A financial bubble can be defined as the inflated, over-valued state of a market by unsustainable means. It is important to distinguish between what an asset is worth compared to its fundamental value.
A house is worth what a buyer is willing to pay for it. During the past few years, a typical single family home in Arcadia could be worth $1MM because people were willing to pay that dollar amount. On the other hand, its value is determined by its intrinsic offering – whether that is the shelter it provides or the cash flow it can generate. When I say “market fundamentals,” I am referring to the factors that contribute to its value, not worth.
It is important to define and understand market fundamentals because it helps illustrate the state of the market and how far away are we from the stable, historical trend. In this post we will take a deeper look at three big factors that are tied to proven fundamental values:
Supply & Demand
Comparable rents are directly related to market fundamentals because it gives a baseline measurement of the value and worth of a property. Whether you rent or own your house, you have a place to live – that is its worth. Its value comes from how the rent and home prices are tied. If you are an investor, you have to rent it for more than it costs you to own it on a month to month basis.
After all, it makes no financial sense to purchase a home when you can rent it for a fraction of the cost, giving the renter a chance to invest the extra money in another financial market at a higher yield. Then again, most people buy property based on emotional, not financial justification. Contrary to popular belief stemming from the lies of the National Association of Realtors, real estate is generally a poor investment in terms of rate of return. We will have to discuss this another time.
Incomes are directly tied to rents. That’s a fact. Why? Because most people pay rent with their salary/wages. Last I checked, there aren’t too many folks born with a golden spoon and just live life off daddy’s payroll. On top of that, have you ever heard of anyone applying for a $500,000 loan at the bank to pay rent? No. Rents are paid with after-tax, net, disposable income.
In my opinion, this is the single most important factor in market fundamentals. It’s at the very core of how much house one can afford to rent or buy. Interest rates are also important, but are secondary players since you don’t need a loan to rent a place.
Supply & Demand
As home prices go up and people realize that it’s cheaper to rent than to buy, the pool of buyers dwindle and supply of homes move up. When home prices drop back in line with the rental rates of comparable properties, the scale shifts and an increase in buyers join the market to absorb the supply of homes for sale. It’s basic supply and demand.
We can analyze it until we all turn blue in the face, but it all boils down to where to put the money. Spend it on an depreciating asset and strap yourself to the house because you can’t afford to do anything else? Or rent a comparable place for much less, invest the difference and add to the future-home-down-payment piggy bank? I think you know where I stand.
Arcadia home prices are falling and will continue to drop until it reaches its market fundamental value. This will take years.
9 thoughts on “Market Fundamentals”
One of the issues facing Arcadia real estate in particular is its proximity to more desirable areas. Arcadia is a really nice place, but if people aren’t originally from there, they will usually choose Pasadena, San Marino or La Cresenta-Flintridge first (if they can afford it). As far as prestige, Arcadia is the middle class ground between the mentioned cities and Alhambra and San Gabriel. It is difficult to understand how homes got to be 10X income. In North Carolina, where I am currently living, houses are between 3 and 4X income. Housing will probably suffer here, but much less than in SoCal because it has much less of a drop to go before rent-savers jump in.
I agree with you Carl. San Marino, La Canada and parts of Pasadena are more desirable than Arcadia. While Arcadia is a popular location for folks who can’t afford those other cities, it is also “the city” of choice for an even lower income class. This slightly lower income class have spilled into neighboring cities like Temple City and Monrovia, in turn driving the house prices up in those cities as well.
With conditions like that during the bubble, I’m not surprised to see homes prices at 10X income. I have a post coming up on what created the housing bubble.
Did you live in the SGV at some point? You’re fairly familiar with the surrounding cities. Enjoy your time in North Carolina. It’s beautiful there 🙂
I’m looking forward to seeing your post. I used to live in Orange County, but did go to the SGV quite a bit, since I am head-over-heels in love with the Huntington Library. I like North Carolina (and my new-found disposable income) but my wife misses SoCal greatly. I am following the housing crash to see if we can get back over there and get a reasonable house at some point.
If you like the Huntington Library, you’ll like Lacy Park in San Marino and the Arboretum in Arcadia too. They probably don’t have as many flowers as HL does, but it’s still gorgeous.
You have a great blog here. I like your analysis. As you might imagine, I totally agree with it.
Thanks for stopping by IR. I found IHB back in 2006 and still read it daily. You’ve done a tremendous job over there and I appreciate all the effort you put into it. Keep up the good work 🙂
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