Real estate is a tangible asset made up of property and the land on which it sits, and while it is unmovable, real estate, like other assets, is also subject to supply and demand. This means that the prices of homes, like those of stocks and bonds, depend heavily on the law of supply and demand. More demand, prices tend to rise; more supply, they tend to fall.

But just what kind of relationship does the housing market have to this law? Learn more by reading below about how this economic theory works, and how it impacts the real estate market.

Key Takeaways

  • The housing market is a good example of how supply and demand works within an industry.
  • When the demand for housing is high, but supply is low, home prices often rise.
  • When there is a glut of housing available in a market, homeowners may lower their prices due to less demand in the market.

The Law of Supply and Demand

The law of supply and demand is a basic economic principle that explains the relationship between supply and demand for a good or service, and how that interaction affects the price of that good or service.

When there is a high demand for a good or service, its price rises. If there is a large supply of a good or service but not enough demand for it, the price falls. The reason is that people will bid up the prices when there is relative scarcity, and there will be unsold items when there is an oversupply.

The theory of supply and demand is one of the most basic principles in economics. Supply and demand work against each other until the point at which the equilibrium price is achieved—that is the price where supply is equal to demand in the market. That happens, of course, when all other factors remain equal.

Demand

The law of demand dictates that people will have lower and lower demand for a good as its price rises ever higher. Similarly, lower prices drive demand, meaning consumers value and purchase something more when it's cheaper.

Supply

The law of supply says that a higher price will induce producers to supply a higher quantity to the market. Likewise, when supply is low, prices will rise as people will scramble to buy up scarce resources.

Real Estate Supply and Demand

The housing market, too, relies heavily on supply and demand, which is why it is a much looked-at indicator in the industry. Each housing transaction, of course, involves a buyer and a seller. The buyer places an offer to buy a property, leaving the seller to accept or reject the offer.

The forces of supply and demand work against one another until the point at which a property's equilibrium price is reached.

The law of supply and demand dictates the equilibrium price of a property. A low supply or housing inventory may drive prices up, which is what tends to result in bidding wars. A specific property may be in demand by multiple parties who all try to outbid each other by increasing their purchase price offer.

The bidding war ends when the seller accepts one of the offers, which then also removes a unit from the available supply. When there is a high demand for properties in a particular city or state combined with a lack of supply of quality properties, the prices of houses tend to rise.

On the other hand, when a weak economy and an oversupply of properties leads to low or no demand for housing, the prices of houses tend to fall.

Factors Affecting Housing Supply and Demand

The precise values attributed to the supply and demand in a market is not an easy thing to measure in the real estate market. This is partly because it takes a long time to construct new homes or fix up old ones to put back onto the market.

Similarly, real estate is not like other industries in that it takes a lot of time to buy and sell homes and other properties. This means that transactions can take a long time to consummate, making real estate somewhat illiquid.

Some of the factors that will influence housing demand include lower interest rates or borrowing costs. When interest rates are low, people are generally willing to take on more debt because they can afford relatively more debt for the same monthly outlay. Put differently, they may be able to finance the purchase of a home because the amount of interest they have to pay is not as burdensome at low rates.

As more buyers enter the market, the demand for housing increases in turn. And if there remains a limited supply of housing inventory, prices in a low interest rate environment may rise even more.

Meanwhile, the supply of housing is in a constant state of flux. Inventory may increase when people are moving elsewhere—some may be downsizing, others may trying to make more room for an expanding family, and still others may be purchasing their very first home. Similarly, there may be an increase in development and new home construction, adding to the existing inventory.

On the other hand, housing inventory sees decreases during times of natural disasters such as floods and earthquakes, or when existing properties are demolished. Land property is also a finite resource, so the amount of new developments is generally limited.

When Housing Markets Crash

One of the main causes of the Great Recession that followed the financial crisis in the mid-2000s was that the housing market crashed. This was due to the law of supply and demand.

During the lead-up to the financial crisis, consumers were enjoying relatively low borrowing rates. Banks began to offer lower rates on mortgages and were also encouraged to relax their lending standards. People who weren't otherwise able to afford a home before, suddenly found themselves able to realize their dreams of homeownership. Many of these consumers, called sub-prime borrowers, were able to snag a home with very low down payments even though they had very low credit scores.

During this time, speculative buyers also began entering the market, driving up demand for housing and, at the same time, cutting into the available supply. All of this, in turn, drove prices up to lofty levels.

Supply couldn't keep up, and investors began speculating in the housing market to make some quick money buying and flipping homes in a very short period of time. But soon, the high prices kept people away, and people began pulling out of the market. Demand started to drop and, so did prices. The prelude to the collapse of the real estate market in 2007 created an oversupply of housing and then rapidly decreasing property prices.

The Bottom Line

The housing industry and its economic factors depend on supply and demand because it is a transactional market that uses buildings and properties. The law of supply and demand creates the circumstances in which buyers and sellers interact.

For example, if a town has a high demand and low supply in housing stock, owners often benefit from getting a higher price for their homes. But if there are a ton of properties for sale and only a few buyers, the sellers may end up getting less than their asking price.

Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).