots of houses. Invariably, the demand is met and the market begins to cool. But the building industry typically takes years to ramp down. Overbuilding is the familiar result. When a market gets saturated with sellers, prices start to fall.

Conversely, a sudden spike in demand will quickly and measurably push prices up. This can occur when a local employer hires hundreds of new employees or opens a major new project. The available housing inventory in a particular area quickly disappears and sellers find they can raise their asking prices without meeting any market resistance. Prices rise.

It?s only about supply and demand.

What It means for a land investor

As land investors we are constantly looking at the market?s future, forecasting values and development activity. That means predicting supply and demand. That forecasting is not limited to single family homes, but includes all potential real estate development. Time has shown that as our metro region grows into outlying areas demand in those areas increases radically, builders meet that demand, and the happy land owners that bought ahead of the growth smile all the way to the bank.