How to Tell A Good Real Estate Market Article From A Bad One

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Don Henley has a fun song off his second solo album called "Driving With Your Eyes Closed". I can't find a video performance, but here's an MP3. It's got a chorus that ends with the line, "You're gonna hit something /but that's the way it goes."

A lot of what I read about the real estate markets reminds me of that song. Mostly, people are looking in a rear view mirror myopically, and think that's going to tell them where the market is going. Not so.

Let me tell you the most important "secret" about the real estate market - or any other market. Short term results are mostly about mass psychology. People are so into what is happening right now that they will react to it the same way as everyone else without thinking, whether it's fear and greed driving the market up or fear and greed driving it down. The short term, in real estate, is this year, next year, and maybe the year after. But the actual real estate transaction is expensive. It can cost you a couple percent just for the transaction to buy real estate, seven to ten percent to sell, so you've got to clear ten to fifteen percent higher price just to break even on the costs. Those costs will more than pay for themselves, but they are there. An average year in my market is about 5% up, and 20% up in one year is one of the best years local real estate has ever had. Short term flippers work by different parameters than most consumers, but these are the market factors most people have to deal with. It takes about three average years to break even on the costs you have to pay for the transaction.

This is enough to take the majority real estate investing out of the frame of the short term market, controlled by mass psychology, and into the realm of the medium to long term market, where psychology is a factor, but as time goes on, more and more of your investment results are controlled by pure economics. Supply versus demand. What people who want housing make. What the interest rate environment is like. Oh, and don't forget the effects of government and public policy. When somebody says, "The market has dropped in the last three months, therefore it's going lower" that is no more correct than the opposite which we had four or five years ago: "The market has been going up - five percent in the last three months alone! Therefore it's going to keep going up!" In either case, making this sort of claim is functionally equivalent to blacking out your windshield and driving by the rear view mirror. "You're gonna hit something, but that's the way it goes!"

Furthermore, there is no such thing as a national market for real estate. It does not exist, and anybody who claims it does is either so clueless as to the nature of real estate markets that you should pat them on the head and say, "That's nice dear. Now run along and play with your Duplos&trade," or they are actively lying. There are factors such as the interest rate environment that influence real estate markets nationally, but there is no national real estate market. In order for a given area to be considered one market, the properties within them must be functionally equivalent for the residents as to location. Let's look at the City of San Diego: No way is San Ysidro, right by the Mexican border, functionally equivalent to Del Mar Heights, thirty-five miles away along the coast on Interstate 5 just north of all the corporate buildings in the Golden Triangle, and neither is equivalent to Rancho Bernardo, which is about that same distance north inland along I-15. All three are part of the City of San Diego, and we haven't even gotten to the suburbs yet, they are three very different markets, with different demographics, different lifestyles, different building styles and all that that implies. For my real estate work, I specialize in and around the City of La Mesa, which borders San Diego on the east, and is different from all three previously described areas, and there are areas of La Mesa which are decidedly different from other areas of La Mesa. These markets are close enough physically to have market interactions, but different enough to constitute different markets - never mind Idaho, Georgia, or Vermont, which are not part of the local commuting area. Talking about a unified countywide market is occasionally a useful fiction, as there are interactions. People are able to commute from home to work and back again, no matter their respective locations within the county. Talking of a national real estate market is blatant nonsense. At most you can talk about a national amalgamation of local markets - a statistical hash of what is going on in all of the individual markets. Even right now with real estate markets in the tank in all the headlines, though, there are local real estate markets that are doing very well, and others that are poised to do so.

You can talk about national factors influencing all of the local real estate environments. Interest rates, lender requirements, legislation in Congress, federal rule-making in general, all of these have a national influence. The markets themselves remain local.

For longer term analysis, you've got to talk about the economics of an area. Current supply versus demand, and where that ratio is going. What do people in the area make? What is the regulatory environment? How difficult is it to build more housing? What are the population trends? What is the economy of the area doing? What are the factors influencing rental price and availability? How likely is any of this to change in the future? It doesn't matter whether people are getting "priced out" or even how many people are getting "priced out." People have been priced out of Manhattan for decades; it hasn't stopped Manhattan real estate from rising in value. What does matter is whether enough people with the economic ability to pay the current prices are available to buy up the new inventory that hits the market. It doesn't matter that people who bought twenty years ago could not afford to buy their properties at current prices. What does matter is that enough people who can afford it will buy to more than balance out the people who want to sell at current prices.

So while you can talk about national trends, any given property sits in a particular local market, and any discussion of whether to buy a given property has to be rooted in the local market situation. National trends may have an influence upon its value. If interest rates go to eight percent, people can only afford about seventy percent of the loan they can afford if interest rates go to five percent, so falling interest rates are a time of rising prices, other things being equal. Of course, we've had falling interest rates the first three months of 2008, and that's not the case. The explanation is that there are stronger factors at work.

Nonetheless, if a million people want to own property in an area (say, La Jolla) and only 40,000 people can, then the price will be determined by the 40,000 people willing and able to pay the most. If twenty million people want to live in San Diego County and only three million can, the prices will be determined by the three million people willing and to pay the highest prices. End of discussion. Not all properties in all locations are equally valuable of course, but the mix will be determined by what prospective buyers are willing to pay the most for. Note that not all costs are in dollars. Sometimes it's opportunity cost, sometimes it's any number of other costs, such as the risk of earthquake, the heat when the Santa Anas roll in, etcetera. Some people absolutely require living in a six bedroom 3000 square foot house, and if they can't afford the prices those command here, they'll go elsewhere despite the fact that they could easily afford something less expensive. Others will put up with living in a broom closet so long as they can go surfing every day.

Analysis focusing on a market's short term results are largely a study in mob psychology. Three years ago when property was overpriced locally, I couldn't slow people eager to follow the other lemmings with a locomotive. The last year or so, with available property prices well below historical trendlines locally, it's taken entire battalions of wild horses to pull people off the sidelines due to media coverage. But mob psychology is a changeable thing. A co-worker and I were talking about modifying an old T shirt the other day. The original version has two vultures sitting on a tree limb, discussing the negative utility of patience: "Patience MY ASS! I'm going to KILL something!" (pardon the vulgarity.) We're going to change the second line to "I'm going to BUY SOMETHING!" That's the mood of the market we're encountering now. The people who have been holding off seem to have realized that this is about as good as things are going to get for them. Maybe they're tired of waiting. Maybe they've realized things are more affordable for them now than they were in 2000, let alone 2004. Maybe they got "priced out" during the bubble and want to move before it happens again. Once you buy, it's not like the seller can come back and ask you for more money later because it turned out to be such a wonderful bargain - you're locking in your cost of housing. Putting it under your own control forever. The vultures are starting to swoop.

Analysis on a local market's longer term prognosis have to ignore mob psychology. It's unpredictable on that scale, and nobody ever knows just when it will turn, or how. But there's only so long mob psychology can trump practical economics, which is the norm that any particular market will follow ever more closely the longer you run the experiment. With the recent decline in values, San Diego has dropped significantly below long term value trends. This means that considering current supply and regulatory barriers to increasing it, demand of people who want to live here, the values that those people can afford to pay, and increasing demand for housing in San Diego, not to mention the changing dynamics of the rental situation (be prepared for rapid increases in rental rates), right now is an excellent time to buy, as prices are below where you would expect, given the longer term factors influencing the San Diego regional housing market.

Articles which consider only short term price fluctuations are looking backwards as we go into the future. They're looking at where we've been, not where we're going. And as always when you're effectively driving with your eyes closed: "You're gonna hit something, but that's the way it goes..."

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About this Entry

This page contains a single entry by Dan Melson published on March 28, 2008 7:00 AM.

CBB: The Art of Setting Buyer's Agency Compensation on a Listing was the previous entry in this blog.

Real Loans for Real People March 28th, 2008 is the next entry in this blog.

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