Real estate represents a significant portion of most people's wealth, and this is especially true for people in the United States. According to economic research published by the Federal Reserve Bank of St. Louis, the homeownership rate in the U.S. in the first quarter of 2023 was 66%.
The size and scale of the real estate market make it an attractive and lucrative sector for many investors. This article looks at four key factors that affect the real estate market and the various real estate investments available.
KEY TAKEAWAYS
- There are four key factors that impact real estate prices, availability, and investment potential.
- Changing demographics can impact home prices due to the age, income, and regional preferences of buyers.
- Interest rates impact the demand and price for real estate—lower rates attract more buyers with lower mortgage rates but also expand demand which can drive up prices.
- Investors can mitigate economic cycle 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.
4 Key Factors That Drive The Real Estate Market
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Investopedia / Ellen Lindner
1. Demographics
Demographics are the data that reflect the composition of a population, such as age, race, gender, income, migration patterns, and population growth.
Major shifts in the demographics of a nation can have a large impact on real estate trends for several decades. These statistics are an often overlooked but significant factor that can affect how real estate is priced and the types of properties in demand.
For example, the baby boomers born from 1945 through 1964 represent a demographic trend that could significantly influence the real estate market. The retirement of the baby boomers, which began in 2010, is bound to be felt by the market for years to come.
There are numerous ways this type of demographic shift can influence the real estate market. For an investor, some key questions might be:
- What would happen to the demand for second homes in popular vacation areas as more people start to retire?
- How would smaller incomes and family sizes (as children move out) affect the demand for larger homes?
The answers to these and other questions can help investors narrow down the type and location of potentially desirable real estate investments before demographic trends start.
2. Interest Rates
Interest rates also have a major impact on the real estate market. If you're considering buying a home with a mortgage, use a mortgage calculator to see how different rates of interest can affect purchase prices.
Changes in interest rates can greatly influence a person's ability to purchase a residential property. That's because the lower the interest rate, the lower the cost of a mortgage. That's great for borrowers, but it can also create greater demand for real estate, which then pushes prices up. As interest rates rise, the cost of a mortgage increases, thus lowering demand and real estate prices.
However, when looking at the impact of interest rates on an investment such as a real estate investment trust (REIT), the relationship of rate to price can be seen as similar to a bond's relationship with interest rates.
When interest rates decline, the price of a bond goes up because its coupon rate becomes more desirable. When interest rates increase, the price of bonds decreases.
Similarly, when interest rates decrease, REITs' high yields become more attractive and their prices go up. When interest rates increase, the yield on a REIT becomes less attractive and that pushes its price down.
3. The Economy
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 the real estate market.
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 hotels as investments, 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 do poorly. On the other hand, office tenants generally have longer-term leases that can't be changed in the middle of an economic downturn.
It's important to be aware of the cycle the economy is in and a real estate property's sensitivity to the each economic cycle.
4. Government Policies and Subsidies
Legislation is 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. 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 in an attempt to jump-start home sales in a sluggish economy (only those who purchased homes between 2008-2010 were eligible). According to the Government Accountability Office, 2.3 million people took advantage of the tax incentive.
This was quite a response (although temporary). Without knowledge of the tax incentive, investors might have concluded that the demand for housing was increasing for other reasons.
FAST FACT
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.
How to Invest in Real Estate
The size and scale of the real estate market make it an attractive and lucrative opportunity for many investors. Individuals can invest directly in actual real estate or indirectly through managed funds.
Investing directly in real estate involves purchasing a residential or commercial property to use as an income-producing property or to sell 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 greater liquidity, lower transaction costs, and lower capital requirements, average investors prefer to invest indirectly in real estate.
What Factors Affect the Price of a House?
Comparable home values, the age, size, and condition of a property, neighborhood appeal, and the health of the overall housing market can affect home prices.
What Is the Biggest Threat to the Real Estate Industry?
A weakening economy or recession may be the biggest threat, due to the potential for people to lose their jobs and for household income to drop. This can not only squelch demand but also may make it difficult for people (and companies) who own properties to continue paying their mortgages.
How Does Inflation Impact the Real Estate Market?
It can cause property prices to increase. That's because, as construction costs rise with inflation, fewer businesses can afford to build new units. This limits supply, which, if demand for properties persists, puts upward pressure on values.
The Bottom Line
This article introduced four of the high-level factors that play a significant role in moving the real estate market. And although some of these factors suggest a clear-cut relationship between cause and effect, in practice, the results can be very different.
However, for investors, understanding the key factors that drive the real estate market is essential to a comprehensive evaluation of a potential investment.
