Economist's Commentary: April 8, 2008

All Real Estate is Local, REALLY Local

By Ken Fears, Manager, Regional Economics

The current housing market has created many strange anomalies. For instance, why are foreclosures rising the fastest on the periphery of large cities? And, how come some areas of these large cities are actually experiencing price increases, while other neighborhoods in the same city are experiencing outright price declines?

On the way up in the last housing cycle, prices rose as interest rates fell. The demand that drove rising prices was strongest in the densely populated metro areas. These large metro areas tend to be priced closest to the limits of local affordability because of the proportionately denser demand relative to supply. Consequently, when interest rates fell, monthly payments fell and demand surged. In these markets, mortgage rates and affordability are a stronger determinate of demand than employment. Indeed, despite the fact that the economy was in a recession in 2001 and 2002, the national market experienced historic records for both sales volume and the median price in each of these years because of the robust sales in the large metro markets.

From 2001 through 2005, the national housing market experienced consecutive price and sales records following declining mortgage rates. The median national home price rose 52.9 percent from 2000 to 2005, while sales jumped 36.8 percent. But the more populous cities on the East and West Coasts appreciated even more.

Within these metro areas, prices rose first and reached the local limits of affordability in those neighborhoods that possess the traditional drivers of demand: access to public transportation, short commutes to work and schools, walkable neighborhoods, nightlife, better schools, etc. As each neighborhood reached its maximum local affordability, demand shifted to the next-best neighborhood and prices appreciated rapidly in that area. This pattern extended outward from the traditional drivers of demand. After setting 6 consecutive record years for median price, the strong sellers' market had forced buyers to sacrifice many of their desired amenities in hopes of just buying a home at a reasonable monthly payment. According to NAR's 2007 Profile of Home Buyers and Sellers which covers the homes sold in 2006, 35 percent of suburban respondents felt that they did not compromise on their desired amenities compared to 37 percent a year earlier. In 1997, 79 percent of the respondents to this same survey listed the quality of the neighborhood as a factor affecting their decision to buy, but by 2007, this figure had fallen to 46 percent. Meanwhile, the share of persons listing convenience to work, recreation areas, friends and family, and shopping as important to their purchase all rose. As buyers' desperation pushed them further into the suburbs, buyers paid a premium, in forgone amenities and higher prices for those that they could attain, just to find an affordable home. This frenzy kept sale prices high in the peripheral areas as a result.

Simultaneously, builders responded to escalating prices and profits with increased production. Builders often build in areas where land is relatively cheap because this helps their profit margins. Consequently, construction increased sharply in the peripheral metro areas, furthest from the fundamental drivers of demand. Since demand was robust and buyers' desperation was escalating prices at rapid rates in these more affordable areas, builders had large buffers built into prices.

Now that the market has slowed, buyers are refocused on the fundamental drives of prices. Consequently, demand and prices have slowed to a relatively greater extent in areas that are further from these market fundamentals. Since builders had large buffers built into their prices and large inventories to move, they could slash prices to move their product. The market for existing homes was forced to compete with new homes on price and this pattern resulted in a general depression of prices in these peripheral areas. Declining prices in these areas have made it difficult to refinance an existing home or to obtain financing for a new purchase. This problem has slowed new demand and increased foreclosures. Negative media coverage only compounded this pattern by scaring demand away.

During periods of uncertainty in financial markets, investors often turn to Treasury securities as they are viewed as having the least risk of all assets. This behavior is an attempt to preserve one's wealth and is referred to as a "flight to quality". Not surprisingly, during a housing market slowdown, when pockets of price deflation develop and uncertainty abounds, buyers will clamor to purchase in areas that are clustered closer to the market fundamentals. The belief is that by buying closer to the market fundamentals they can minimize any decline in the price of the home after purchase, thus, preserving wealth. Thus, one can observe a pattern where a metro area can have a neighborhood with falling or flat prices, while another neighborhood experiences resilient prices or even robust price growth.

After six years of an extreme sellers' market, these markets are experiencing a sharp transition to a buyers' market. During these periods of uncertainty, local expertise — the kind of knowledge possessed by a REALTOR® — is more valuable than ever.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >

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