In the general investment theory “buy low and sell high” is the paradigm of investing. In real estate investing, which is subject to multiple influences of the local market, this paradigm is supplemented by an additional consideration for maximum return on investment: property location. When the two are combined, buying properties at low prices in the right local markets can yield substantial returns on investments. However, the question is how to spot when a particular property market is ripe for investment. The answer may lie in the specific economic dynamics of that market.
Like prices of any investment asset, prices of real property depend on the supply and demand dynamics of a particular market. Overall demand for residential properties, either as primary or second homes or as investments, depends mostly on population, income, and net worth growth of the local community. These three demand drivers benefit from the good economic times and rising stock markets, in which businesses expand and hire more people and personal wealth grows.
This increases local incomes and consumer spending in general. Rising household incomes, especially if economic conditions allow for the cheap and readily available credit, enable households to purchase homes and to add value to their residences through remodeling. Increased housing spending boosts construction, which, in turn, boosts construction-related spending. This additionally props up incomes of the community and allows for further expansion in the housing market.
As long as there isn’t too much new construction in place, housing prices will continue to rise if demand is sustained by homebuyers and remodeling. Usually, when the economy is expanding, job creation boosts homeownership and creates opportunities for home values to rise and therefore for household new worth and investment returns to increase. The market is held in balance as long as the supply is kept in check with the demand.
However, there are several factors related to financial aspects of the housing market dynamics that drive prices to unsustainable proportions, notwithstanding the economic dimensions of the market. These are primarily related to the government’s policy on interest rates and the banks’ willingness to lend. If interest rates are low and bank lending easy, people may seize the opportunity to buy.
Readily available credit at favorable terms also brings in investors in the search for yield. This increases demand substantially and drives prices to levels that may negatively affect affordability. When cheap credit is coupled with lending practices that give high-risk (sub-prime) borrowers easy access to credit or that enable inventive, highly-leveraged financing schemes for investments, demand can boost prices much higher. This effect may be exaggerated if gains in other investment asset classes allow for wealth diversification into real estate. Once investors interested in flipping properties are added to the scheme, prices may be propelled to unsuitable levels.
However, once job and income growth slows down, housing demand weakens, expectations of future price increases dissipate, and investment flows weaken, prices no longer rise or start falling. If financial problems emerge, demand for residential properties weakens substantially as a result of tighter lending standards or higher cost of money. Expectations of future returns correct again, and markets plunge into a downturn. If the magnitude of job losses and financial problems is large, the magnitude of price declines will also be substantial.
However, precipitously falling prices in many markets do not necessarily mean that those markets offer best investment perspectives. If there are indications that business, job, and income growth in the local market will not recover for a long time, it is unrealistic to expect that even a beaten-down local housing market will offer high and quick investment returns. Certain areas may remain depressed for an extended period of time, keeping the residential property market subdued for long.
This is exactly why it is important to weigh markets with major home price declines against the opportunities for future demand and therefore for home price growth in those markets. Prices in those markets may have been driven to unreasonable levels by speculative activity and unrealistic expectations about future economic growth and investment returns. Those factors may offer an explanation for substantial corrections in home prices. Yet, once expectations about investment returns adjust to new realities, especially if prospects for local job growth remain weak, what constitutes a good investment will no longer be a property that can yield a fast return, but the real property that will offer a reasonable and safe return over the medium or long terms.
Therefore, when looking for investment opportunities in the residential market, it is necessary to put the attractive home prices against the perspectives for business, job, and income growth of a particular local community. If the community is affected only by short-term economic weakness that will disappear once the economy rebounds, then that locality may offer some promising real estate investment opportunities. However, if the locality suggests that job and income growth will remain depressed for a long time, investments in properties in those markets may provide a return, but that return may comparatively be lower than the return on similar properties in those markets that have a better job and income growth potential in the future.