The Law of Supply and Demand Drives Bay Area Home Prices

The real estate market, like all other markets, is heavily influenced by the principles of supply and demand. This economic law dictates the equilibrium price and quantity of any good or service, including real estate. This article dives into the intricacies of how supply and demand affect the housing market, providing valuable insights for both buyers and sellers so they can fully understand how the law of supply and demand drives Bay Area home prices.

The Fundamentals of the Law of Supply and Demand

The core principles of supply and demand are pivotal in comprehending the dynamics of the housing market. Essentially, when the demand for a good or service surpasses its supply, prices rise. Conversely, when supply outpaces demand, prices fall. The law of supply and demand is universal Рit is a law, like the law of gravity.  It applies everywhere, in all markets, at all times in the past, present, and future and persists regardless of market conditions or the good or service being traded.

In the context of the housing market, these principles translate into the fluctuating prices of properties. This fluctuation is true for entire markets, specific zip codes, neighborhoods, streets – and even for individual homes.¬† Your home’s value (yes, your home too!) is likewise subject to the law of supply and demand, and its resale price will rise and fall accordingly.

How the Law of Supply and Demand Affects Your Home’s Value

I once sat down for a chat with Leslie Appleton-Young, who was then the Chief Economist for the California Association of REALTORS at the time.  Leslie used to put out these amazing yearly forecasts for the California housing market.  Given that there are so many inputs into her forecasting, I asked her what is the most important thing to look at to figure out which way home prices are heading.  She said it comes down to one thing: inventory.

Inventory is another way of saying supply – but when we talk about inventory in real estate, what we’re really talking about is months of inventory, or how long it would take to sell all the homes presently for sale, at the current rate of consumption (i.e., demand – also called the absorption rate), assuming no new homes were put on the market.

In other words, Leslie was saying that the direction for California home prices (and home prices anywhere) really comes down to the balance of supply versus demand.  And while that is true for the market as a whole, it is also true for your home as well.

The truth is, there is no one set price for your home.¬† The price that your home sells for depends on a number of factors, but key among them is demand for homes like yours, coupled with availability of supply for “similar” homes.

For the sake of argument, let’s say there are three homes for sale that are for all practical purposes identical. Imagine that they are the only homes for sale, and are priced at $1,000,000 and $1,500,000 and $2,000,000 – demand is going to be greater for the lowest priced home, and weaker for the highest price home. The law of supply and demand tells us that the lower priced home will attract competing offers and sell for much more than asking price, whereas the highest price home will likely attract no offers and may not even ever sell, as demand for that home at that price may be non-existent.

Demand in the Housing Market

The primary factor influencing the demand for Bay Area housing is its price. According to the law of demand, as the price of a good or service decreases, the quantity demanded increases. This principle applies to the housing market as well. As houses become more affordable, more individuals decide that they can afford to purchase a home, thereby increasing demand.

This is easily observable and is common sense.  Ask yourself this:  which homes would be more in demand:  single-family homes in San Jose that cost $1,000,000 or single-family homes in San Jose that cost $2,000,000?  Irrespective of factors like location, square footage, lot size, and condition Рeven accounting for all of those Рthe demand for the $1,000,000 home would be far, far greater than the demand for a $2,000,000 home.  It would not be twice as great Рit would be several orders of magnitude greater, because there are several orders of magnitude more buyers able to afford a $1,000,000 home vs. a $2,000,000 home.

Supply in the Housing Market

On the other hand, the supply of housing on the market (versus the absolute supply, that is, the total number of homes in existence) will vary considerably.  The law of supply and demand suggests that as demand for housing increases, the supply would increase to meet that demand, although the pricing for that housing would be dictated by just how much demand there is given the characteristics (i.e., age, square footage, lot size, etc.) of the home.

An interesting phenomenon we have seen in the Bay Area is that while demand has increased, supply has not kept up with demand.  This is due to many factors which have distorted the market.  For example, California Proposition 13, passed in 1978, has worked to incentivize homeowners to keep their homes for many decades, to keep the low property tax basis and pass it on to their children after they themselves leave this mortal coil. Likewise, the tax laws for inheriting property dictate that when you die, your property tax basis steps up to match fair market value at the time of passing, which means that for estate planning purpose, it is much better not to sell your property while you are still alive, further suffocating supply.

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Factors Influencing Demand and Supply

Several factors affect the demand and supply in the housing market. These factors can either stimulate or hinder the growth of the market, depending on their nature.

Factors Influencing Demand

The demand for housing is affected by an array of factors. A significant determinant is the mortgage interest rates. When rates are low, it costs less to finance a house, meaning homebuyers can afford more expensive homes on the same monthly budget. Other factors that influence demand include buyer demographics, consumer financial well-being, and societal norms towards homeownership.

Strength of the Jobs Market

The strength of the job market significantly influences the demand for housing, especially in a dynamic area like the Bay Area. Here’s a concise breakdown:

Job Market Growth: When the job market in the Bay Area is strong, with tech and other industries hiring, it attracts more workers. This influx of new residents increases demand for housing, as these employees need places to live. This is especially true for areas like Silicon Valley, which are hubs for high-paying tech jobs.

Higher Incomes: Strong job markets often mean higher salaries. People with higher incomes can afford more expensive homes, which drives up housing demand and, subsequently, housing prices. This is particularly relevant in the Bay Area, where tech jobs often pay well.

Investor Interest: A robust job market can attract investors who see potential in the housing market. They might buy properties for rental or resale, believing that the demand will continue to rise. This can further escalate housing prices.

Competition and Pricing: With more people vying for a limited number of available properties, competition increases. This can lead to bidding wars, driving up prices. In the Bay Area, where housing supply is often limited, this effect can be particularly pronounced.

Regional Variability: Different parts of the Bay Area might feel these effects to varying degrees. For instance, areas closer to major tech companies (e.g. Cupertino and Mountain View) or with better amenities (e.g. Saratoga and Los Gatos) might see more significant impacts on housing demand than more remote areas.

In summary, a strong job market in the Bay Area, particularly in tech-dominated regions like Silicon Valley, can lead to increased housing demand due to population growth, higher incomes, investor interest, and competitive housing markets. This interplay significantly shapes the real estate dynamics in these areas.

Rate of Household Formation

The rate of household formation is a crucial factor influencing housing demand in the Bay Area, particularly when considering the behaviors and preferences of millennials, which is America’s largest generation (eclipsing even the vaunted Baby Boomers). It is this rate of household formation that is putting pressure on Bay Area housing supply – even as the absolute population of the Bay Area has been in bit of a decline since the pandemic.

Here’s how it plays out:

1. Millennials Entering Market: As millennials age, they increasingly enter the housing market. This generation is now at a point where many are starting families or seeking to own their first homes. Given the Bay Area’s appeal due to job opportunities, especially in tech, there’s a significant influx of millennials looking for housing.

2. Shift from Renting to Buying: Millennials, who previously may have preferred renting, especially in urban areas, are now transitioning towards homeownership as they seek more stability and space. This shift adds to the demand for housing, particularly for starter homes and properties in neighborhoods perceived as family-friendly.

3. Preference for Certain Amenities: Millennials often have specific preferences, such as proximity to work, access to public transportation, and nearby amenities like parks, restaurants, and shopping areas. In the Bay Area, neighborhoods that offer these features are likely to see increased demand from this demographic.

4. Telecommuting Trends: With the rise of remote work, especially post-pandemic, many millennials are reconsidering their housing needs. Some may opt for larger spaces or locations slightly farther from city centers, affecting housing demand patterns in the Bay Area, including suburban and exurban areas.

5. Economic Factors: Economic stability and job market strength in the Bay Area directly impact millennials’ ability to form households. High-paying jobs enable more millennials to afford homes, but in high-cost areas like Silicon Valley and San Francisco, even well-paid professionals may find affordability a challenge.

6. Housing Supply Response: The rate at which new housing is constructed in response to this demand is also key. If supply doesn’t keep up with the increased household formation rate, it could lead to higher housing prices and more intense competition for available properties.  And low housing construction is something that has plagued California and especially the Bay Area since the 1980s.

In essence, as more millennials reach the stage of life where they form households and enter the housing market, their preferences and economic capabilities significantly influence housing demand in the Bay Area. This generation’s unique characteristics and the region’s response to these needs shape the real estate landscape, particularly in areas known for high economic activity and job opportunities.

Factors Influencing Supply

The supply of housing on the market available for purchase, on the other hand, is influenced by largely by economic factors.¬† To understand how economic factors influence housing supply let’s take a quick trip down memory lane.

Many of us easily recall the 2007-2008 mortgage crisis, which tanked the U.S. economy and brought on the Great Recession. While the Great Recession actually started in the housing sector, it quickly impacted the rest of the economy and caused millions of jobs to be lost. Even “safe” jobs with local, municipal, county, and state jobs were effected, with many local governments cutting budgets and furloughing employees, reducing income for millions of more Americans.

The widespread loss of job and reduction in income for people who still had job pushed a lot of people to sell their homes. Many people were forced to sell via short sale to avoid foreclosure; sadly, many others were actually foreclosed on and their homes sold by the banks as REO/foreclosure real estate.  This rapidly and dramatically increased the supply of homes for sale, driving prices down in many parts of the Bay Area by 30-70% in the span of a couple of years, during a time when demand was also weak due to mass layoffs, reduced income, and tightened credit standards.

The Impact of Government Policies

Government policies, laws, and regulations can significantly influence the balance of supply versus demand in the Bay Area housing market. Policies that encourage home ownership, such as lower interest rates, tax deductions for mortgage interest, and exclusions on capital gains tax can stimulate demand. Conversely, policies that restrict building or incentivize would-be sellers to keep their homes off the market will decrease the market supply of homes, pushing prices higher up.

The Role of Interest Rates

Interest rates play a crucial role in the housing market by impacting the affordability of homes. Lower interest rates make mortgage payments more affordable, which increases the demand for housing. Conversely, higher interest rates make mortgage payments more expensive, which can dampen demand.¬† Interestingly enough, it seems that it isn’t actually the absolute rate of mortgage interest that really affects demand.¬† Rather, it is the change in mortgage rates, rather than the actual rates, that temper or stoke demand.

That’s why it is actually common to have home prices rise even as interest rates rise.¬† When buyers believe that interest rates are set to rise, even if they are high now, they may enter the market in anticipation of rates rising later.

Supply and Demand Imbalance

As we saw in the aforementioned 2007-2008 mortgage crisis, imbalance in supply and demand can lead to significant shifts in the housing market. When demand outpaces supply, as seen in many urban areas, prices can rise rapidly.  This is something that occurred in 2020 and 2021, as the pandemic forced people to work from home, causing millions of people to look for more and better living space, often further out from city centers where they had more and better outdoor space as well.

While the change in demand for housing wrought by the pandemic is a good example of how demand can suddenly spike, there are other examples, such as¬† the relaxation in mortgage lending standards (100% financing liar loans) in the early 2000’s which caused demand to spike, leading to bidding wars, inflated house prices, and, ultimately, economic catastrophe.

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Market Equilibrium in the Real Estate Market

The point where the supply and demand curves meet is known as the market equilibrium. At this point, the quantity of homes that buyers are willing and able to buy equals the quantity that sellers are willing and able to sell. This balance between supply and demand determines the equilibrium price and quantity of homes in the market.

The Importance of Understanding Supply and Demand in Real Estate

Understanding the dynamics of supply and demand in the real estate market is crucial for anyone looking to buy or sell property. It can help buyers and sellers predict market trends, determine the fair value of a property, and make informed decisions. For investors, understanding supply and demand can help identify profitable investment opportunities, assess market risk, and maximize returns.

In conclusion, supply and demand play a critical role in shaping the housing market. By understanding these dynamics, buyers, sellers, and investors can navigate the market more effectively and make informed decisions. As the market continues to evolve, keeping a pulse on supply and demand trends will remain crucial for success in the real estate industry.

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About the Author
sebfrey
Seb Frey helps long-time Bay Area homeowners make their next move easily the next one yet. If you're looking for a minimum of hassle, maximum net cash on sale, and certain results, contact Seb today.