I’d like to explore how home prices come about, (as distinct from costs, described in Part 1), and in particular, prices of non-income generating, owner-occupied housing—typically a single family house or a condo. (We’ll look at income-generating residential properties in a future installment).
Rising home prices are a hot topic in many cities, and not just super-star expensive coastal metros. Here in Rhode Island, the median sale price for a home increased about 30% in a couple years. Median incomes did not.
So what is driving this change? Where do housing prices come from?
Fundamentally, home prices are the result of a whole bunch of negotiations between sellers and buyers. Sellers generally want the highest price they can get and some certainty that a sale will close with a minimum of headaches. A seller (and their agent) will look around at what other properties have been selling for recently, and whether recent sales prices seem to be going up or down, when considering the price they will accept.
In contrast, the buyer is looking to buy a house and has some preferences about the house they plan to buy and live in: size, quality, location, and other features. And the buyer would like to get those preferences for as little as possible up to some maximum amount they can afford to pay. The maximum amount that a buyer can afford to pay depends on a combination of their available cash, access to debt, income, interest rates, property taxes, and insurance rates—all coming together to a monthly mortgage payment. Generally, the higher their income and the higher their savings, and the lower the mortgage interest rates, the higher the maximum price a buyer can afford to pay.
The main factor that determines whether the seller or the buyer has more leverage in this negotiation is the ratio between homes for sale and potential buyers.
If there are more homes available than potential buyers, the buyers have the advantage (a buyer’s market). They will be able to view many properties and take their time making considered offers. They are less likely to engage in bidding wars and may even generally offer under asking price. Sales prices will be set by what sellers will accept.
Conversely, when there are many more potential buyers than homes available, sellers have the advantage (a seller’s market). In a seller’s market you will get bidding wars for properties, sometimes with a dozen or more offers. Properties may stay on the market for just a few days. Buyers may waive inspections & other contingencies. Here the price is set by the top few bidders (the ones that the highest bidder had to beat to win the sale).
So why do housing prices tend to go up in a seller’s market?
First, the bidding competition to buy each of the limited number of homes will tend to drive up the price as people compete for something (a home) they really want. If the only way to get it is to stretch budgets, work more hours, borrow money from family and friends, etc., then at least some buyers will do that.
Second, the composition of buyers could be changing. For example there could be an increasing number of households with larger budgets looking to live in a city or neighborhood. Their resources (maybe from higher incomes or significant savings) can allow them to outbid other potential buyers. If housing is scarce, it only takes a relatively small number of these higher income households to drive up the prices in a whole housing market.
Imagine: You add a dozen new high wealth households to a seller’s housing market. They will likely compete with each other to be the highest bidders for houses that meet their preferences. Because these households have larger budgets, they are able to bid up the price of each sale. Other sellers watching this dynamic will begin listing their houses for more and more money, chasing these new buyers who are willing to pay so much more.