Do you think residential sales are in a supply driven market, or a demand driven market?
- Demand is the real driver, it’s a buyer or nothing. (49%, 106 Votes)
- It’s a bit of both, in equal measure. (35%, 76 Votes)
- It’s all about supply, the seller controls. (16%, 34 Votes)
Total Voters: 216
This article series casts a critical eye towards the supply-side paradigm, and posits that in recessionary periods, and particularly during periods of zero-bound interest rates, the real estate recovery is propelled by demand from organic buyer-occupants – the end users of property.
For an analysis of how to nurture demand and obtain more buyers, see Part II of this article series, Where have all the buyers gone? to be published in the August journal.
“If you build or list it (and the government makes cash available) they will come”
To all those vociferous quibblers who proclaim the elixir to the real estate market’s ills is supply, listen up! While sales volume is temporarily propped up by speculators snatching up inventory, this is but a mini-boom in reported sales, and does not paint a picture of market realities one year hence (2013 and beyond as we ride out this bumpy plateau recovery).
Changes in the availability of real estate inventory, known as supply, inversely affects the price of property. Worse, in a recovery era of zero-bound interest rates as we have today, the market is not driven by supply – it’s driven by demand.
This truism will soon be felt around 2013, when the current speculator-fueled mini-boomlet subsides and the hot money finds somewhere else to park itself.
During the past 30 years, real estate sales of all types of property operated under supply side paradigm behavior. The supply side paradigm was a boon to the construction industry, listing agents and sellers as their jobs were made easier by the ever-enlarging availability of mortgage funds at constantly lowered rates for any entrant they were able to drag to the table for the closing of a real estate deal.
These roughly 30-year periods of dropping interest rates are known as seller’s markets. In a seller’s market, sellers command a high price, knowing that energized buyers with ready access to cheap money will always be available to continuously sop up the housing supply. If a property is built and offered for sale, it will invariably be sold since, under the supply side paradigm, there is always a demand for housing.
In stable or rising markets, the supply of available units for purchase is indicative of the health and momentum of the market. Under this market reasoning, so long as there is supply, as a matter of certainty, demand will equal (or likely exceed) it.
And the mantra continued: list, list, list and build, build, build.
The demand side paradigm shift
However, we are still stumbling over the washboard shaped recovery of what has become the Lesser Depression, forged by a massive and widespread financial crisis.
Though the speculator-propelled boomlet we’re currently experiencing has provided a false sense of hope for some, it is fleeting. This is decidedly NOT a seller’s market — or at least won’t be once the mini-boomlet crests. The supply-side way of thinking is ill fit to the forthcoming realities, a truth that will likely be in effect well into the next two or three decades of interest rate movement.
In recovery periods shackled – trapped – with zero interest rates, embracing the supply side paradigm is akin to donning a thick, thermal pelt after the ice age has passed. It is discordant to the point of being laughable (pun intended – Laffer curve), and resistant to evolutionary necessities imposed by the liquidity trap placed on sellers by zero-bound interest rates. You simply cannot escape ownership by raising or keeping prices high and waiting.
Proponents of the confused supply side paradigm claim to witness both multiple listing service (MLS) inventory slipping and prices dropping – two trends which cannot exist concurrently, in violation of the basic laws of supply and demand. If prices were going up, supply would then become relevant again.
Real estate price indexes going forward are, quite simply, a story of demand. Adjust your survival plan accordingly by giving ardent attention to the type of buyers you represent, or prepare for a bitter future ahead. California brokers take note, at your next monthly award ceremony to traditionally give public recognition to the agent who brought in the most property listings to the office, change the language of your award certificate to read instead, “Agent who contributes most to our forthcoming Chapter 11 petition.”
Organic indicator of demand
Before the level of buyer demand can be properly gauged, the factors which create demand must first be determined.
The only real indicator of long-lived organic demand is the end user of a property. Every builder of subdivision homes knows speculators are the death of his expansion into the next stage of development since they are not users, but usurpers.
The end user of a property is a buyer who will take personal possession of the property for a considerable length of time, as would a collector. Thus, the end user most frequently takes the form of a buyer-occupant, one who purchases property for use as shelter for his family or business, and takes steps to retain the property as a store of his wealth for as long as it serves the purposes of his occupancy.
In addition to buyer-occupants, long-term investors are also a key player in demand. Long-term investors purchase a property with the intent of renting it out to tenants to produce a steady income flow, a process also known as buy-to-hold. Thus, they are collectors at heart.
As with buyer-occupants, duration of possession is the key factor determining whether they are an end user of a property. It is purchases by these end users which reflect the true level of organic demand in a market – everything else is noise, temporary distractions and fluctuations which attempt to extract profits from the market, transitory actions devoid of any actual demand for the item being offered, i.e., long-term possession of the property.
Let’s do the math
But what about the obverse side of this ownership coin?
Absentee homebuyers, a group consisting of speculators and renovators (and true buy-to-hold investors) accounted for 28% of Southern California non-foreclosure-related sales in April, 2012, near the record high of 30%. In Northern California, absentee buyers made up 24% of homebuyers, down from a record high of 26%. Note the trend.
Critically, these percentages do not include the estimated one third of all trustee’s sales that were picked up by speculators.
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Thus, when you combine absentee homebuyers (and subtract buy-to-hold investors who are long-term income property owners) then add speculators at trustee’s sales, approximately half of all transactions effecting a change of ownership do not currently go to the end user.
Speculators, who by profession contend with a high degree of risk, come in two basic species:
- quick flippers, also known as hot money handlers, who add no value and invest little to no money in a property. Flippers purchase properties (mostly of the low-tier, distressed variety) with the intent of selling them at a higher price at a later date (and renting short-term if necessary to reduce their negative cash flow); and
- renovators who add value to a property before attempting to flip it.
Flippers rely solely on the upward dynamics of a momentum market, pocketing any price appreciation by sandwiching themselves between the seller and the ultimate end user of the property (read: the buyer-occupant or buy-and-hold investor).
Similarly, renovators add value to a property by rehabilitating it before selling it back into the market. Renovators frequently target damaged low- to mid-tier properties and improve them, bringing the property’s amenities and appearance to a level consistent with that of the surrounding neighborhood.
Editor’s note – Preferably, the improvements are not to a degree which over-improves the property so it becomes the most valuable in the neighborhood, as a renovator will find it difficult to recapture his investment.
Similar to flippers, renovators do not intend to hold and maintain the property for the long-term. Instead, they want to limit the length of time it is in their possession, typically 75 to 90 days to complete their renovation work, then immediately release it back into the market.
Unlike their quick flipper brethren, renovators contribute value to the property by returning it to a state fit for occupancy. Renovators also help the property avoid obsolescence by replacing fixtures which are out of date.
Speculator activity is not any part of demand
Speculators are not in the real estate game to acquire property for their long-term investment or shelter. Quite to the contrary. Like a day trader, they have no demand for the property, and similar to commodities dealers, do not take possession of it. They demand only the temporary use of title to the property as a tool to extract money from the market before the ultimate end user enters the equation and takes possession.
While the property is in the temporary hands of the speculator, it is effectively pulled from the market and unavailable to those who have an organic demand for it. Remember, speculators still have to find an end user buyer to purchase the property. Thus, the property will be returned back to the market for sale, as it was before, though offered at a far higher price. Thus, inventory is deceptively reduced below the level of demand.
Speculators are much like the unkempt agent who shows up late at a marketing session, Twitters until he makes his pitch, then departs, leaving nothing of value in his wake.
Speculators never intend to hold the property for the long-term, their involvement is kept to the shortest duration they can by design, much like a catch-and-release fisherman immediately returning his catch back into the water for the end user: the fisherman who will catch then actually eat the fish.
In terms of real estate parties, the speculator is more genetically similar to the role of a seller than that of a buyer. Even though the speculator purchased the property from the seller, what he is essentially doing is stepping into the shoes of the seller, a title he will officially don himself as soon as possible (immediately on a quick flip, or within about three months for a renovator).
Thus, the speculator isn’t really buying the property from the seller – the seller is merely assigning the speculator the resale task of locating the ultimate occupant-buyer at a not-too-distant future date, the buyer being the only party who actually has demand for the seller’s property. The speculator is a surrogate seller.
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Thus, to acquire the sense of demand, you must look for the percentage of all sales which are going to an end user, not those reported sales maligned by the “parking” of property with an intermediary. With this rubric in mind, it is clear that lack of demand, not supply, is the real long-term obstacle blocking California’s definitive ascent out of this economic morass.
Life-cycle of a speculator
The activities of a speculator are not synonymous with demand for real estate, and the second shoe of their distorting presence in the market is still to fall. When this time will come will be the subject of future conversations.
Speculators rely solely on an upward oscillating market to turn a profit on their investment. This means that in this bumpy plateau recovery, flippers will have a very long time to wait before a consistently rising market turns a sufficient profit to warrant selling at the dollar figure originally intended.
Thus, speculators who bought “cheap property” hoping for a quick flip at a higher price will have to adjust their modus operandi once they realize that prices will remain unstable through 2015-2016. Thus, these speculators will rely on their default fallback plan: hire a property manager (broker), rent the home and collect some income until they are able to unload the property on someone else. In this way, they will become landlords-by-necessity, a position which is not in any way consistent with their desired purposes for taking title to the property (or their skill set).
However, unlike before the Lesser Depression, they will find the market will not gain sufficient traction as quickly as the hit-and-run investor would like to resell at a profit (and function as a §1031). In their impatience, as soon as they sense even the remotest bump in the market, speculators, acting in improvised unity, will all try to sell their investment-turned-sour properties at the same time. This collective activity will likely occur within one or two years’ time.
This sudden flood of failed investment properties will be the second shoe to drop, and again exert downward pressure on the market. Ultimately, end user buyers must return at roughly double or triple the pace they’re at now to begin soaking up some of this excess inventory as it again saturates the market.
Editor’s note – For a discussion of where all the organic buyers have gone – and how agents can successfully pair with these buyers – see the upcoming Where have all the buyers gone? article to be published in the August 2012 edition.
What I find most laughable about this article isn’t the obvious and sensible demand side equation that any econ 101 student knows is part and parcel to supply/demand for a viable housing market, but more so its contentious dig against the supply-side theory per se. Why criticize the Laffer Curve with this (pun intended nonsense) seriously? The author is taking a topic of housing and trying to make a cheap dig at a sound economic principal known as supply-side economics (Laffer curve) and correlate it to speculative inflation over builder participation. Wow, talk about apples to oranges. BTW, the Laffer curve has to do with broad based tax cuts which DOES allow for economic stimulus: it was proven to work in the 1980s and 1990s respectively. There’s no debate there!
Interesting responses, I am in the property management side of RE, and I was trying to correlate what most are saying about nothing being available for purchase, to the rental market, which is a little strange right now. I have never been spooked in all these years, and can usually read the market trends/causes pretty quickly, but it is a little spooky right now I have to admit.
Very little movement out of the rentals, but prospective tenants with decent credit for the vacancies we have, are extremely, almost non-existent, slim.
My inexpensive South Bay buildings are the only ones that are behaving normally.
Thank you for your brilliant summary.
The road ahead is challenging. With any recovery comes at least a modest increase in inflation, which will cause interest rates to rise, and decrease the “organic” buyers ability to purchase. There are no quick corrections right around the corner, especially with so much of the “the market will always increase” attitude still in the market.
Doom and gloom is always the way First Tuesday perceives the future. No one wants Real Estate now might be true due to the last 4 years performance. What about the Municipal Bond Market? Once all the investors find out the flood of Chapter 9 Municipal Bankruptcies are wiping them out, they may all want to come back to the Real Estate Market and again make it a happier place. Hang in there, watch, wait and prosper in 2013!
This article presents some fascinating arguments, but it seems not everyone is agreeing with the conclusions made.
From what we see, all reasonably priced middle to low end homes are selling rapidly in the Southbay, some immediately. The demand is therefore obviously IN EXCESS of the supply of homes in that price range.
Who is buying? If it is long term investors, buying them as rentals, that will be a good thing. If it is buyer occupants that will be even better. But, if it is flippers or renovators, indeed those buyers DO hope to dump them back onto the market soon.
In this area, there seems to be a mini-boom in purchasing, no doubt fueled by speculators (many from foreign nations)–which could bump up prices, at least temporarily. That bump up in prices could coerce wavering potential sellers to list their properties, thus increasing inventory—but this is mere speculation on our part.
We do believe the would-be flippers will be stuck with properties and end up renting them out for much longer than they expected. But, we do not think that will be for the reasons stated in the article.
It will be for this reason: Considering the OVERALL economic and financial situation of the U.S. and the world, it seems another Great Depression may be immanent if powerful actions are not taken by the governments of the world, including our own, to circumvent it. And, they may be helpless to do so even if they wanted to.
Therefore, with a depression comes DEFLATION in values. The dollar INFLATES in value, which means it then purchases much more as everything else plummets in cost due to massive unemployment and social unrest. The other side of the coin is HYPER-INFLATION, which would result if the dollar were deflated and the economy stayed the same or picked up—in which case Chinese imports would rise dramatically in price as would everything else, including –presumably– property values.
Yet in this bizarre current world, where all the old “rules” seem to be unraveling, could property values actually fall as everything else inflated? Massive unemployment could be a causative factor in such an ironic scenario. Massive unemployment is a given without dramatic action by government to circumvent it. Jobless persons cannot buy homes, and will have trouble paying rent—throwing more people onto government programs for life support.
Americans will soon learn what it is like to live in a third world country, as the middle class is vanishing, the welfare class is ballooning, and the wealthy will be subject to added scrutiny by government and IRS, higher taxes, and diminishing market returns.
The fraud perpetrated by the “ruling” class upon the masses for decades will finally be exposed for what it is, and BIG MED, BIG PHARMA, BIG OIL, etc. will finally see their day in court—–if we’re lucky.
Only when true balance is restored—a healthy and growing middle class, a diminished welfare class with jobs to go to, and a curbing of the excesses of the wealthy elite, will America ever see a healthy sustainable economy.
I agree with Frank Zak…there is NOTHING to buy!!!! Every listing has multiple offers (many all cash) within a day or two of coming out. I have been in the business 33 years…and in the past there was always something to sell. All the low end properties are gone “sale pending/backup” before you know it!! There is no time to think about anything. I just bought a condo on the market 2 days…5 offers…another all cash…I did NOT ask for my part of the commission-let the other realtor have both sides of the deal, which helped my cause in getting the property. I overpaid and knew it, but that was the only way to get it. Tried to find another…NOTHING available. On the other hand, if one could afford a high end property, there are a lot of them. A friend sold her house, but could not find anything to buy. That’s what’s going on the SO CAL.
Demand is the key in the housing market place, supply will come if the market is there, usually to a higher degree than the demand causing cycling in the market place. We have another factor in the California market, in my opinion, the over regulation in many sectors, the EPA is and will continue to attract business and individuals to move to other states. Many people have voiced this opinion but are locked in with there current property that are not marketable with out heavy loss of equity value.
If you have the same demand as last year and only 50% of
inventory to sell compared to last year, prices must go up.
It is an optical illusion that this is demand driven, because twice
as many people are making offers on the same house.
This is the most obvious fundamental turn around I have ever seen.
I called the tops in 1989 and 2006. we are about to enter
a hot market and it will pick up steam.
I don’t agree with this article at all. Have been a real estate broker 30
years and bought extensively at trustee sales.
Something very unusual has happened no one expexted. Sellers
just stopped listing. They see the turn around and say, “I’ll hold now.”
Listings are down 50% in one year. There is little to sell.
Can FHA foreclosed (Auctioned)a property without informing the owner. According to the buyer(investor) it was FHA who called him about this property. The owner was not home out of country for family reunion. What can the owner do this time. He was in process of loan modifiation.