The next indicator of property value

We started by talking about the difference between price and value. Then we began our discussion about how one can go about determining value for real estate. Last time we spoke about how population can affect value, and how comparing population growth to new home building is a good tool to help figure out the demand in the area.

You've probably seen a supply and demand curve before. Just in case, here is one again:


Basic economics teaches us that demand drives up price. For example, if you have 100 collectible bobble heads and 600 people are willing to pay $10 for them, then your price is too low. Ideally you'd want to find a price for the bobble heads that exactly 100 people would be willing to pay, so you could maximize your profit.

Houses are the same way, there are fewer houses than there are people. If we theoretically assume that there are two potential buyers for every one house, then the goal is to drive up the price until exactly half of the buyers are priced out. Now this is very rough math, because homes are not a standard commodity, and each home is different and therefore valued differently. But the general concept is the same, by raising the price, you remove potential buyers until there is a smaller pool of buyers left for your home. Simple supply and demand.

Unfortunately, things are never really that simple. This model can work when looking at items that people pay cash for, like bobble heads or TVs. But when it comes to houses the question isn't what people are willing to pay, but often what the banks will allow them to pay.

Homes don't sell unless people can afford to pay for them. So when housing prices soar, they can only be met by one of three factors:

1) A lot of new money enters the market.
This happens a lot in big cities. In London, where I reside now, people are getting priced out of the market because a lot of European millionaires have been purchasing homes here.

2) Loans become easier to obtain in larger amounts.
When prices go up, people need to be able to afford the higher prices. A neighborhood that supports middle income families is unlikely to start selling homes to multi-millionaires. If banks lend out more money, then new middle income families can afford to pay more for those houses.

3) Salaries grow
The only other way that people can afford to pay higher prices for housing is if those people are now earning more money. Then again they can qualify for larger mortgages.

The second method is obviously unsustainable. As banks are figuring out now, you can't just keep lending people more money. There is a limit as to how much a family can repay. As shown by the higher foreclosure rates throughout the country, these extreme mortgages simply don't work once they've passed a certain point.

The first method is also unsustainable to a certain point. Even the wealthiest people need access to labor provided by the less wealthy. Even Orange County and Manhattan have McDonald's, janitors and cab drivers. If rich people keep moving into an area and riving the less fortunate out, a point could be reached where it's no longer feasible for the less wealthy to provide the services to the wealthy. At that point the community begins to lose value due to the lack of basic services.

Fortunately that rarely occurs because new money tends to boost the local economy, bringing us to the third point, rising salaries. This is the only independently sustainable method that supports rising housing costs. When people are earning more, they can afford to make higher payments, and thus (excluding interest rate climbs) can afford to pay more for a house.

So a key factor in figuring out the value of homes in an area is trying to discover what people can afford to pay for them. So starting with Fairfax, we are looking at one of the highest grossing counties in the nation. The median household income is $88,100. Now as a general rule, I believe that a healthy mortgage for a family is approximately 3 times the family's income. Recently that number has averaged out nationally to be far higher than that, which is part of the reason that foreclosures are climbing so rapidly. That's just for the mortgages, so when you factor in previous equity and down payment, I believe that a sustainable price for an average home is about 4 times the median household income.

So right now I'd expect an average Fairfax home to be fairly valued at around $350,000. Note that an "average" home could be a farmer house, a McMansion, a town home or even a condo, depending on the market you are researching. In this case, Fairfax, we're talking about a single family detached home, as most of the county is white collar commuters to Washington DC.

In Orange County the median household income is $61,899. So I would expect an average house in that county to be worth somewhere in the neighborhood of about $250,000. Now you may gasp at this number, because we all know Orange County due to it's high-income areas, but there are other parts that are not quite as nice. Compare the village of Anaheim Hills with it's median income of over $120,000 to the less prosperous village of Laguna Woods with a median income of closer to $30,000.

Which brings in a nice point. The narrower you can restrict you focus, the better you judgment will be. For example, I'd value a typical home in Laguna Woods at being somewhere in the neighborhood of $120,000, but it's easy to see a typical home in Anaheim Hills reaching $500,000.

Now can you find a home in Laguna Woods right now for $120,000? I honestly don't know since I've never been there, but I suspect not. The thing to remember is that we're trying to separate price from value here. When eBay stock reached heights of $400, that didn't mean it was time to plow in and buy more eBay. So this indicator tells us that if you see homes in Laguna Woods asking for $300,000 they are probably still on the high side of price.

Now this information comes, as all information does, with caveats. for example if you are buying in Florida or Phoenix, it's possible that median incomes are being driven down by retirees. Retirees who saved properly (or have nice pensions and lots of equity) can usually afford far more than 20-year-olds on the same income. The rules simply aren't the same.

Secondly, just because a home in Fairfax is priced at $500,00 doesn't means it's a poor value. Nor does seeing a house listed in Orange County for $100,000 mean you should place an offer immediately. What we've simply done is given ourselves a baseline for the area, and learned what we're expect the majority of people to be able to pay. When it comes to a specific property, that's where things get a lot more complicated.

But that will have to wait for another post. Because once again I've run out of the time and the will to continue. Until next time. Cheers.