Home Prices Will Continue To Seek Real Market Value (Market Forecast by Jeff Collins)

Amid discussions of bail-outs and buy-outs the critical question is what is a piece of real estate worth?

The determination of value is a function of interaction between would-be sellers and buyers reaching an agreement as to price. In the current environment, the inability of market participants to agree on price is at least partially to blame for the dearth of transactions in the real estate market.

Each participant in the exchange has a basis from which they determine value.

For the seller, expected sale price is often a function of recent sales of like property adjusting for idiosyncratic factors of the property they own.

In the current real estate market, the lack of transactions implies that sellers have few if any comparables upon which to base their perception of value.

Further, it is likely that most would-be sellers initially have an upward bias on the value of their real estate. In an uncertain market the tendency to over-price an asset clearly inhibits transactions.

Finally, certain types of property are simply not exchanging hands in the current market. Raw land for example, which in the best of times is difficult to value, is simply not moving.

For sellers unwilling or unable to lower prices, it is a waiting game for a buyer who perceives a value close to their own. In the existing housing market, where sellers are usually individuals, days on market has consistently risen over the last year and a half. This is a non-monetary cost to the homeowner. That is, homeowners trying to sell are trading a quick sale for sale price.

One reason many homeowners may be unwilling or unable to lower price is the level of debt to equity on their home. For sellers who pulled out equity during the boom period, current market prices may be inadequate to make them whole.

Potential buyers’ basis for determining value has changed significantly in the last 24 months. One of the most interesting and disturbing aspects of the market is the level of speculation — speculation in sub-markets that seldom experience such behavior. For example in some parts of the U.S., single-family housing actually experienced speculation.

Houses were bought with the intent of buyers holding for a brief period of time and then selling to take advantage of rapid appreciation. This inflated value and expectations of appreciation. It allowed homeowners to withdraw equity at levels that given the depreciation in some markets has left them upside-down.

The basis for determining value in the current market for a potential buyer has returned to fundamentals. That is, real estate has value because of the expected cash flows it will generate in the case of commercial property, or based on the expected cash flows of the household in the case of residential. Herein is a deterrent to consummating transactions from the buyer’s perspective.

Given the economic downturn, there is a great deal of risk to future cash flows. Business owners are uncertain about their ability to sell in the near-term. Potential homebuyers may be concerned about their employment but even if they are not, they have seen a sharp decline in their net worth as stock markets and real estate markets have depreciated. One only needs to examine consumer confidence or retail sales numbers to ascertain the outlook of the average American. Uncertainty is clearly eroding the buyer’s perception of real estate values.

Lastly, the impact of foreclosures cannot be omitted from a discussion of buyer perceptions of the real estate market.

Many buyers are waiting on the sidelines for further price reductions. These expectations are fueled by the belief that it is only a matter of time before the market becomes a fire sale.

The reality is that banks can no more afford to heavily discount price than can the homeowner who recently refinanced and pulled equity out of their house. In the end banks will choose to hold real estate assets and bide their time until the market improves rather than dump real estate they own.

In Northwest Arkansas, slow steady absorption of various types of property implies eventual return to equilibrium market conditions. That we have added almost 2,000 new non-farm jobs in the last year is strong evidence of the relative strength of the Northwest Arkansas economy. Once potential buyers perceive the economic strength of the region, the accurate perception of real estate values will be at hand.

(Jeff Collins, Ph.D., is an economist and partner in Fayetteville’s Streetsmart Data Inc. The company produces a quarterly report on all aspects of real estate in Northwest Arkansas. Collins may be reached at (479) 872-1000.)