The real estate market over the last several years has progressed through a number of phases. There is no doubt that a price adjustment has taken place in the real estate market in the last few years. Newspapers across the country have reported price adjustments in the residential market that seem to be affecting the entire nation but more heavily the east and west coasts.
During the years leading up to the recent correction, many property owners recognized substantial unearned gains as their property values skyrocketed. If an owner invested in an average house in January 2002 they would have paid roughly $145,000. Over the years, that value would have increased to $151,000 by the end of that year, then to $167,000 in December of 2003, on to $208,000 to end 2004, and to $284,000 at the end of 2005. Eventually, the investment suffered a loss back to $268,000 during the correction in 2006.
Year
Month
Price
Annual Gain (Loss)
Total Gain (Loss) Annualized
2002
Jan
145,240
Dec
150,862
3.9%
3.87%
2003
Dec
167,048
10.7%
7.51%
2004
Dec
207,688
24.3%
14.33%
2005
Dec
284,108
36.8%
23.90%
2006
Dec
268,193
-5.6%
16.93%
On the whole, the investment is very sound and has dramatically outperformed a 'typical' real estate market. For an individual who has purchased their primary residence and intends to live in it for some time, a small market correction such as this is not a factor. In fact, the investor who has owned an income producing property for some period of time has still gained an appreciable return on investment and likely has a low enough basis in the investment that rental income can cover costs. However, for an investor who acquired property at the market's peak that may not be the case.
The underlying data is shown with all monthly averages on the chart titled ?Change in Market Conditions.? This graph plots the average price of residential homes over time along with the number of transactions in any given month. There are a few areas of note to be identified. First, note the seasonality in the chart. Contrary to common belief, summer months are the peak sales period for our area. (See Mid Year Trends ? Market History. Also, note the price stagnation and reduction in transactions at the end of 2004. This period coincides with four hurricanes striking Florida. During this period it was extremely difficult to close sales because of insurance requirements. Further, compare the number of sales in 2006 to the previous few years. Clearly there has been a reduction in investor activity. Finally, recognize the trend inherent in the price graph. The graph shows a rise from a steadily improving market to a period of extended hyper-growth, followed by a peak and ultimately a small decline.
Back to the example of the investor who acquired property at the market's peak. The investor will have a very high cost basis. Given the number of properties on the market, it would be extremely difficult for him or her to recognize a gain on the transaction. The 'market conditions graph' highlights the advantages of long term investments.
Market Stages in our Recent HistoryOne of the most important factors to consider with any market is that they move through various stages. Whether an investor is considering stocks, housing, or widgets, there will be periods of growth, decline and flat markets. The ebbs and flows of the market create valleys and troughs that represent the best and worst of any market. Obviously it is always best to try to 'buy low and sell high?.
Over time, however, most markets in an expanding economy such as ours will move in an upward fashion. The long term investor is sure to reap the benefits of this overall growth. At the same time, there are instances where an investor would like to liquidate their capital for purposes of reinvesting elsewhere. The housing market is somewhat unique, also, because the vast majority of real property owners are not investors but are individuals who are using their investment for personal purposes. They live in them!
Because of this uniqueness, there are times when a property owner would like to sell and the current market state is irrelevant. By way of example, a young family may want to move to a larger house as their family expands; an empty-nest family may want to move to a smaller house to reduce expenses; a family may need to relocate to another area for career objectives or to be closer to extended family. In all of these cases, the value of the house may be a consideration but would probably not be the overriding factor. Rather, the sale of the house would be incidental to the reason for the lifestyle change.
In either case, when a real property owner would like to sell, they should be mindful of the current market conditions and take an approach to ensure that they can achieve their goals. Let's examine the market stages in further detail. We can use our recent history to see the various market stages. The graphs below are subsections of the more comprehensive graph shown above.
In any market stage, there are various pricing strategies available to us. It is important to review each of the stages and the pricing strategies in order to explore what works and what doesn't in each stage.
GrowthUsing the data from the chart above, we can focus on January 2002 to December of 2003 and add a trend analysis. The data clearly indicates that while there were fluctuations on a month to month basis, the overall gain in the marketplace was positive. This type of growth is expected in the real estate market and, everything else being stable, should continue at a reasonable rate.
Data from 2004 and 2005, however shows something more aggressive. Instead of the traditional growth cycle, the market entered into a period of hyper growth leading to a substantial increase in market activity as the prices spiraled upward. Investors clamored into the market in an attempt to improve properties and 'flip' them so to new buyers at ever increasing prices. During this time, many strategies had to be changed in order to conduct a transaction. It was not uncommon for many buyers to make offers on the same home.
FlatA flat market occurs when the price is neither increasing nor decreasing. We entered a flat market during the middle of 2005 and continued in it though the middle of 2006. During this time property values on the whole did not change dramatically. While there were subtle adjustments, the overall market neither contracted nor expanded. In fact, this time was highlighted by a lack of concurrence on the part of buyers and sellers. On the whole, buyers were willing to pay far less than sellers were asking. The result was a dramatic reduction in transactions that is obvious in the above chart.
DeclineOver the past twelve months we have seen a period of moderate decline. As record numbers of sellers flooded the market in order to attempt to capture premium prices, buyers receded from the market. Ultimately, an excess of supply and lack of demand reduced prices. The market continues to have dramatically higher supply than we had seen in previous years although it appears to be declining both as new buyers enter into the market and as sellers recognize that they can not sell homes at the extreme prices that were being offered eighteen months ago
Pricing Strategies in Various Market CyclesWhen it is time to sell a property, each market cycle offers unique challenges. For purposes of this discussion, we will assume that a seller wishes to maximize the dollar volume of their investment while trying to move the property in a reasonable period of time. It should be made clear that property owners may have a wide variety of reasons for selling and each has its own merits.
Growth market in any market cycle, one of the challenges is to determine where the market will be tomorrow. When a seller is in a growth market, it is tempting to wait until the market reaches a peak in order to maximize our return. There are a few flaws with that strategy. First, the peak is difficult to detect. Even after we have crossed over it can be difficult to see that we have passed the mark. If we could see it coming as easily as on a historic graph things would be much simpler. Second, once we've reached the pinnacle, the buyers step away from the market and sellers step in. At that point, values are already starting to decline. Finally, if an investor needs capital, he or she must sell the property.
Given these issues, please review the simplified example above. If we believe that we are in a growth market, one strategy is to price slightly above what we believe to be market value. Market value can be determined by reviewing comparable, current sales or through an appraisal. In a growth market, we can price above the market value and wait for the market to 'catch up?. In theory the property will sell whenever the asking price (yellow) falls below market value (pink). In this example, it should sell at the intersection of the two lines.
The difference between an asking price and the current value should be determined based on a few factors. Primarily we should be concerned about our opinion of the market. The higher the asking price is above the market value, the greater the risk that the market may shift before reaching our price. Further, we should consider the amount of time that we have for a sale. The higher our asking price, the longer it will take for the market to recognize our price.
This strategy was widely used during the growth and hyper growth periods leading into 2005 but will not work in our current market.
Flat MarketA flat market brings one of the largest challenges. When we are in a flat market it is very hard to predict where we will be heading next and how long it will last. In a flat market there is the obvious danger that the market will begin to decline. In the example below, the market value of the property is represented by the pink line. Any asking price below that line should represent a sale. However, with no substantial change to market value, a list price above market value will not sell. In this case, our strategy of pricing slightly above market will fail and the property will not sell. In order to move a property during a flat market, the best strategy is to price as close to market value as possible.
Because the housing market allows for some give and take during the offer and counter offer process. An asking price very close to market value may generate buyers who are willing to offer the highest possible price. However, a flat market is often highlighted by reduced transactions (as is the case between late 2005 and mid 2006) meaning that market value is more elusive as there are fewer comparable sales.
Declining
A declining market represents the highest risk of all three market stages. First, let's review the common strategy of pricing just over market value in an attempt to generate the highest possible sale price. In the example below, the seller has prices slightly higher than market value. As is the case in the flat market, the asking price (yellow) will not fall below the market value (pink) and the property will not sell. However, in this case the outcome is even more severe. Not only is the property not likely to sell but the value is getting further and further from the ask price. While this is obvious when shown in graphical format, it is perhaps one of the most common tactics used in residential real estate today.
Chasing a Declining MarketAnother common mistake when pricing in a declining market is a strategy called 'chasing the market?. It is not uncommon to see a property whose price has been adjusted time and time again over a listing period but without ever reaching current market value. This strategy is used as sellers try to maximize their return while still generating a sale. Invariably, the result is a longer sale for less money. The property generates a lower sales price than if it had originally been offered at a more aggressive price or reduced once to consider market value. In addition, the strategy leaves the property on the market for a longer period of time which incurs, at a minimum, tax and insurance costs. It likely will also incur a myriad of other holding costs and increase marketing expenses. A recent review of a number of properties currently for sale in the multiple listing service showed that 49% had a price change of some sort. These sellers are likely chasing the market.
Pricing based on active properties. Current market value is best determined based on recent closed transactions. However, in a hyper growth market it is not uncommon to see sellers determine the sales price based on the current asking price of other, similar properties (active asking price). The fundamental flaw with the strategy is that the asking price only represents one side of the transaction. It does not represent a meeting of the minds of a buyer and seller but is rather what a seller would like to receive.
However, there is one instance where the active asking price can become a factor. The current ask price of similar properties on the market can be used as an absolute ceiling. Let's take a simple example in which there are 100 identical units in a condominium. Ten units were sold last month. There are ten more for sale. Each of the ten units that sold last month was sold at $500,000. It would seem reasonable that the market value of any unit in the building is $500,000. However, if the ten that are for sale this month have an asking price of $400,000 each, it is likely that the market has shifted since the previous units had the meeting of the minds between buyers and sellers. If a new unit were placed on the market with an asking price of anything over $400,000, the seller would be forced to wait until the ten new units were all sold before his would be sold. Obviously this is an overly simplistic example but it represents an important factor.
Cost based pricing. One of the most common approaches to determining the asking price for a piece of property is to analyze the costs associated with it. Let's take the following example:
Purchase Price 100,000
Taxes Paid
5,000
Insurance Paid
10,000
Closing Costs
5,000
Net
120,000
Sales Commission
8,400
Net Costs
128,400
A buyer purchases a piece of property for $100,000. The buyer holds the property and pays taxes, insurance, and other costs. The total net cost of the property is $120,000. To sell the property will require a real estate commission so the total sales price should be $128,400. Often, the seller will add in a little 'wiggle room' and price it slightly higher.
Unfortunately, the market does not care about your costs. The market only cares what a reasonable price is for the property. If the property is worth $200,000, it will easily sell for $130,000. However, if the market is still flat, the property is likely still worth $100,000. This type of analysis has become more and more common with the creation of 100% financing and interest only loans. All too often a property owner has purchased a home based on a maximum amount that they can afford and has never been able to service the principle of the loan. Instead they pay only the interest due. In those scenarios, the current mortgage is likely the same as the original purchase price. In a declining market that means that the seller may have less equity in the property than they currently owe to the bank. Unfortunately, the cost basis is irrelevant to the market.
As an example I?ve used to clarify the weakness of cost based pricing, consider a call to your stock broker in which you say ?Larry, please sell the 100 shares of XYZ that I bought last year fro $100 each. I?d like to cover your commission on the buy and sell side so let's sell them for $140 each.?
Worse, consider if the shares are currently trading at $50. What is the broker going to tell you? Stocks, like anything in a free market can be sold only for a price that both the buyer and seller agree is reasonable. Attempting to sell at too high a price based on your needs simply does not work.
Summary
We've examined the various market cycles and have reviewed a number of strategies that are used and a series of common mistakes. The truth is that pricing in an adjusting or declining market is simply more difficult. It tends to include conversations that lead to anxiety. When the market is declining some people will lose money. Luckily, those that are in the market for a long period of time are often very secure. You need only to look at the gains that occurred prior to 2005 to see that there are earnings out there and plenty of them.
Given all of the information above, what is the best strategy associated with declining markets? First, consider your objectives. If you can wait for the long term, don't sell. However, if the decline lasts for longer than you expected, the long term may be a while. If you decide that you need to sell now, be aggressive. Think about an aggressive pricing model that will help your home to move quickly. Even in a declining market, properties are offered which generate excitement. These are the properties that will create a sale for the owner and will throw off cash.
Work with a professional to determine the current market conditions. Build a value model based on similar properties which have recently sold. When considering similar properties, find several and eliminate the highest and the lowest priced. For each recent sale, identify attributes of the property which could have positively or negatively affected the value and make adjustments accordingly to develop true comparable data. Use the aggregate of all of these sold properties to determine market value. Repeat the process to determine the adjusted asking price of those homes on the market now. Remember that the sold homes represent the market value unless the asking prices are lower in which case the market has shifted and the adjusted asking price may represent the market.
Using the lower of the two as market value, consider how much risk you are willing to take. If you are a risk averse person, chose a price considerably below this new market value. If you are risk inclined then consider pricing at the market value. Regardless of your risk profile, be ready to make adjustments as the market shifts.
