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.