What Determines Real Estate Prices

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It is often quite interesting how pricing of something is determined. When we think about how goods are priced, we think companies come up with a price based on a myriad of factors, some of which include what the cost of the goods are, what the companies think the consumers are willing to pay, and what other competitors are charging. These signals are complex and ever changing; however, at the end of the day the company makes the call and then responds to how the decision goes based on revenue and profits.

On the other hand, real estate prices, similar to the stock market, are not determined by one decision maker nor by all decision makers together. While there are always new home being build and there are new public stock offerings, real estate and stocks are, in reality, commodities being traded back and forth by buyers and sellers.

Determining Real Estate Pricing: An Example

Pricing in these cases does not often reflect true reality of economics. For example, if in a city Widgetville a total of 10 homes were built and the first 9 were sold for $100,000, you would surmise that the 10th house should have been sold for $100,000. What if it was sold for $100,000 and then the buyer subsequently sold it to his neighbor for $120,000? And what if homeowner C, seeing the sale, then proceeded to sell his to homeowner D for $120,000 as well? Then does it mean that Widgetville’s total home value went from $1,000,000 (10 houses at $100,000 each) to $1,200,000 (10 houses now valued at $120,000 each)?

Just because the 10th buyer resold his house and so did homeowner C Widgetville just has become a lot wealthier by $200,000. But did those two sellers really contribute any value to the city at all? Can Widgetville citizens really realize these increased values? Unfortunately, most of them would not stand to gain anything unless they sell the homes or if Widgetville Bank is willing to loan money based on the market value of the house.

So what if homeowner F and homeowner G subsequently sold their homes for $80,000? What then? Did Widgetville residents become a whole lot poorer?

The Point Is…

The point is, real estate pricing is reliant on what the latest buyers and sellers are willing to trade at and does not reflect true economic values at times. The same can be said for stock markets. So as a result this type of pricing is extremely susceptible to large traders making decisions. As a result of a large trade then other players may following the pricing of the latest trade in making their decisions. There is no efficient market and there is no true supply and demand. The fundamentals are at the mercy of people really. And people, I think, do not make the best decisions all the time. After all, isn’t that why we always have bubbles and crashes?

With that in mind, I think it is to best invest in real estate like a business – taking all the operating and financing costs and returns in mind. One needs to invest with return on investment ratios in mind than appreciation potential. Yet one should not forget that real estate prices are a product of the latest buying and selling decisions. There are many opportunities when the latest traders make unwise decisions and trade at prices that diverge too far from economic values. The herd will see the latest signals and will further exacerbate the pricing errors by making decisions based on those signals (I.e., Homeowner A in Widgetville sees the latest sales are trending up so she better buy now before it goes up even more/Homeowner B sees latest sales are trending down so he better sell now). It is near the peak of those times when you can capture tremendous values by actions such as buying at the lows or selling at the highs.

Photo:seier+seier

About Author

Leon Yang

Leon Yang is an active real estate investor in Las Vegas. He is a buy and hold guy who also likes to flip from time to time. His main passion is to traveling to the less traveled places and inspiring others to become financially independent through real estate.

11 Comments

  1. One of the biggest contributors to the “reality” of housing prices is the media.

    Our area never had a bubble so we never had a bust. However, the hysteria was alive and well in practically every local conversation about real estate. And, therefore too, the pricing highs and lows.

    I constantly tell people I speak with, “You HAVE to stop listening to CNN!!”

    Thanks, Leon, for your post.

  2. Mehran Kamari on

    This is a great post Leon. We can thank the large traders (hedge funds) and other factors for influencing property values lately. It’s been helping me because I’m leveraging my primary’s appreciation to buy in markets that haven’t appreciated as much. #Winning!

    A lot of people I work with know that I invest in real estate and many have approached me lately asking “Do you know a good agent that can help me buy an investment property? I hear real estate is doing good now and I want to get in because it is a good investment.” It makes me cringe! They know nothing of the market, analyzing deals, expenses, property management, leases, tax implications, lending guidelines, nothing!

    What they should be asking me is “I see prices are going up and want to learn more about real estate investing so I can make sound investment decisions. Where can I get more information?” I warn them about the above aspects of REI. I let them know some books to read, and to come visit BP to learn about investing. All I get in return are blank stares, and almost resentment for stealing their thunder 🙂

    After I get some more properties under my belt and have a proven track record, I’ll be able to actually help some of them make $$$ by private lending on my acquisitions.

    • Mehran
      You are very astute in your observations. There are a lot of “sheep” out there that will follow the news and jump on the band wagon. My brother once told me housing prices were way down, he heard it from the government. I said- O! where? Not where I buy.

  3. I would agree with your premise to a point if we actually had a free market.
    In reality what sets the price of housing was just witness in the last cycle.
    The last cycle was totally influenced by government policy, this the reason it ended poorly for many.

    What would the best property you own sell for if there was no financing available?
    What would someone pay for that same property at 0% interest for 15 years? How about we add 0% down what would that house sell for?

    Credit markets dictate the market price of every item that requires debt financing.
    The media reports the facts after they happen, notice we are all seeing the flipper shows again, and the guru’s are coming out of the woodwork.

  4. Dennis is the closest to the cause the bank control all and people’s attitudes are altered by what they can borrow. Lenders caused the melt down and are slowing the recovery by restricting lending and this hold prices artificially low

  5. The basic forces are still supply and demand but analyzing each is truly complicated and then adding human nature to the mix often makes it a guessing game. When I played the stock market I was amazed how a hot tip caused prices to rise because of all the buying activity even though the only factor was a rumor that such and such was about to happen which in most cases didn’t. I later met and became good friends with the top stock broker in San Francisco and found that these tips were often generated by inside people going to sell a stock or buy a stock so they could manipulate the price they sold or bought at. They made the money and the herd got shafted. When my first stock broker would call suggesting I buy XYZ stock right away I had learned he was just pushing the latest stock the brokerage wanted to dump.

    The quote about the immigrants is basically true because the are seeing what is, not what was and preconceived notions about what will be. I noticed when I first got my real estate license that us newbies seem to be better in touch with the current market while many of the old timers were 6 to 12 months behind, and thus the same principle was at work.

  6. Essentially this post is saying that the “market” doesn’t always correctly attribute true value to the assets sold on it. Sometimes prices are too high, sometimes they are too low. Your duty as an investor isn’t too listen to the market to tell you what something is worth, but to determine that on your own, then take advantage of the market’s crazy prices. If you have something truly worth say $100,000 but the “market” says it is worth $500,000, you may want to sell. If you see something worth $100,000 but the “market” says its worth $60,000 doesn’t make it a more risky investment…it makes it a less risky investment, and you should take advantage. As Warren Buffett has stated (through his teacher Ben Graham) in reference to the stock market… “The market isn’t a weighing machine, it is a voting machine”. Meaning that you should consider the market as a guide for value, it just shows you what is currently marked up or on sale.

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