Sometimes it’s best to get back to basics when it comes to investing, finance, and economics. And what could be simpler than supply and demand? This month we’re going to talk about how the fundamentals of supply and demand can help us predict long-term appreciation in market value.
For those of you who have never taken a business class, supply and demand are simple and intuitive concepts. For every good / service / thing in the economy there is supply (how much of it is there) and demand (how much people want that thing).
Supply and demand are generally explained as two curves, or basically two lines, as in the following figure.
There is a supply line (S) that represents the behavior of the sellers in the market – because sellers control the supply. This could be a business or, more relevantly, a homeowner. The supply curve is generally up and to the right, which indicates the willingness of sellers to sell more of something when the price goes up. When house prices rise, more sellers will be ready to sell their properties.
The demand curve (D) represents the buyers in the market. Demand curves are almost always sloping downward, suggesting that, in general, the less it costs, the more willing buyers are to buy. Again using the example of real estate: when prices fall in the market, more people are willing to buy houses.
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 a balance. This happens when you are negotiating a property, it happens a million times a day in the stock market, and it even happens in sales and promotions at your local grocery store. Supply and demand are the most basic pillar of our economy.
The pandemic has seen some examples of the supply and demand for steroids in recent months. My personal favorite was the toilet paper craze from March 2020.
Usually, the supply and demand for toilet paper remains relatively constant. People usually need toilet paper at a constant pace, suppliers know how much the market needs, and the price stays stable.
Until last year, when the demand for toilet paper grew far too fast for suppliers to adjust their logistics, which previously focused more on the supply of toilet paper for commercial needs. People were stealing single-ply papers from their offices, Costco restricted bulk shopping, prices on Amazon were skyrocketing – it was a frenzy. All because of a peak in demand.
Could this happen to real estate? On the scale of toilet paper? Probably not.
But it begs the question, what is driving real estate demand (and home prices)?
In reality, many things play a role here, but the simplest thing is the population. How many people are there in a city (demand) compared to how many apartments (supply)? If a city’s population is growing faster than the number of apartments in the city, house prices are very likely to rise.
With that in mind, I’ve put together a list that I’m really looking forward to. It uses census data to measure supply and demand from 2010-2019. I then combined that with some BPInsights data to show 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, I’ve created a new metric that answers the question, “How many new people are moving into a city for each new unit built?”
Note that these are not the fastest growing cities in the US. These are the cities where demand (represented by population growth) exceeds supply (as measured by the total number of units in the city).
At the top of our list is Cambridge, Massachusetts, where a new unit has been built for 36 people who have moved to the city since 2010. How does this work? Well, I guess with all these college students, people get roommates.
These cities all have populations that are growing faster than they are adding units. This will put a lot of pressure on prices.
A growing population also increases the city’s tax base so cities can provide more basic services, build infrastructure, and support their populations. All positive things also for recognition.
Below you can also see the rental-price ratios and the growth rates for these cities over the same period.
This is in line with many of the patterns we see in our BPInsights data: there is generally a tradeoff between cash flow and appreciation. These markets tend strongly towards the appreciation side of the equation.
Of course, aside from population growth, there are other factors that affect these numbers, but you can see from the eyeball test alone that these cities are generally highly valued.
However, there is cash flow real estate in all of these markets. I guarantee it. If you can find a cash flow deal in any of these markets it could lead to a home run.