What Really Drives Real Estate Values?

The past 15-to-17 years has seen a massive run-up, crash, and rebound of home and other real estate prices. A big cause of that was the decrease in interest rates that we have seen since the year 2000. When interest rates go down, you can spend more on your house or investment property because now your mortgage payments are much lower. Makes sense, right?

Many will also say the adage, “location, location, location!” Yes, location does matter. 100%. I have never denied that nor will I deny it. But, as with most things in life, when such a general statement is made with such conviction, there is usually something inaccurate in it. People are flocking to the south and to the southwest areas of the United States to live. So, with that increased demand, everyone assumes that real estate prices will go up and up and up indefinitely at higher rates than other areas of the country.

Is that possible? Sure, but it’s not the whole story.

Remember, when there is more demand in an area, everyone will flock there, including real estate developers. So, naturally, there is more supply, as well.

A quick example: a Range Rover is a nice car. I think most people would agree, right? And because of how nice a Range Rover is, more people want it. The quality of the car, plus the desire of people to purchase it, lead to the price being higher. But, if in response to people’s desire to own a Range Rover, more factories are built to produce more of the car, prices won’t go up because you are meeting the already-high demand with more supply It’s basic economics.

But look at Ferrari. They built 400 Enzos and that’s it. No more. There have already been a couple that have been destroyed by accidents, so the total number existing is around 398 or so. Every time one gets destroyed, the prices will go up because they aren’t making anymore. Supply is decreasing as demand stays the same. Over time, that will lead to higher prices. I think you get my point.

So, if it’s not location, and it’s not supply and demand, what really drives prices? Well, think about it. When you buy your home, how do you determine what price range you are looking at? You look at what you can afford. And how do you determine what you can afford?  Sure enough, you look at your income. That’s what matters.

~Novel Serialisation: Heavens Fire~

As income goes up because of inflation, it doesn’t matter where you live; your income is probably going up at a rate pretty close to inflation.  So over long periods of time, if your income increases by 30%, you will be able to spend 30% more on the same housing. This naturally leads to higher housing prices. Now, of course, there are other factors, like the ones we discussed above, that affect this. But if an area isn’t growing as fast (like the Midwest) and doesn’t have as much development going on, then there will be less supply and therefore the less demand is not going to affect prices as much.

So how do I know this is true? Well, I went and pulled up the top 130 Metropolitan Statistical Areas (MSAs) and sorted them by population size, population growth since 1990, income growth since 1990, and real estate value growth since 1990.  I ran correlations between the following areas: Population Growth to Real Estate Value Growth, Income Growth to Real Estate Value Growth, and then finally Population Growth to Income Growth.  The reason I did the last one was to say “well, maybe the sexy high growing areas will have higher real estate value growth because they will be highly correlated with high income growth.” This was a thought I had. Here are the results.

[Quick Math Side note: Correlation is displayed between -1 and 1. Negative one is a perfect inverse correlation which means that if one metric goes up X, the other one goes down by the same factor of X. A positive one correlation is a perfect correlation, which means that if one metric goes up by X, then the other goes up by the same factor of X. And zero means there is no correlation. A correlation of above 0.45 or below -0.45 is considered an area where the correlation is strong.]

When comparing population growth rates to real estate value growth rates, the correlation overall was 0.26. This is not considered a material correlation in the world of statistics.  It’s not awful, but it’s nothing to make note of.

The correlation between income growth and real estate value growth, however, was 0.67! That is a strong correlation. Not perfect by any means, but it’s strong. Ironically, we found a stronger correlation in that metric when going to the smaller markets of the top 130 MSAs.

So, the last one is population growth to income growth. Did we see more income growth in a market that is growing faster because of more opportunity? That’s a “fact” that I always hear from people: “move to a growing population area because you will have more income growth potential.” The result when we ran the actual correlation?  0.06.

This is practically zero correlation! Doesn’t seem logical, does it? The sample must have been not representative of the rest of the country? No, because this isn’t just a small subset.  This is based on the top 130 markets which range in size from 175,000 to 20,000,000 people.

What’s the moral of this story? Don’t go overspend in the “hot” markets because of the growth. I see the nosebleed prices being spent on real estate, and what I always hear is “well yeah, we pay a lot now but we will make it when the property values appreciate so much more than other areas.” The data shows otherwise.