The Complexities of Real Estate Economics

Real estate economics is the field that studies all the numerous factors influencing the real estate market, including property values, construction activity, and the ways land is used. It plays a pivotal role in explaining not only the housing market but also the broader economy. That said, it is its own branch of economics because it suffers from a variety of unique challenges that require special treatment. While economic fundamentals still play a key role, it also employs its own unique methods.

Key Ideas of Real Estate Economics:

Supply and Demand

At its core, like all branches of the dismal science, real estate economics revolves around the fundamental principle of supply and demand. The value of a property is determined by the balance between the supply of available properties and the demand from potential buyers or renters. When demand exceeds supply, as is the case with all goods, property values rise, and vice versa. Understanding the demand side, however, requires understanding consumer preferences and how much consumers must save to accept a less desirable home. Moreover, real estate economists must understand the behavior of different market segments. Homes belong to different classes, and studying supply and demand dynamics involves understanding how the supply of, and demand for, low-end, medium-grade, and high-end housing differs over time.

Labor Markets and New Construction

When judging the trajectory of future home prices, one of the most important things to consider is how many new homes are being built. All else being equal, more new homes will tend to drive home prices down; of course, this trend is rarely directly observed as builders build in response to home price increases, but it is still vital to keep this relationship in mind. The number of new homes can, in turn, depend on the tightness of the labor market, the willingness of municipalities to issue permits, etc.

However, labor markets can also affect the demand side of the equation: For working-aged people, most choose to live where they can make the most money. To forecast changes in housing demand, one must anticipate how the labor market will affect that demand. This involves understanding the overall trajectory of the regional economy being studied.

Demographics

To understand real estate, it is essential to understand people: While the labor market plays a major role regarding where people want to live, family formation plays the primary role in determining what kind of house people need. Of course, demographic factors play a role in determining where people want to live as well: As people retire, some will move to places with a lower cost of living and a more favorable climate. To make long-term housing forecasts and to general market trends, demographic information is essential.

Location, Location, Location

The old adage holds true in real estate economics. Location is a primary driver of property values. Factors such as proximity to employment centers, schools, transportation hubs, and amenities can significantly impact a property’s desirability and, consequently, its price. Figuring out which sets of locations are “basically the same” is harder than it might seem. Noise levels, road access, traffic patterns, parcel shape, inclination, and size, view quality, and water frontage are just a few examples of things that can make two properties vastly different.

Comparable Sales and Other Valuation Methods

Determining the value of a property is a complex process. Real estate economists use various methods, including comparable sales analysis, income approach, and cost approach, to assess a property’s worth. Comparables sales analysis looks for similar properties that sold recently and arrive at the value estimate by adjusting the comparable homes’ features on a dollar basis to be like the property being valued. Accurate valuation is crucial for buyers, sellers, investors, and lenders to make informed decisions.

Market Cycles

Real estate markets are cyclical, with periods of growth, stability, and decline. Understanding these cycles is vital for investors and policymakers. During boom times, property prices soar, while during recessions, they can plummet. Recognizing these trends, and more importantly, what causes them, not only helps stakeholders make timely decisions but also explains a great deal of market behavior. To some extent, real estate economics presupposes an understanding of macroeconomics and business cycles.

Financing and Interest Rates

Access to financing and prevailing interest rates play a significant role in the real estate market. Lower interest rates can stimulate demand by making homeownership more affordable, while higher rates can deter potential buyers. Most buyers need to borrow in order to buy a home, so the terms under which people can borrow have a major effect on price movements.

The Rent vs. Buy Decision

At the end of the day, one must find a place to live, and you either pay someone to live in a property they own, or you own the property yourself. (I suppose you can coach surf or try to live with your parents, but someone, somewhere must own or rent something; not everyone can freeload.) Thus, rents and purchase prices can influence each other in complicated ways. For example, if prices are inflated relative to rents (the price-to-rent ratio), that can be a sign that there is a property bubble forming. On the other hand, if rents are accelerating, that can place upward pressure on home prices; people might want to buy now to shield themselves from those rent increases. Indeed, one method for valuing properties, mentioned above, works of the assumption that you can discern the value of a property from the rental income it produces—known as the income method.

Regulation and Incentives

Regulation does not only affect how much it costs to create new properties; it also affects what kinds of homes are built and where. Zoning determines where housing will go up and where commercial activity will occur. The number of permits a municipality issues limits new supply; and minimum lot sizes incentivize builders to build bigger homes; after all, who wants a small home on a large lot. All these effects must be considered as well.

Challenges in Real Estate Economics

Real estate economics is challenging due to several factors:

Data and Information

Gathering accurate and comprehensive data in real estate can be challenging. Property transactions are infrequent, and information can be fragmented. This lack of transparency can hinder market analysis and decision-making.

Imperfect Substitutability

No two homes are perfectly alike. Most of economics assumes, in one way or another, the law of one price. However, in real estate, ever property is unique, but—at the risk of sounding somewhat Orwellian and angering those who are semantic sticklers—some properties are ‘more unique’ than others.

Local Variation: Real estate markets are highly localized. What holds true in one region may not apply in another. This necessitates in-depth knowledge of specific markets, making it challenging for real estate economists to discuss the US, let alone the world. Very often, the people with the most local market expertise do not have broad economic training.

Non-Arms Length Sales, Over-Improvement, Days on Market, and Other Complexities

A number of things can complicate the valuation of a property; the need to sell quickly, for example, can reduce the price a seller receives. Furthermore, people often modify their properties in a manner that does not coincide with what most buyers are looking for, a set of circumstances referred to as over-improvement. Lastly, foreclosure sales and court-ordered sales can be transacted at very different prices than normal, arms-length sales. Indeed, the presence of foreclosure sales can have a “contagion effect” that reduces the value of homes surrounding them—this effect can also complicate real estate analytics.

Even though other branches of economics seem to receive more glory, real estate economics is one of its most complicated—with business cycle and monetary theory being the only parts that deserve to be considered equally difficult. Hopefully, as novel analytical methods are invented, real estate economics will receive the academic attention it rightly deserves.

Franklin Carroll

Franklin Carroll is Kukun's VP of Modelling and Analytics; After finishing his studies at the University of Chicago, he worked at Fannie Mae where he helped build Collateral Underwriter, roll out the Value Verify initiative, and specialized in collateral related and credit related policy.

Published October 31, 2023