Home prices represent, perhaps, the most important piece of information for investors that are active in the residential market. For this reason, investors need to have a very good understanding of how house prices are determined, what are the forces that drive their movements and under which circumstances they are more likely to register significant gains (see article below titled “What May Cause Home Price Increases?”.
Such an understanding will help investors better evaluate the prospects of the local housing market in which they operate and better identify circumstances, locations and properties that are more likely to provide high investment returns. Given the importance of home prices for residential investors, including the millions of home-buyers, we have devoted this special section of our website on this issue to provide a more thorough discussion, as well as relevant articles, a reading list, sources of data and forecasts, and seminar programs and providers. The article below provides valuable insights regarding the factors that drive increases in housing demand and home prices.
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What May Cause Increases in Home Prices?
According to the conventional economic theory, home prices are determined by the interaction of demand for housing units and the supply of housing units. Assuming that the housing market is at equilibrium, that is, housing demand equals housing supply, home prices will start increasing if demand for homes increases while the supply remains constant. From an investment point of view, it is obvious that a purchase of a house in a market that has strong prospects for increases in home prices is a wiser choice than a purchase of a housing unit in a market where home prices are expected to remain stagnant. For this reason, it is very important for investors focusing on the residential property market to understand the determinants of housing demand and housing supply. Most importantly, property investors need to understand the forces that can trigger increases in demand for housing.
Forces that Trigger Increases in Demand for Housing
Housing demand is, on the aggregate, a simple concept, since it refers to the total number of housing units needed to house an area’s population. The concept becomes more complex if we try to think of it in more specific terms, such as tenure mode (owner-occupied and rental units), sub-type of housing (single-family detached, single-family attached, apartment, etc.), amenities, and locational characteristics. In this article, I will attempt to shed light on these issues.
In thinking about drivers of housing demand, we need to distinguish what factors cause increases in aggregate market demand and what factors cause increases in demand for a specific location or locational demand. Since a property is fixed at a given location, it is extremely important to understand from the outset these two mechanisms by which demand for a specific location may increase. Although I referred to these two mechanisms earlier, their repetition here is warranted given the importance of this issue in understanding the forces that can trigger increases in home prices:
1) Increases in aggregate market demand, due to economic and population growth, will contribute to increases in demand at many locations within a market. The strongest and most advantageous locations, as perceived by the types of households that represent the increase in demand, are likely to reap the highest benefits from such increases. This is where properties with market-driven value increase potential can be found, as long as these locations are not oversupplied. I refer to this locational demand increase as a market-driven increase.
2) Demand for a specific location may also increase due to changes in a property’s environment as a result of significant developments in surrounding areas or elsewhere within the urban area. These are the locations where properties with development-driven value-increase potential can be found. I refer to this type of locational demand increase as a development-driven increase.
Figuring out which locations in a metropolitan market will experience increases in demand for housing, can help property investors evaluate and identify residential neighbourhoods where home prices are more likely to rise (if supply conditions are also appropriate). Identifying locations with potential for increases in housing demand within an urban area, requires an understanding of how aggregate demand for specific types of property is distributed across competing locations. The most important principle regarding the distribution of demand for property in general, and housing in particular, at different locations within an urban area is the comparative advantage. This is a very important concept that property investors should always have in mind in their search for properties with significant profit potential.
I suggested earlier using Sweeny’s framework of bi-hierarchical structure in classifying locations in terms of their comparative advantages. Residential investors looking for highly profitable opportunities in the housing market should be constantly monitoring developments and prospects in the urban fabric, evaluating and assessing how comparative advantages that are valued by households looking for a home are likely to change and how such changes are likely to affect home prices in the different residential zones. Changes in comparative locational advantages shift demand for property from one location to another, raising home prices and rents in the latter and depressing home prices and rents in the former. This is true not only as far as intra-urban demand shifts are concerned (shifts among locations within the same urban area), but also as inter-urban location demand shifts (demand shifts from one urban area to another).
What May Cause Increases in Aggregate Market Demand for Housing
The basic unit of housing demand is the household. The link between housing demand and the number of households is set by definition since, according to the US Census Bureau, the term household refers to one or more individuals living together in a family or non-family setting in a separate housing unit. Thus, increases in aggregate demand for all housing types are equivalent with increases in the area’s number of households. Within this context, the following forces can trigger increases in the total housing demand in a market and potentially contribute to increases in home prices, depending on local supply conditions:
1) Household Growth
2) Household Income Growth
3) Decreases in Mortgage Rates
4) Expectations of Future Increases in Home Prices
Household growth, which is measured as the change in the number of an area’s number of households from one period to the other, triggers increases in total market demand for both owner-occupied and rental housing depending on the age and income characteristics of new households. For example, if the new households that enter the market are mostly young individuals with low incomes they will boost demand for rental housing. If the vacancy rate in the rental housing market is low, such demand increases will push rents and home prices up, since there is an inherent link between rents and prices.
Household income growth trigger increases in demand for both rental and owner-occupied housing. Increases in income can contribute to increases in demand for housing in several ways. First, income increases are likely to contribute to new household formation, as they may allow many individuals living in a family or non-family setting to form their own household. For example, young adults living with their parents are likely to form their own households as soon as their financial situation allows it. Second, increases in the average income of an area’s households, especially those headed by persons in the prime renting age group of 25-35, may contribute to increases in the demand for owner-occupied housing. Keeping home prices constant, higher incomes will make housing more affordable to several renters and enable them to enter the market for owner-occupied housing. Finally, increases in the income of households in the full-nest stage will allow them to upgrade their housing situation, thereby triggering increases in demand for larger and higher-quality houses.
Keeping home prices constant, decreases in mortgage rates will trigger increases in demand for owner-occupied housing, since they reduce the monthly loan payment and the cost of financing house purchases, thus making housing affordable for more households. The last five years provide the best example of the influence of low mortgage rates on residential demand and home prices, as demonstrated by the very strong increases in home prices registered in most markets in North America and Europe.
Expectations of rising home prices in the future affects positively housing demand because most households realize that buying a home represents a significant commitment of capital and understand the investment nature of their decision. In addition, many first-time home buyers know they will eventually resell their first home in order to upgrade to a better and larger house when their income allows it. Finally, homeowners realize that their house is the only collateral they can use to borrow money when a need arises. As the value of their home increases, the amount of money they can borrow increases, too. For these reasons, home buyers are strongly interested in the prospects for increases in home prices in the markets they are active and they respond accordingly. Thus strong expectations for future increases in home prices trigger increases in housing demand, while expectations for stagnant home prices in the future discourage housing demand.
Home Price Indices
The measurement of home prices and their movements through time is not an easy task because houses are highly heterogeneous goods. As it has been repeatedly been said in the literature, no two houses are exactly the same. Furthermore, even if we had two houses that were exactly the same, but in quite different neighbourhoods, their price levels could be quite different, since locational attributes, such as the qualitative characteristics of the neighbourhood, land-use mix and accessibility characteristics, play also a significant role in determining house price levels.
Accurate and reliable information on home prices, their movements through time and recent trends is necessary from an investment point of view since the purchase of a house is for most households the largest capital expenditure and it should be viewed as an investment that can increase their wealth through value appreciation. That is why home buyers should be quite selective and try to purchase houses that have strong appreciation potential, even if the purchase of the house is for owner-occupation.
Besides home buyers, information on house price levels and their movements through time form the basis of key decisions for a variety of professionals and players in the private sector such as mortgage lenders, house builders, home sellers, and property consultants. Accurate and reliable information on home prices is also necessary for the formulation and evaluation of economic and social policy, thus providing an invaluable tool to local government officials and planning departments. Finally, as the housing sector, represents one of the largest contributors to local and national economies (both directly and indirectly through its linkages to several sectors of the economy such as furniture, building materials, home equipment, etc.) a measure of movements in home prices, is necessary in researching and measuring the effect of the housing sector on key economic indicators such as inflation, income and employment growth, construction activity and economic cycles.
It has been empirically established that home price levels and changes through time vary considerably across metropolitan markets and even across sub-markets within the same metropolitan area. Variations of home prices across sub-markets are mostly in terms of price levels and to a lesser extent in terms of movements through time. There is a tendency for home prices, and generally property prices, in sub-markets within the same metropolitan area to follow similar movements but at somewhat different timing. The smaller differences in the time path of home prices at different locations within the same metropolitan area is due to considerable substitutability across locations that are subject to the same local economic cycles and resultant fluctuations in demand and supply conditions.
What is a Home Price Index?
A home price index is a measure of changes in home prices through time. Most home price indices focus on single-family houses, which is the favourite type of unit for home owners. A home price index refers always to a specific geographic level, depending on the data sample and the methodology used to construct it. For example, it can refer to the U.S. as a whole, to a specific region of the country (South, West, etc.), a specific state, a metropolitan area, a city, a zip code or even a specific neighbourhood. However, it has to be noted that it is more difficult to construct indices for home prices for smaller geographic units because of data limitations. In particular, the typical econometric methods used to construct home price indices, require a minimum sample size for the estimation results to be reliable. Thus, the problem that often arises in the case of small geographic units when it comes to constructing indices for home prices is that there may not be enough transactions each period to make up a sufficiently large data sable to guarantee reliability of the estimates. A good example of a home price index is the one published by the Nationwide Building Society. They publish figures on a monthly and quarterly basis and have historical data going back many years. .
How often is a Home Price Index Updated?
A home price index is meaningful only if it can be replicated with a consistent methodology over time so it can provide a reliable measure of movements of home prices through time. Given that property transactions in general, and house purchases in particular, are time consuming processes, a reasonable frequency of estimating home price indices is the quarter. In such cases it is useful to estimate changes in the index not only from quarter to quarter but also from the same quarter of the previous year in order to get a sense of both the quarterly the annual price change respectively. The formulas for estimating the quarterly and annual changes are indicated below where t represents the current quarter:
Quarterly Change = (Pricet / Pricet-1) – 1(1)
Annual Change = (Pricet / Pricet-4) – 1(2)
How is a Home Price Index Calculated and Updated?
The two main econometric techniques for estimating house price indices are hedonic regression and Repeat Sale Regression (RSR). The main issue in estimating changes in home prices through time is controlling for changes in the quality of houses that are transacted each period so as to isolate the change in price that is exclusively attributable to changes in market demand and supply conditions; this issue is central in the case of home price indices given the high heterogeneity of the housing stock. This is why indices of changes in home prices are more accurate if they reflect changes through time in the price of a constant-quality house. The hedonic regression technique estimates the effect of all characteristics that affect the prices of the houses included in the sample, such as number of bedrooms, bathrooms, number of rooms, quality of construction, amenities, etc. The measured effect of this attributes on house price levels is then used to estimate the price that the constant-quality house would command in each period. Changes in home prices from period to period are then measured as the changes in the price levels for the constant-quality house.