Upturns and downturns are inevitable and part of a natural economy. There have been peaks and valleys since the U.S. Federal government began selling land in the year 1800 as described in this complete history of real estate bubbles.
In the world of investments, a market correction is described as a decline of 10% or greater in the price of an asset. Unlike the stock market where large swings are common in high risk trading, homeowners don’t anticipate as much risk when purchasing a long-term investment like a home. In comparison to other markets, the housing market is generally not as susceptible to pricing bubbles due to the significant transaction costs and effort involved in buying and selling real estate. Since real estate prices in most areas tend to increase over time, people don’t purchase a house expecting value to decrease. However, from time to time prices dip. This is considered normal in housing markets that go through periods of rapid price appreciation.
Supply, demand, and housing prices
The simple logic of what goes up must come down is often applied. A booming housing market can lead to a bubble burst when factors inflate pricing to a level that is no longer sustainable. Home prices that have risen too quickly will correct to be more in line with a long-term average. This correction could appear as a quick decline or a gradual drop. Sometimes prices remain constant while the long-term average catches up.
The law of supply and demand largely drives housing prices. Usually low supply and high demand increases price and visa versa. In recent history, we’ve seen this theory at play in communities across the country facing inventory shortages where homebuyers are forced to compete. Homes receive multiple offers and bidding wars drive up pricing.
The inverse of this scenario occurs during a buyer’s market, which is an economic situation in which housing inventory is plentiful and pricing is down. By tracking price trends, you can draw a conclusion about the underlying levels of supply and demand and whether it’s a buyer’s or seller’s market. In theory, if prices decrease demand is declining in relation to supply.
The market strives for equilibrium
Another significant principle that drives a correction is the market’s tendency to strive for equilibrium. Equilibrium is a state in which the supply for housing meets the demand and price, cost, and value find balance accordingly. With regards to this concept, the market moves to meet supply and supply moves to meet demand.
Take the example of a booming suburban market where a large company decides to open up a new headquarters. Over a short period of time, the town sees an uptick in buyers relocating to the area for employment. Housing becomes scarce as the influx of buyers snatch up available homes for sale. A price increase follows suit. Developers catch wind of the opportunity and begin construction on new housing developments. Once the new homes are built, supply meets demand and the market starts to balance out.
What this example also describes is the equilibrium lag time. Market corrections take time and the real estate market is relatively slow to respond. Homes aren’t built or sold overnight so there is a time lag between when an imbalance is recognized and the market adjustment actually occurs.
Factors that impact the real estate cycle
There are a number of factors that influence the real estate cycle and the rate at which it speeds up or slows down. The market is usually in flux because the underlying determinants of supply and demand (scarcity, desire, utility, purchasing power, and costs) are constantly changing.
A real estate market correction can be healthy for the overall economy because price adjustments on overvalued housing inventory creates buying opportunity. While damaging in the short-term for those who already own property, it’s a good scenario for wannabe homeowners.
A distinguishing feature about real estate is that demand must quite literally come to meet supply. Unlike other types of financial assets, real property and particularly the land it sits on cannot be physically moved — buyers must come to the home. This creates an inherent risk for homeowners. If the demand in your local market wanes, you can’t simply transfer your home into a higher demand market. Ultimately, homeowners have to wait out lulls and hope for the best.
Note: This article was originally written for realestate.com by Dana Bull