Real estate represents a significant portion of most people's wealth, and this is especially true for many homeowners in the United States. According to the Survey of Consumer Finances by the Federal Reserve, 65.1% of American families owned their own primary residence in 2019. The size and scale of the real estate market make it an attractive and lucrative sector for many investors. This article will look at some of the main factors that affect the real estate market and the variety of investments available.
TUTORIAL: Exploring Real Estate Investments
4 Key Factors That Drive The Real Estate Market
- There are a number of factors that impact real estate prices, availability, and investment potential.
- Demographics provide information on the age, income, and regional preferences of actual or potential buyers, what percentage of buyers are retirees, and what percentage might buy a vacation or second home.
- Interest rates impact the price and demand of real estate—lower rates bring in more buyers, reflecting the lower cost of getting a mortgage, but also expand the demand for real estate, which can then drive up prices.
- Real estate prices often follow the cycles of the economy, but investors can mitigate this risk by buying REITs or other diversified holdings that are either not tied to economic cycles or that can withstand downturns.
- Government policies and legislation, including tax incentives, deductions, and subsidies can boost or hinder demand for real estate.
Demographics are the data that describes the composition of a population, such as age, race, gender, income, migration patterns, and population growth. These statistics are an often overlooked but significant factor that affects how real estate is priced and what types of properties are in demand. Major shifts in the demographics of a nation can have a large impact on real estate trends for several decades.
For example, the baby boomers who were born between 1945 and 1964 are an example of a demographic trend with the potential to significantly influence the real estate market. The transition of these baby boomers to retirement is one of the more interesting generational trends in the last century, and the retirement of these baby boomers, which began back in 2010, is bound to be noticed in the market for decades to come.
There are numerous ways this type of demographic shift can affect the real estate market, but for an investor, some key questions to ask might be: i) How would this affect the demand for second homes in popular vacation areas as more people start to retire? Or ii) How would this affect the demand for larger homes if incomes are smaller and the children have all moved out? These and other questions can help investors narrow down the type and location of potentially desirable real estate investments long before the trend has started.
Interest rates also have a major impact on the real estate markets. If you're considering buying a home with a mortgage it is beneficial to research interest rates using a mortgage calculator. Changes in interest rates can greatly influence a person's ability to purchase a residential property. That is because the lower interest rates go, the lower the cost to obtain a mortgage to buy a home will be, which creates a higher demand for real estate, which again pushes prices up.
It's important to note that as interest rates rise, the cost to obtain a mortgage increases, thus lowering demand and prices of real estate. However, when looking at the impact of interest rates on an equity investment such as a real estate investment trust (REIT), rather than on residential real estate, the relationship can be thought of as similar to a bond's relationship with interest rates. When interest rates decline, the value of a bond goes up because its coupon rate becomes more desirable, and when interest rates increase, the value of bonds decreases. Similarly, when the interest rate decreases in the market, REITs' high yields become more attractive and their value goes up. When interest rates increase, the yield on a REIT becomes less attractive and it pushes their value down. (To learn more about these effects, see How Interest Rates Affect Property Values.)
Another key factor that affects the value of real estate is the overall health of the economy. This is generally measured by economic indicators such as the GDP, employment data, manufacturing activity, the prices of goods, etc. Broadly speaking, when the economy is sluggish, so is real estate.
However, the cyclicality of the economy can have varying effects on different types of real estate. For example, if a REIT has a larger percentage of its investments in hotels, it would typically be more affected by an economic downturn than a REIT that had invested in office buildings. Hotels are a form of property that is very sensitive to economic activity due to the type of lease structure inherent in the business. Renting a hotel room can be thought of as a form of short-term lease that can be easily avoided by hotel customers should the economy be doing poorly. On the other hand, office tenants generally have longer-term leases that can't be changed in the middle of an economic downturn. Thus, although you should be aware of the part of the cycle the economy is in, you should also be cognizant of the real estate property's sensitivity to the economic cycle.
Legislation is also another factor that can have a sizable impact on property demand and prices. Tax credits, deductions, and subsidies are some of the ways the government can temporarily boost demand for real estate for as long as they are in place. Being aware of current government incentives can help you determine changes in supply and demand and identify potentially false trends.
For example, in 2009, the U.S. government introduced a first-time homebuyer's tax credit to homeowners in an attempt to jump-start home sales in a sluggish economy (only those who purchased homes between 2008-2010 is eligible). According to the National Association of Realtors (NAR), this tax incentive alone led 900,000 homebuyers to buy homes. This was quite a sizable increase, although temporary, and without knowing the increase was a result of the tax incentive, you may have ended up concluding that the demand for housing was going up based on other factors.
For average investors, buying real estate indirectly—through REITs, real estate exchange-traded funds (ETFs), or other managed funds—is less risky and more lucrative than buying real estate directly.
What's the Best Investment?
The size and scale of the real estate market make it an attractive and lucrative market for many investors. Investors can invest directly in physical real estate or choose to invest indirectly through managed funds. Investing directly in real estate involves purchasing the residential or commercial property to use as an income-producing property or for resale at a future time. Indirect ways to invest in the real estate market include investing in real estate investment trusts (REITs), real estate exchange-traded funds (ETFs), commingled real estate funds (CREFs) and infrastructure funds. Due to the higher liquidity available in the market, the lower transaction costs, and lower capital requirements, average investors prefer to indirectly invest in real estate.
The Bottom Line
This article introduced some of the higher-level factors that play a significant role in moving the real estate market, but there are also more complex parts that come in to play. And although some of these aforementioned factors suggest a clear-cut relationship between the factor and the market, in practice, the results can be very different. However, understanding the key factors that drive the real estate market is essential to performing a comprehensive evaluation of a potential investment.