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Supply and demand refers to the relationship between the buyers and suppliers of a particular product. The housing market depends extensively on this dynamic, because generally speaking housing prices rise and fall in sync with supply and demand.
There are many housing market supply and demand scenarios. These scenarios are sometimes referred to as market cycles. Now consider the past several years: In most markets we've seen a shortage of supply, but healthy demand, for housing. So what happens in this case? Prices in most markets have been rising.
Here's an overview of housing market supply and demand, what high and low supply and demand means for investors, and how this dynamic affects your real estate investment portfolio.
How does supply and demand affect housing prices?
When the demand curve for housing increases, so too do prices. It makes sense: If more people want something than is available for purchase, then they are willing to pay more for that product. As prices increase, demand generally drops as affordability decreases.
Further, when supply can't keep up with demand, prices generally increase as well. But in a situation where demand drops and supply increases, you have fewer people who want housing and more houses than there is a demand for. Prices in this case drop. Housing market supply and demand generally work against each other until an equilibrium price is achieved.
Indicators of housing market supply include housing starts, permits issued, and construction completions, among others. Indicators of housing market demand include home sales, days on market, home prices, and inventory levels.
Generally speaking, supply and demand in housing follow suit. Take a look at historical charts from the Office of Policy and Development and Research (PD&R):
Historical data for housing starts (supply):
Historical data for home sales (demand):
See how they follow along similar trend lines? You can also see that during the Great Recession in 2008, both demand and supply for housing fell dramatically. This type of supply and demand scenario will see supply slow down substantially as prices of homes drop because of a drop in demand. In this case, this was caused by unhealthy lending practices and high debt loads by borrowers.
What factors underlie the supply and demand for housing?
There are so many factors that can affect the supply and demand for housing, and many aren't economic in nature. Consider the current COVID-19 pandemic, which grounded constructions, paused home sales for a period, and caused building materials to be intermittently (un)available.
That certainly put significant downward pressure on housing supply and demand. Or, consider a local government that wants to encourage urban growth and opens up new urban land for development that will increase supply as inward migration increases demand.
Here are some other factors that can affect housing market supply and demand that real estate investors should consider.
- Mortgage rates: As mortgage rates rise and fall, so too does affordability and the purchasing power of the consumer, which directly affects supply and demand. If rates go low, more people can afford to purchase a home.
- Building materials: The cost of materials will generally push housing prices up or down as builders pass on their costs or savings to buyers. If lumber now costs 1.2x more than what it was last year, then builders have to make up that cost on the sale to keep profits and production at stable levels.
- Household incomes: The more or less people earn generally puts pressure on housing prices up or down. Low incomes are also symptomatic of an unhealthy economy, which is also likely to affect housing demand and prices downward.
- Jobs: The more jobs a city, town, or state has available will dictate positive inward migration, incomes, and therefore demand for housing and what people are willing to pay for homes. If you have a net loss of jobs in your area, then people may need to move, or may have less income. This increases housing supply and decreases demand, all of which will see home prices drop.
- Household debt: The more consumer debt someone holds, the less they can afford and the more susceptible they are to economic downturns. If credit card debt increases dramatically, households may put off homebuying as they pay down that debt, decreasing demand for housing. The inverse is also true.
- Local market factors: Positive or negative migration into a geographic area will have a dramatic impact on housing supply and demand. An unhealthy economy or anchor employer shutting down is one example of local economic factors that will drive demand down and supply up as homes come on the market as people leave.
- Policy: Local and state-level legislation and rules can have a dramatic impact on housing market supply and demand. Consider favorable tax incentives and low development fees for builders. This makes it more economically feasible for builders to build new homes, increasing supply of below-market-value homes (due to the incentives), and therefore demand will rise assuming the local economy is healthy.
A 2020 look at housing supply and demand
We are certainly looking at some sort of recession over the coming 12-24 month period. But this will not be a repeat of 2008. That is because current supply of housing is tight, and demand continues to rise, as do prices. Real estate is a lagging economic indicator because the length of construction and transactions in this industry are long. If the current indicators change, so too will this positive outlook.
Over the 2020-2021 period, look for housing supply to slow as economies recover from the COVID-19 pandemic. Housing demand will likely soften in most markets, but not tank. Demand will also increase in secondary and tertiary markets.
According to Redfin, as of May 2020, home-buying demand was 5.5% higher than it was pre-COVID-19. Inventory is down 24%, prices are up 5%, and new listings are increasing week over week. In terms of housing market supply and demand, this tells us a lot about the current health of our national market. Demand for housing is increasing so we see price increases as well, and low inventory and increased listings tell us that supply is having trouble keeping up with the current demand. This is a balanced market.
How is this possible? John Clark, VP at The Regional Group of Companies, noted eloquently when speaking about the above trend, "There are enough, if a reduced number, sellers balanced with enough active buyers for selling prices to be maintained and still track upwards. While the overall level of activity is down, the market as a whole remains in balance."
Housing market supply and demand can be affected up or down depending on a myriad of factors. Jobs, interest rates, local regulations, and affordability, to name a few, all put pressure on the supply and demand curve for housing.
Real estate investing is a hyper-local business. Therefore, investors must keep all of these indicators in mind as they analyze and benchmark their current portfolio assets, as well as when considering adding new ones.
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