Sometimes it’s best to go back to basics when you’re thinking about investing, finance, and economics. And what could be more fundamental than supply and demand? This month we’re going to talk about how the basics of supply and demand can help us predict long-term market valuation.
For those of you who have never taken economics before, supply and demand are simple and intuitive concepts. For every good/service/thing in the economy there is supply (how much of that thing is there), and there is demand (how many people want that thing).
Supply and demand are generally explained as two curves, or actually two lines, as in the image below.
There is a line for supply (S), which represents the behavior of sellers in the market as sellers control the supply. This could be a shop or, more relevantly here, a homeowner. The supply curve generally moves up and to the right, indicating the willingness of sellers to sell more of something as the price rises. If real estate prices rise, more sellers will be willing to sell their properties.
The demand curve (D) represents the buyers in the market. Demand curves almost always slope downward, meaning buyers are generally willing to buy more of something the less it costs. Again, taking real estate as an example, when prices in the market fall, more people are willing to buy homes.
The place where the two lines meet is often referred to as equilibrium and is really just the sweet spot of pricing. Sellers and buyers always do this little dance to find balance. This happens when you negotiate a property to buy, it happens millions of times a day in the stock market, and it even happens with sales and promotions at your local supermarket. Supply and demand form the basis of our economy.
The pandemic has provided some examples of supply and demand on steroids in recent months. My personal favorite was the March 2020 toilet paper craze.
Normally, supply and demand for toilet paper remain relatively constant. People generally need toilet paper constantly, suppliers know how much the market needs and the price remains stable.
Until last year, when demand for residential toilet paper peaked far too quickly for suppliers to adjust their logistics, which had previously been more focused on providing toilet paper for commercial deliveries. People stole single-layer from their offices, Costco imposed restrictions on bulk purchases, prices on Amazon were pushed up – it was a frenzy. All because of a spike in demand.
So, can something like this happen in real estate? On the scale of toilet paper? Probably not.
But it does beg the question, what’s driving real estate demand (and house prices) up?
In reality, there are many things that come into play in this, but the simplest of all is population. How many people are there in a city (demand), compared to how many homes (supply)? If a city’s population grows faster than the number of homes in the city, house prices are very likely to rise.
With this in mind, I’ve put together a list that I’m really excited about. It uses Census data to measure supply and demand from the years 2010-2019. I then combined that with some BPInsights data to display sales and rental information for the current market.
The table below shows the top 15 markets for what I call the ‘supply/demand ratio’. Basically, what I did was create a new stat that answers the question “how many new people move into a city for every new unit built?”
Note that these are not the fastest growing cities in the US. These are the cities where demand (as reflected by population growth) exceeds supply (measured by the total number of units in the city).
At the top of our list is Cambridge, Massachusetts, where one new unit has been built for every 36 people who have moved to the city since 2010. How does that work? Well, I guess with all those students, people get roommates.
These cities all have populations that are growing faster than they are adding units. This will put significant upward pressure on pricing.
A growing population also increases the tax base for the city, allowing cities to provide more essential services, build infrastructure and support their populations. All positive things also for appreciation.
Below you can also see the rental price ratio and the valuation percentages for these cities over the same period.
This is consistent with many of the patterns we see in our BPInsights data: there is generally a tradeoff between cash flow and valuation. These markets shift strongly to the appreciation side of the equation.
Of course, there are other factors influencing these numbers besides population growth, but you can tell from the eyeball test alone that these cities generally have an excellent rating.
That said, there are cash-flowing properties in all of these markets. I guarantee it. If you can find a cash flow deal in any of these markets, it could be a home run.