The real estate market in the United States has rebounded significantly from the housing crash of the late-2000s, with low interest rates and limited inventory creating an ideal environment for sellers in some parts of the country. Buyers, on the other hand, often face escalating real estate prices, bidding wars and prolonged search periods as they enter an increasingly competitive market. This is particularly true in parts of California, which is home to four of the nation’s five most expensive housing markets in San Jose, San Francisco, Orange County and San Diego.
So how exactly are real estate prices determined? We’ve uncovered eight of the most important factors affecting the housing market and that will almost certainly impact the price of your home.
Micro-Factors Affecting Real Estate Prices
We’ve all heard the phrase “location, location, location” but what does this mean in practical terms when it comes to property prices? Economists encapsulate “location” in something called “hedonic pricing” – for most homes, this translates to some key factors that impact your life and your lifestyle:
- Quality of local schools is frequently the single most important factor for buyers with children of school-going age
- Proximity to local employment opportunities is a very high priority for most employment-age buyers
- Proximity to social, shopping and recreational centers is valued most by younger buyers but plays an important role in pricing for all homebuyers
These factors are not independent of one another – e.g., many parents want to drop the kids off and pick them up at school as part of a reasonable commute to and from work. These three preferences – proximity to school, work and entertainment/shopping -- are a trinity that make for immensely valuable property. Generally, getting a home which has one of the three attributes won’t blow the proverbial roof off the price per square feet. If you’re getting two out of three, one should expect stiff competition and commensurate prices. To get all three, one might need a small war chest to finance your home-buying exploits.
Updates and Upgrades
While some buyers actively seek out fixer-upper properties, most home buyers prefer a house that is move-in ready – and they are willing to pay a reasonable premium for that comfort. A new roof, for example, generally recoups more than 80% of its value when the home is sold. According to the National Association of Realtors, upgraded kitchens and bathrooms are among the most important upgrades cited by homebuyers because they represent a major expense (and headache) if the buyer has to upgrade them. To understand regional variations in how upgrade investments recoup their value, Remodeling Magazine provides regional reports rich with data. For example, steel entry doors and manufactured stone veneers tend to give Pacific coast homeowners the most bang for their buck upon selling their properties.
In some hot markets, buyers may forego their right to an inspection report but that’s a risk that most mortgage lenders won't underwrite. For most buyers, mortgage financing is contingent on a favorable inspection (the banks don’t want to lend you money for a termite farm). Even if a home is under contract, the inspection report can greatly impact the price of the home (usually downwards as the buyer uncovers previously unknown/undisclosed issues that require repairs). The more recommended repairs on the report, the more negotiating room a buyer has. If the deal falls through, the seller must disclose the inspection report to future buyers, further dampening the chance to sell at the original listed price.
There is no licensing or certification for inspectors by the state of California which makes inspections something of a wild west. Experienced inspectors usually come with Errors & Omissions (E&O) insurance to cover themselves in case of a mistake – the absence of this insurance is a red flag. Using referrals from friends, families and real estate agents and calling references from an inspector’s actual past customers will help you find an inspector you can trust.
Comparable properties, sometimes called "comps", sold in your area also impact your own home’s market value. Appraisers and real estate agents look at recent sales of homes with similar features to use as a benchmark against your home’s potential price. Foreclosures and short sales often complicate things because they tend to sell at lower prices, decreasing the neighborhood’s overall average sales price. Comps (along with offer details) are usually the key driver for the appraisal process: most appraisers will rely heavily on recent nearby transactions on homes of a similar size to yours.
The appraisal is the real estate industry’s formal process for pricing a property. All states require appraisers (for any federally regulated lender) be licensed or certified by an organization accredited by the Appraiser Qualifications Board (AQB). Whenever a loan is involved in the financing of a property purchase or home equity borrowing, an appraisal is almost always required. Most lenders won’t approve a loan for more than the appraised amount, so if the assessed value falls short the seller either needs to lower the price or the buyer needs to put extra money down to decrease the loan amount. Additionally, if the appraiser deems there is a structural issue such as a faulty roof or termite damage, the bank will not approve the loan until the issues are fixed - most often at the expense of the seller. Appraisers follow a structured process for evaluating the property by looking at recent comparable sales (see above) to establish a benchmark price and then adjusting the price up or down according to the upgrades and improvements you have or have not made relative to the comparable properties.
Macro-Factors Affecting Home Prices
A lot of factors can help predict the price your home will receive when you put it up for sale. Ultimately, it's worth how much a buyer will pay for it....
The strength of the overall economy significantly impacts the real estate market as consumers’ ability to support housing prices largely depends on key factors like GDP, unemployment, and income growth. The Great Recession from 2008 to 2012 underscored the link between real estate and the broader economy. Local economies with a large number of real estate-related jobs (whether in construction or mortgage financing) experienced significant property price depreciation. Other local macro-trends can outsize national factors in their importance; for example, California’s income growth rate came in at 1.2% in the first quarter of 2015 compared to the national average of 0.9%. This gives buyers the ability to spend more on housing, consequently increasing real estate prices.
When people talk about the “Fed interest rate”, they usually mean the Federal Reserve overnight borrowing rate for depository institutions. This is a key factor in how mortgage rates are established because it sets the cost for banks to borrow money. Lower Fed interest rates typically lead to lower mortgage rate offers from banks; this, in turn, decreases the monthly mortgage payments a homebuyer must pay for a given mortgage amount. The smaller the monthly payment, the more “affordable” a loan is to prospective homebuyers; this fact can increase the size of the mortgage for which homebuyers are eligible to get which, in turn, might drive up property prices. While current Fed interest rates are at near-historic lows, the Federal Reserve has hinted at a hike in the federal funds rate by the end of the year, which should eventually manifest itself as an increase in mortgage interest rates. However, because income and other economic factors continue to strengthen, particularly in California, some experts don’t believe that a rise in Fed interest rates will have a significant impact on residential property prices.
The housing crisis created an appealing environment for investors with an appetite for residential real estate. The increased volume of foreclosures and short sales provided both domestic and foreign investors with the opportunity to snatch up inexpensive properties to either rent out or renovate and resell at a profit. Recent research from the National Association of Realtors shows that the percentage of homes purchased by investment buyers stands at about 20% of the market As the number of distressed properties begins to dwindle, the market could potentially slow as these parties wind down their purchasing. Many of these investors will want to liquidate some of their property holdings at some point, which, if mistimed, could result in too many homes hitting the market at once.
Of course, there are a slew of other factors that deserve extensive coverage in their own right but the following summarizes some of the major ones:
- the mortgage interest tax credit has an enormous impact on home values – it’s free money for homeowners and drives up property prices by as much as 25% by altering the perceived affordability of home prices;
- local builder activity, zoning restrictions, and local regulations dictate new home supply and prices react to too much or too little supply;
- proximity to parks and playgrounds, noise pollution, light pollution, crime, zoning laws, air quality, internet connection quality, traffic volume, road quality…. most prospective buyers have customized lists of features and services that are personally important to them.
Real estate prices are deeply cyclical and much of it is dependent on factors you can’t control. Whether you plan on buying a new property or want to use the equity in your home for other expenses, it is important to analyze both broader market conditions and your specific property to determine how the home’s value may fare over the course of time.