You may have heard that the real estate industry is cyclical, that it booms and busts, and rises and dips as years go by. To better understand why, let’s take a look at supply and demand.
The housing supply is constantly changing, some of it planned, and some by natural events or abandonment. The supply of housing is an important barometer to effectively keep home prices constant, and to avoid a boom or a bust.
Housing Supply Always in Flux
Every year the housing supply is reduced by events such as demolitions, abandonment, conversion, and natural disasters such as earthquakes or hurricanes. At the same time, new housing starts are added to the supply, with construction and redevelopment in areas that were dormant.
To keep supply at a good pace, new construction and should hover around 3% of the current housing supply. If the number is above that, we could see a housing bust, and if the number is below, we could see a boom.
New construction activity is a good way to measure the state of affairs in the real estate industry, with the cost of construction often running in sync with the cost of real estate. As construction costs rise, the price of homes also go up; the inverse is also true. But if construction costs surge, further development will likely be discouraged.
The housing supply is also affected by political and social factors such as Federal Clean Air Act in the 1970s, or “no-growth” and “limited-growth” planning in communities to make additional construction more difficult. While these measures have had good intentions, the result has been higher prices due to tighter demand, with homes less affordable for the masses.
Demand Runs the Show
So what about demand? Without buyers, supply means very little. Demand is a strong determinant of real estate pricing as well, and changes just as supply does.
One factor that determines demand is the population of a city, state, or county. Because planet Earth has a limited amount of real estate, as the population grows, the supply is diminished, and housing prices go up. If there are twice as many buyers in a certain neighborhood, sellers can up their asking price.
Cities and states also increase and decrease in popularity, and thus see shifts in growth. Look at Las Vegas, Nevada or Phoenix, Arizona. Both cities saw huge growth spurts in a short amount of time. The increased demand for real estate in those cities led to an oversupply which has now leveled those markets, halted construction of many planned developments, and led to increased foreclosures.
Demand is also contingent upon the purchasing power of potential homeowners. If buyers aren’t qualified, supply won’t be met and demand will be weaker. To gauge the purchasing power of American consumers, Gross Domestic Product, inflation, jobs reports, Consumer Price Index, wage levels, disposable income, and more are used to determine what people can afford. Generally, if disposable income increases faster than inflation, demand for housing should be strong.
The Federal Reserve is called upon to see over the economy, effectively controlling inflation and avoiding recession by adjusting the discount rate to determine the flow of money and credit. Fiscal policy is also key, with taxation reduced and government spending increased during times of recession to spurn demand for real estate, along with the inverse. Government housing programs also play a role, such as FHA loans and VA loans which provide money for real estate financing to select groups nationwide.
Real estate is highly important to the economy of the United States, as it represents nearly two-thirds of the nations’ net worth, accounts for a large number of jobs in related industries, and is an essential part of the production process. It clearly gets a lot more complicated and detailed, but this is simply a taste of the importance of real estate in our economy.