When trying to maximize the return on your investment there is a long list of questions that you should be asking yourself. Some of those questions include but are not limited to: What is the price of the home? What is the value of the home? How will I finance the purchase of the home? What will my monthly expenses be? What will my monthly revenue be? How much will my house appreciate over a, 1, 5, 10-year period? These are only a few questions you should consider. The list is much larger. Let’s begin unpacking some of those questions.
Before we begin, I want to make it clear that I am speaking purely from a financial point of view without subjective/sentimental reasoning for buying a home such as purchasing your childhood home, purchasing a home in a specific school district or purchasing a home that has a better commute to work. From a financial point of view, once again the goal is to make the most amount of money for the lowest risk of loss of capital.
After all the confusing metrics and fancy financial figures used to evaluate the price of a home, what it really comes down to is what is somebody willing to pay for it. If you buy the home today for price X, would somebody be willing to pay X+Y in a year? And if they would, how much would Y be? If I buy a home for $250,000 today would somebody be willing to pay $300,000 tomorrow. If so, then why? If one is looking to make a home purchasing decision then, the first question you should ask yourself is what determines the price of a home?
In economic terms, the price of a home depends on the equilibrium price set by supply and demand. Meaning the price of a home today depends on how many homes there are for sale in a particular market and how many buyers are looking for a home in that market. The price of a home tomorrow depends on how many homes there will be for sale in a particular market tomorrow and how many potential buyers will be looking for a home in that market tomorrow. When supply of homes is high in a market, meaning there are many homes for sale, a potential buyer has more options from which to choose. When a buyer has many options to choose from, potential sellers are in direct competitions with each other and must lower their prices to entice potential buyers. Correspondingly, when supply of homes in a given market is limited, buyers have fewer options from which to choose and bid up the price of the given homes. This dynamic functions in similar fashion on the demand side as well. When there is higher demand, meaning more buyers, they compete and bid up the prices of homes. When there is low demand, meaning less buyers, the sellers of homes compete and entice buyers by lowering their prices. If you are trying to predict what the price of a home may be in the future, you need to think about what factors will contribute to supply and what factors will contribute to demand.
For any given market, supply of homes depends on the prices of the homes in that market, the amount of land available, the price of materials needed to construct a home, laws and regulations and increased interest rates.
Price: It is slightly counterintuitive to say that the price affects supply and that supply also affects the price. When the price of a home increases, due to an increase in demand, constructions firms and other business opportunist will rush to build homes and take advantage of those higher prices. But if too many home-builders rush to a market, the increased supply will cause firms to compete and lower the price. Price then, acts as a feedback loop on supply.
Land: Assuming we don’t begin to colonize Mars, we will eventually run out of land on which we can build. When there is no more land upon which homes can be built, the only two options for new construction is tearing down current homes and rebuilding them or building up, such as apartment buildings and skyscrapers. Because land is a constraining factor, once it runs out, a headwind is placed on supply and a corresponding tailwind is placed on price.
Raw Materials Prices: To build a home, one would need raw materials such as wood, energy, labor, metals etc. If the price of any one of those were to increase, the profit margin of the selling firm would shrink. If less money can be made from building homes, less people will participate in the construction of them. Conversely, if the price of raw materials were to decline, profit margins of the constructing companies would increase, and more people will try to participate in the sale of homes.
Interest rates: Many construction companies use some form of debt to buy the raw materials necessary to construct a home. The cost of that debt is set by interest rates. The higher the interest rates the higher the costs to build a home and the lower the profit. The lower the profits, the less firms will be willing to enter the marketplace. Conversely, the lower interest rates are, the lower the costs to build a home and the higher the profits. The higher the profits, the more likely a firm will be willing to enter the marketplace.
For any given market, demand for homes depends upon the current and future prices of homes in that market, the current economy and income levels, the rental rate of properties in the area, and other unique circumstances.
Current and Future Prices: The reason someone would purchase a home instead of renting is because they want to receive some type of return on their investment. If potential buyers believe that the price that they would buy at today would be less than the price they would be able to sell at tomorrow, they will forego the investment and wait until prices decreased. When the price of a home decreases, potential buyers enter the market. When potential buyers enter the market, they compete and bid up the price. Price and demand then work in a similar manner as price and supply.
Current & Expected Economy and Income Levels: If a potential buyer doesn’t have cash for a down payment or sufficient income to qualify for a loan, then there can be no transaction. When there are less people who can purchase a home, i.e. demand is lower, sellers will lower their prices. Conversely, when incomes are high and are expected to increase further, people will have more money saved for down payments and banks will be more willing to lend funds for the purchase of homes. This increases the amount of potential buyers and correspondingly raises prices.
Rental Rates: Not everyone plans to live in the home they purchase. Instead they choose to rent them out to people who need a place to live in exchange for rental income. The higher the demand to live in a specific neighborhood, the more a landlord would be able to charge rent for a property. If the amount of money someone makes on rental income exceeds the costs to finance the purchase, a profit is made. The higher the profit, the more willing someone would be to make an investment. The increased demand would result in higher prices. The same is true as well. If incomes in a neighborhood are low relative to what it would cost to finance the home, profit margins would shrink and there would be a reduction in the amount of people willing to purchase a home and a corresponding decrease in price.
Other Circumstances: Demand in a neighborhood could also increase for other circumstances outside of investment decisions alone. Some reasons include living in a certain school district, a close commute to work, being near family or sentimental attachment to a childhood home, moving away from a polluted area. There are many other potential reasons tied to human emotions that could affect someone’s home buying decisions that will have a corresponding effect on demand.
Once you have a concrete understanding of the supply and demand factors that affect pricing, you can begin to think about what the value of your home is. The way one should think about value is the long-term benefits you will receive from the ownership of a home whereas price can be thought about as the short-term fluctuations from buyer sentiment. Often there is a disconnect between the price and value of a home. This depends on a plethora of extenuating circumstances but the main reason for this difference is due to short-term supply and demand characteristics which we mentioned prior. If someone was going to make a long-term investment, they should focus on value of the home much more than the price of it.
The value of a home depends largely on the same that price does but on a much larger time-horizon. Instead of asking will the price of this home go up in a year, ask will the value of this home go up in thirty years. Instead of asking will there be people willing to buy or rent this home tomorrow ask will there be people willing to buy or rent this home in thirty years. When you begin thinking in terms of value not price, long-term not short-term, you are better able to recognize when the market is in your favor vs. when it is not. It becomes easier to recognize when a storm is on the horizon and endure it so that you can enjoy the sunshine that comes after. So when thinking about whether or not you should buy a home, try and look as far into the future as possible, that’s still realistic, and bring to present the paths and decisions that you will have to take to get to that future point. Then make the decision.
